Final Exam, Econ 10, Fall 2007
PART 1 OF 4
NAME_________________________________________
RECITATION INSTRUCTOR_____________________
Instructions for Dr. Eudey’s Fall 2007 Econ 10 exam:
•
•
•
•
•
•
•
There are 4 parts to the exam. Write your answers in the space provided.
This is a 120-minute examination. You have twenty minutes for review.
Show all work. Use diagrams where appropriate and label all diagrams
carefully.
Write your name and your Recitation Instructor’s name on the top of the
front page of each part of the exam.
This exam is given under the rules of Penn’s Honor system.
All exam pages, blank or filled, must be handed in at the end of this exam.
No exams may be taken from the room.
The use of Programmable Calculators is in violation of Departmental rule. It
is strictly forbidden.
Part 1 Monetary Policy (10 points, 25 minutes)
1. The FOMC is expected to further reduce the target federal funds rate at its next
policy meeting December 11.
a. (2 points, 4 minutes) Show the graph for the market for money (money
supply and money demand).
½ point: both axes labeled
½ point: both curves labeled (may say “M2” or “MS” for supply)
½ point: initial interest rate shown
i
Ms1
Ms2
i1
i2
Md
M2
b. (2 points, 5 minutes) Explain in words how the FOMC can use an open
market operation to target a reduction in the federal funds rate.
½ point: Fed buys government securities
½ point: Checks deposited, so banks have more reserves
½ point: Banks (may) make more loans (because have more reserves)
½ point: Loans are less scarce so interest rates (or can say “the federal funds rate”)
fall.
c. (1 point, 2 minutes) What is the deposit multiplier formula?
Full credit if say “required reserve ratio” rather than “reserve ratio.
Don’t need to define “rr” or “rrr” if they just write it in notational form.
Deposit/money multiplier = 1/rr where rr = reserve ratio
d. (2 points, 6 minutes) Use your graph from Part A to show the impact on
equilibrium interest rates of a reduction in the target federal funds rate.
Make sure to explain any shifts in or movements along curves in your
graph.
½ point: M2 increases as lending increases (or can say as reserves increase)
½ point: Money Supply shifts right in the graph
½ point: As rates fall the opportunity cost of holding money falls
½ point: and show move along Md to new equilibrium
e. (1 point, 2 minutes) Based on your answer to Part E, how might a policy
to lower the target federal funds rate cause an increase in Aggregate
Demand? Explain.
½ point: Lower rates means a lower cost of borrowing
½ point: so firms buy more Investment goods and AD increases.
(Or can say r>i as rate of return from Investing exceeds the fallen cost of getting a
loan so I increases and AD increases.)
f. (1 point, 3 minutes) Explain one reason that current monetary policy
efforts to stimulate Aggregate Demand may fail. (In other words, what is it
about the current economic environment that may make monetary policy
like “pushing on a string”.)
(At the same time that banks have more reserves, which may make them more
willing or able to lend), the housing crisis may be making every loan riskier than it
was before, so they are still unwilling to lend.
g. (1 point, 3 minutes) What are the two official policy goals of the U.S.
Federal Reserve System?
½ point: price stability (or can say inflation stability)
½ point: unemployment near its equilibrium level (or can say at the level
implied by full employment; if say unemployment stability then deduct ¼
point)
Final Exam, Econ 10, Fall 2007
PART 2 OF 4
NAME_________________________________________
RECITATION INSTRUCTOR_____________________
Instructions for Dr. Eudey’s Fall 2007 Econ 10 exam:
•
•
•
•
•
•
•
There are 4 parts to the exam. Write your answers in the space provided.
This is a 120-minute examination. You have twenty minutes for review.
Show all work. Use diagrams where appropriate and label all diagrams
carefully.
Write your name and your Recitation Instructor’s name on the top of the
front page of each part of the exam.
This exam is given under the rules of Penn’s Honor system.
All exam pages, blank or filled, must be handed in at the end of this exam.
No exams may be taken from the room.
The use of Programmable Calculators is in violation of Departmental rule. It
is strictly forbidden.
Part 2: Oil (10 points, 25 minutes)
a. (2 points, 5 minutes) Show long-run equilibrium in the graph where AD=AS
at AS(LR). (In other words, show equilibrium at trend GDP.)
Deduct ½ point if don’t label axes
Deduct ½ point if don’t label curves
Deduct ½ point if don’t show initial price
b. (1 point, 2 minutes) Explain why rising oil costs are equivalent to falling
productivity (from the firm’s perspective).
The firm is forced to use less-efficient means of production (though they will
be more fuel-efficient and “greener”) and so it can produce less at any price
(or can say costs rise at any level of output).
c. (2 points, 5 minutes) Explain the impact on AS(LR) if the price of oil
continues to rise. Show this in your graph from Part A.
