Econ 305 Midterm 2
July 14, 2011
D. Andolfatto
Name (yours and TA)
Instructions. Limit your answers to the space provided below each question. The exam is worth
70 marks. Exam begins at 10:30AM and ends at 12:00PM.
[1] [15 marks] The income-expenditure identity is usually expressed mathematically as  ≡  +
 +  + 
(a) Define each of the five terms in the expression above, and explain why both sides of the identity
correspond to the GDP.
Y - gross domestic income (income generated by domestic factors of production)
C - private sector spending on final consumer goods and services
I - private sector spending on final investment goods and services
G - public sector spending on final goods and services
NX - foreign sector spending on final goods and services less domestic spending on imported
final goods and services (net exports)
All that is produced (GDP) must be purchased by someone and is therefore equivalent to
expenditure. As any expenditure by one party constitutes income for another, it follows that
expenditure must be equivalent to income.
(b) What is the meaning of writing this expression with ≡ instead of = ?
Using ≡ means that income is equivalent to expenditure; and not just equal to expenditure.
Equivalence means that income is by (accounting) definition equal to expenditure. Something that
is true by definition is called an identity. (An identity is not a theoretical statement.)
(c) The income-expenditure identity implies that an increase in  will lead to an increase in 
(answer either true, false, or uncertain, and explain).
False. An identity is not a theory and cannot, therefore, be used (by itself) to make theoretical
statements. (Note: in class we showed examples of where increasing  could lead to an increase or
decrease in  ; and in all cases, the income-expenditure identity held. No marks for this note, just
FYI.)
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[2] [15 marks] Consider an individual with preferences defined over current and future consumption
(1  2 ) with  (1  2 ) = 2 1  The individual has an endowed earnings profile (1  2 )
and can borrow or lend freely at the (gross) real interest rate 
(a) Derive the demand for current consumption 1 ( 1  2 ) and desired saving  ( 1  2 )
2
=  and 1 + −1 2 = 1 + −1 2 implies
1
1 = 05(1 + −1 2 ) and  = 05(1 − −1 2 )
(b) According to Milton Friedman’s permanent income hypothesis (PIH), consumer demand should
be proportional to wealth. Is the theory here consistent with PIH? Explain why or why not.
Wealth in this model is given by the present value of income,  = 1 + −1 2  The PIH
claims that consumer demand is proportional to wealth; i.e., 1 =  where  is the factor of
proportionality. In our model,  = 05; so yes, our theory is consistent with the PIH.
(c) Consider a person for which 1  2  and who is not able to borrow (so that  ≥ 0). Show
that consumer demand no longer depends on wealth, as much as it depends on current income.
In this model,  = 05(1 − −1 2 ) so 1  −1 2 implies   0 Since borrowing is ruling
out, the solution entails  = 0 And since  = 1 − 1  it follows that 1 = 1  That is, consumer
demand depends on current income and not on lifetime wealth. (A diagram can also be used to
demonstrate this.)
[3] [20 marks] A government agency has planned a temporary increase in its purchases of nondurable goods and services from the private sector. There is a debate, among members of
this agency, concerning the best way to finance this expenditure. One side insists on a temporary increase in income and sales taxes (sufficient to keep the budget balanced). The other
side is against any tax increase, and instead favours deficit finance (issuing bonds).
(a) You are asked to serve as a consultant in this debate. What would you recommend and why?
First thing to point out is that the taxes will have to be raised; the only question is how to
time the taxes. Because taxes are distortionary, it makes sense to smooth the distortions over time.
Thus, raise taxes just a little bit today, and finance the majority of the expenditure with bonds.
Keep taxes slightly higher for as long as it takes to pay off the interest and principal on the debt.
In this way, one can avoid the major disruption in economic activity that might occur if one was
to load all of the tax burden over a short period of time.
(b) How would your answer to part (a) change if the increase in expenditure was permanent,
instead of temporary? Explain.
The prescription of smoothing distortionary taxes over time implies raising taxes now and
forever to finance the permanently higher level of government expenditure. That is, do not use
bond finance. Using bond finance would imply postponing an even higher distortion to the future.
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[4] [5 marks] The Ricardian Equivalence Theorem states that, under an appropriate set of conditions, government spending does not matter (answer either true, false, or uncertain, and
explain).
False. The RET states that if one holds fixed a government expenditure program, that the
timing of taxes does not matter (under certain conditions). The theorem has nothing to say about
the effects of government spending on the economy.
[5] [5 marks]How does a standard Labor Force Survey define unemployment? In light of this
definition, explain why it may be misleading to describe unemployment as representing “idle
resources.”
The standard LFS definition of unemployment is people who are not employed and who are
actively engaged in job search activities. To the extent that job search requires a lot of effort (time
and resources), it is misleading to characterize the unemployed as “idle.”
[6] [10 marks] Why do unemployed workers coexist with job vacancies?
Unemployed workers are looking for jobs. Unemployed jobs (vacancies) are looking for workers.
It seems that there must be something that prevents match formation from occurring instantaneously. One does not necessarily want to take the first job that comes along. Likewise, a firm
may not want to hire the first person who comes through the door. Matchmaking means searching
through available alternatives and making the best match possible, given limitation on time and
resources. The fundamental friction is a lack of information; i.e., information relating to the location of one’s best match. Search activity is an information-gathering activity. When information
is absent, it may make sense to invest in information-gathering activities (up to a point). Since
this is presumably true for both sides of a matching market, it likely explains the coexistence of
unemployed workers and vacant jobs.
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