AMERICAN UNIVERSITY
Department of Economics
Comprehensive Examination
ECON 01A – MA Theory
January 2005
Page 1 of 4
Instructions: You must answer both the macroeconomics and microeconomics sections of this
exam. Each section receives equal weight in the grading. Plan to spend two hours on each
section. Make sure you follow the directions in each section carefully.
MICROECONOMICS SECTION
Directions: Answer the indicated number of questions in both Part I and Part II. Pay strict
attention to the suggested time allocations.
PART I: SHORT-ANSWER QUESTIONS. CHOOSE (2) OF THE FOLLOWING (SPEND ABOUT 15
MINUTES ON EACH).
1. Suppose that butter and margarine are substitutes and that most butter in England is
imported, while most margarine is produced domestically. Assume that butter is a
homogeneous good, so that domestic and foreign butter are perfect substitutes, and that
margarine cannot be traded internationally. Is the following statement true, false or
uncertain? (Explain your answer briefly.)
“A binding import quota on butter would lead to an increase in the
domestic production of butter which would decrease the price of
margarine.”
2. Will doubling the fine do better in deterring speeding than doubling the probability of
being caught if drivers are risk-averse? Does the same hold for risk-loving Ferrari
drivers? (For simplicity, assume that the driver’s decision is either to speed or not and
that, in the absence of punishment, drivers would prefer to speed.)
3. In the city of Metropolis, entry is restricted into the market for taxicabs, and a driver is
permitted to operate a cab only if she has a medallion. The total number of medallions
has been fixed at 1000 for 25 years, but medallions can be bought and sold. The current
price is $100,000. The mayor is concerned about the shortage of cabs and has come up
with a novel plan. Based on careful study that shows that, without entry restrictions,
there would be twice as many cabs in operation, the mayor wants to double the number of
medallions issues. Realizing that the current taxicab operators are unlikely to welcome
increased competition, the mayor proposes that an additional medallion be issued to the
new owner of each current medallion. The owner will then be free to do whatever she
wants with the new medallion, such as selling it. You are the economic advisor to one of
the 1,000 medallion owners. She wants to know whether to support the mayor’s plan or
oppose it. What do you tell her and why?
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PART II: LONG-ANSWER QUESTIONS. ANSWER ALL THREE (3) QUESTIONS (SPEND ABOUT 30
MINUTES ON EACH).
4. Suzy Scurvy gets utility from consuming steak and potatoes according to the utility
function:
Suzy has $w dollars to spend on the two goods.
(a) Find Suzy’s Marshallian (uncompensated) demands for steak and potatoes as a
function of her income, the price of steak (ps) and the price of potatoes (pt), and her
indirect utility function. What is Suzy’s price elasticity of demand for steak?
(b) Calculate Suzy’s Hicksian (compensated) demands for steak and potatoes as a
function of the prices of the two goods and her utility level (u), as well as her
expenditure function.
(c) Now assume that the price of steak and potatoes increases to qs and qt, respectively.
How much additional income would Suzy have to be given in order to compensate
her for the price change?
5. U.S. Steel produces tons of cold rolled steel according to the production function:
where K is the number of units of capital and L is the number of units of labor.
(a) Define w as the price of a unit of labor, and r as the price of a unit of capital.
Calculate the firm’s long-run cost function, C(w,r,q).
(b) If this firm operates in a perfectly competitive environment, calculate its supply
function and profit function.
(c) Union contract negotiations temporarily fix U.S. steel’s labor force at 100
workers. Calculate the firm’s short-run cost function.
6. A single monopolist producer of widgets faces the demand curve P = 10 – Q, and has a
cost function of C(Q) = 4 + 2Q.
(a) What is the level of production (Q), price and total profit of the monopolist.
(b) Now assume that a second firm enters the market with a cost function of C2(Q2) = 3 +
3Q2. If the two firms behave cooperatively and act as a cartel, what is the joint
maximizing level of output? How much will each firm produce?
(c) Assume that cooperation breaks down between the two firms, and the two firms
compete by simultaneously choosing quantities (like in the Cournot model). How
much will each firm produce in equilibrium? What is the market price? What will be
the profits of the two firms? How much should the original firm be willing to pay to
purchase firm 2 if collusion is illegal, but a takeover is not?
(d) Now assume that the original firm is able to act as a market leader and choose its
quantity prior to firm 2 (like in the Stackelberg model). How much will each firm
produce in equilibrium? What is the market price? What are the profits of the two
firms?