½ point: Equilibrium full employment falls (or can say equilibrium K
stock falls)
½ point: so trend GDP falls
1 point: AS(LR) left
d. (2 points, 5 minutes) Explain the impact on AS if the price of oil continues to
rise. Show this in your graph from Part A.
½ point: Scarcity of oil will drive up costs for firms (or can say produce
less at any price as productivity falls)
½ point: prices must rise at any level of output to cover higher costs
1 point: AS shifts up (to the left)
e.
(2 points, 5 minutes) Although it is commonly understood that rising oil
prices will cause inflation in the U.S., the impact on the inflation rate is in fact
ambiguous (unclear). Explain why this is so and illustrate that explanation
graphically.
1 point: The fall in productivity means that returns from I fall and so I
falls (can say r falls below i) and AD falls (or can say C falls with the fall
in future expected wealth, or that firms can’t buy as much I if spend
more on oil—this is a real balances effect described in the book)
½ point: AD falls (show graphically)
½ point: both AD and AS fall, so net effect on prices is ambiguous
AS(LR)2
AS(LR)1
AS2
P
AS1
P1
AD1
AD2
GDP2
GDP1
GDP
f. (1 point, 3 minutes) Explain why substitution bias may cause the CPI to overestimate inflation when energy prices are rising.
When energy prices rise, households reduce their cost of living by substituting into
energy-efficient products. The CPI assumes that households buy the same goods as
in the base year (before energy prices rose so much) and so there is a bias in the CPI
that makes it look like the cost of living is higher than it is.
Final Exam, Econ 10, Fall 2007
PART 3 OF 4
NAME_________________________________________
RECITATION INSTRUCTOR_____________________
Instructions for Dr. Eudey’s Fall 2007 Econ 10 exam:
•
•
•
•
•
•
•
There are 4 parts to the exam. Write your answers in the space provided.
This is a 120-minute examination. You have twenty minutes for review.
Show all work. Use diagrams where appropriate and label all diagrams
carefully.
Write your name and your Recitation Instructor’s name on the top of the
front page of each part of the exam.
This exam is given under the rules of Penn’s Honor system.
All exam pages, blank or filled, must be handed in at the end of this exam.
No exams may be taken from the room.
The use of Programmable Calculators is in violation of Departmental rule. It
is strictly forbidden.
Part 3: Following the Economy (10 points, 25 minutes)
1. (3 points, 7 minutes) Explain three reasons that falling housing prices might now
negatively impact U.S. Aggregate Demand. Make sure in your answer to indicate
which Aggregate Expenditure component of AD will be affected.
1 point per reason, ½ point within each for the explanation of why it is relevant for
Aggregate Demand.
Likely answers are:
There is less residential construction, which is part of I.
There is less borrowing against the value of the home to finance Consumption
spending because houses are worth less and also many would-be borrowers are now
unable to get loans in the risky market (C down so AD down).
Households have re-evaluated their lifetime wealth, and now that home prices are
falling they realize they need to save more for retirement and other expenditures. (C
down as Savings up and AD down)
2. (6 points, 15 minutes) It is difficult to know the impact of the housing crisis on
the current economy. Economic analysts will often look to the employment and
unemployment data as timely indicators of changes in Aggregate Demand and
Aggregate Supply.
a. (2 points, 5 minutes) How are the employment data collected? What is one
weakness of these data? Explain what the problem is and why it may make
the data misleading.
1 point: The employment data are collected from a survey of (don’t need
to say large) firms.
½ point: one problem is that it is a survey only of large firms
½ point: Sometimes large firms behave differently from small firms, so
the data are not very representative of what is happening in the aggregate
market. (Or you can say a few reporting errors by a few firms can really
mess up the data and lead to large revisions and misperceptions about the
labor market until those revisions are made.)
b. (2 points, 5 minutes) How are the unemployment data collected? What is
one weakness of these data? Explain what the problem is and why it may
make the data misleading.
1 point: The unemployment data are collected from a household phone
survey
1 point: One weakness of the data is that the pool of respondents is biased
toward the unemployed simply because the working population is
unlikely to be willing to participate in the survey.
c. (2 points, 5 minutes) How are the unemployment insurance claims data
collected? What is one weakness of these data? Explain what the problem
is and why it may make the data misleading.
1 point: The unemployment insurance claims data are just the number of
people claiming unemployment insurance from government agencies in
any week.
1 point: One weakness of these data as a measure of unemployment is
that not all unemployed workers are eligible for unemployment
insurance—in particular the long-term unemployed do not show up in
the data.