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MACROECONOMICS SECTION
Directions: Answer one question from Part A, one question from Part B and three short answer
questions from Part C.
PART A. Answer one question.
1.
(a) Explain in detail the monetary transmission mechanism (i.e., the effects of an increase
in the money supply) in a closed economy in the short run. Be sure to use an IS/LM
graph to illustrate your explanation. (b) How is the short run monetary transmission
mechanism altered in a open economy with perfect capital mobility and a flexible
exchange rate (the Mundell-Fleming model)? Include a version of the IS/LM graph along
with your explanation. (c) Explain how the short run effectiveness of monetary policy
would be altered in a system of fixed exchange rates, also assuming perfect capital
mobility. Again illustrate with a version of the IS/LM model.
2.
(a) Explain the short run effect of a fiscal expansion in a closed economy using the
IS/LM framework. Explicitly show and explain the potential role of “crowding out,”
assuming a traditional monetary policy that holds the money supply constant. (b)
Suppose the monetary authority (central bank) instead follows an interest rate targeting
rule. What steps will the central bank take and what effect will this have on the response
of real GDP to the fiscal expansion? Show the effects on a graph and explain. (c)
Analyze the long-run impact on the economy of the fiscal expansion using aggregate
demand and aggregate supply (AD/AS) graphs. (You may assume either of the monetary
policy responses from part a or b; you do not need to consider both. For students who
used the Blanchard text, please note that “long run” here means what Blanchard calls the
“medium run.”)
PART B. Answer one question.
3.
(a) What are the assumptions behind the classical macroeconomic model? (b) Write the
basic equations of the classical model. (c) Use the classical model to analyze the
consequences of a positive shock to technology. Be sure to include graphs of the
production function, the labor market and the aggregate demand and supply model. (d)
Separately, explain in detail the consequences of an increase in the money supply in the
classical model. Include the graphs of the classical model in your answer.
4.
The citizens of a country have increased their saving rate. (a) What are the effects on the
long-run growth of the economy, according to the neoclassical (Solow) growth model?
Be sure to analyze the effects on steady-state equilibrium levels of output per worker (per
capita), capital per worker, and income distribution (the real wage and rate of return to
capital), as well as on the growth rate, and explain your results both graphically and
intuitively. (b) What are the short-run effects of an increased saving rate (consider a
reduction in the marginal propensity to consume) in a Keynesian macro model (you may
use either original Keynes or Keynesian IS-LM)? Why are these short-run effects more
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or less beneficial than the long-run effects predicted by the Solow model? Explain the
key differences in assumptions that account for these different views of increased
savings.
5.
(a) Explain the meaning of the steady state equilibrium condition in the neoclassical
(Solow) growth model. (b) What are the consequences of a decrease in the saving rate in
the neoclassical growth model? Explain in detail and demonstrate using a graph. Also,
summarize the effects on the level of per capita real GDP and the growth rate of per
capita real GDP. (c) What are the main elements of an endogenous growth model based
on a learning-by-doing premise? (d) What are the consequences of a decrease in the
saving rate in the endogenous growth model? Explain and show these on a graph.
PART C.
SHORT ANSWER.
Answer three questions.
LIMIT YOUR ANSWERS TO TWO PARAGRAPHS EACH!
6.
What does the endogenous growth model predict about the relative growth performance
of two countries with the same saving rate but different starting values of the capital
stock?
7.
Explain the term “monetary neutrality.” Is this concept an argument for or against using
monetary policy to stabilize output? Explain carefully.
8.
What constitutes a sustainable level of government debt? Explain carefully.
9.
Is disinflation (i.e., reducing a high inflation rate) costly or costless? Compare the
implications of adaptive vs. rational expectations using an expectations-augmented
Phillips Curve model. Be sure to define your terms and explain what kinds of “costs”
may be involved.
10.
Explain the relationship implied by the original Phillips curve. What events caused views
of this relationship to be reconsidered? Discuss how views of the Phillips curve have
been altered over time. Are there any conditions under which the original Phillips curve
can still be considered reliable? Explain.
11.
Explain the concept of Ricardian equivalence and evaluate one of its strengths and one of
its weaknesses.
12.
A small open economy with perfect capital mobility is subject to an “interest rate shock”
(an increase in the foreign interest rate). Using an open economy IS-LM (“MundellFleming”) model, compare the effects under a fixed versus a flexible exchange rate and
explain briefly.