3. (1 point, 3 minutes) In our labor market graphs for Econ 10 there is no
equilibrium unemployment, yet unemployment seems to exist in the real world
even when labor markets are “at rest” or in equilibrium. Using the language from
class, briefly explain why it is an equilibrium to have some people unemployed on
average.
Frictions in labor markets make it take time for firms and workers to find a
good match, and so there will be frictional unemployment while this search is
underway. There is always a certain fraction of the population engaged in this
search, and so there is always a certain fraction unemployed. (Answers to this
question may be significantly less elegant! Try to read them carefully.)
Final Exam, Econ 10, Fall 2007
PART 4 OF 4
NAME_________________________________________
RECITATION INSTRUCTOR_____________________
Instructions for Dr. Eudey’s Fall 2007 Econ 10 exam:
•
•
•
•
•
•
•
There are 4 parts to the exam. Write your answers in the space provided.
This is a 120-minute examination. You have twenty minutes for review.
Show all work. Use diagrams where appropriate and label all diagrams
carefully.
Write your name and your Recitation Instructor’s name on the top of the
front page of each part of the exam.
This exam is given under the rules of Penn’s Honor system.
All exam pages, blank or filled, must be handed in at the end of this exam.
No exams may be taken from the room.
The use of Programmable Calculators is in violation of Departmental rule. It
is strictly forbidden.
Part 4: (10 points, 25 minutes)
1. (2 points, 5 minutes) Explain why a government budget deficit may cause
“crowding out” of private investment spending.
½ point: Increased borrowing by government is an increase in the demand for loans.
½ point: Consequently, the price of loans will increase.
½ point: As the cost of borrowing (of getting a loan) increases (i up), borrowing by
firms will fall
½ point: which causes I to fall.
2. (2 points, 4 minutes) Explain two factors that may make Social Security unable to
pay for itself.
1 point: There will soon be more people collecting social security benefits than
are paying into the system (two separate factors for full credit might relate to
this: baby boomers retiring while fewer younger workers paying into the system
and old people living longer but young people not paying into the system longer)
1 point: Welfare aspects of the system that allow some recipients to earn more
than they put into the system so it is no longer just “forced savings” and
therefore no longer self-financing.
3. (1 point, 3 minutes)Explain why it is that, in spite of the two factors you describe
in Question 2, there is likely little or no problem with financing of the U.S. Social
Security system.
If productivity growth continues at historically “average” rates, then the wage
increases of the young will be enough (or maybe nearly enough) to generate enough
revenue to compensate for the large expenses outlined in Question 2.
4. (2 points, 5 minutes) Explain how fiscal policy automatically stabilizes
movements in Aggregate Demand (i.e. how do automatic or built-in stabilizers
make business cycles smaller?). Make sure to explain how automatic stabilizers
reduce the magnitude of both increases and decreases in Aggregate Expenditures.
1 point: Stabilizing recessions: Transfers to those whose incomes fall are
automatic (e.g. welfare and unemployment insurance payments rise as income
falls), which keeps the consumption spending of those households from falling as
much, which keeps AD from falling as much as it otherwise would.
1 point: Stabilizing expansions: Income taxes reduce the disposable income of
households as their incomes rise and therefore reduce their spending power as
incomes rise: Consumption spending therefore rises by less during expansions
than it would in the absence of income taxes.
5. (3 points, 8 minutes) Policy and the widening U.S. wage gap.
a. (2 points, 5 minutes) The wage gap between skilled and unskilled workers
has been increasing in the U.S. over the last ten years or so. Based on the
lecture material and course readings, explain two reasons for this
phenomenon. [Note: no graph necessary.]
1 point per reason so long as it makes good economic sense and is related to the
readings. Likely reasons are
•
Productivity is rising for skilled workers faster than for unskilled workers
therefore workers are worth relatively more in that sector (deduct ¼ point if
don’t point out link to wages or “what workers are worth”, don’t deduct
anything for not explicitly saying productivity is rising faster than for
unskilled workers—we can assume ceteris paribus for all unmentioned
things in both questions and in answers!)
•
Prices are falling for unskilled workers because of international competition
and so unskilled workers in the U.S. are worth less (deduct ¼ point if don’t
make link to wages or what the workers are “worth”)
If productivity growth continues at historically “average” rates, then the wage
increases of the young will be enough (or maybe nearly enough) to generate enough
revenue to compensate for the large expenses outlined in Question 2.
b. (1 point, 3 minutes) Do you think policymakers should do anything to
address the widening U.S. income distribution? Explain one reason to
defend your position.
All the credit comes from the explanation. Likely answers will say that either there
is no need to do anything because the incentives are already there for workers to get
educated (so the problem is short-term and doesn’t need intervention), or that more
incentives need to be created (more student loans to the needy), or that educational
access is not available to all (racism or just inter-city problems) and so policy needs
to address that.