Econ 1120 – INTRO MACRO – Fall-2011 –November 3, 2011
REGULAR PRELIM #2 (Thursday)
PRINT YOUR NAME:
____________________________________ Your C.U. Netid: _____________
YOUR C.U. STUDENT NUMBER: ____________________________
Check YOUR TA’s NAME:
_____________TA = Minwook Kang (Tuesday sections)
_____________TA = Mirinda Lee Martin (Wednesday sections)
_____________TA = Lingwen Zheng (Thursday sections)
_____________TA = Yu Zhang (Friday sections)
INSTRUCTIONS:
There are two sections in this exam
 Part I: 15 multiple choice questions @ 3 points each
 Part II: 2 short answer questions (17 points) + 2 Newspaper Article questions (19 points for each)
 ANSWER ALL QUESTIONS. TOTAL POINTS = 100. TOTAL TIME = 90 minutes.
 Prelim2 score weights 27.5% of final grade.
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AGAIN, please….
PRINT YOUR NAME:
____________________________________ Your C.U. Netid: _____________
YOUR C.U. STUDENT NUMBER:
____________________________
_____________TA = Minwook Kang (Tuesday sections)
_____________TA = Mirinda Lee Martin (Wednesday sections)
_____________TA = Lingwen Zheng (Thursday sections)
_____________TA = Yu Zhang (Friday sections)
GRADING---------------------------------------------------------------------------------------------------------____/45 (mc)____/9(short essay 1) ____/8(short essay 1)____/19 (long essay 1)____/19 (long essay 2)
TOTAL: ___________/100
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Part I:
Multiple Choice.
1. Read the following scenario and answer the following 3 questions:
In July 2011 data collected about the second quarter of 2011 indicates that the economy is in a
recession. The Fed’s economists reach a consensus in October 2011 as to what the best course of
action to restore full employment would be. The corrective policy is implemented at the end of
October 2011. The economy only registers the full impact of the policy in May 2012.
1. The time period between July 2011 and October 2011 is defined as ______ and the time
period between October 2011 and May 2012 is defined as ______.
a) response lag; implementation lag
b) implementation lag; response lag
c) recognition lag; response lag
d) recognition lag; implementation lag
2. Which of the following policies could the Fed’s economists recommend?
I.
FOMC (Federal Open Market Committee) should buy back securities
II.
The Fed should decrease the supply of the US Dollar
III.
The discount rate should be decreased
IV.
The treasury should increase taxes
a) I, II and IV
b) I, II and III
c) I and III
d) I only.
3. Assume that the economists in the Fed are amazing and that they implement monetary policy
that is just enough to offset the recessionary gap of July 2011 and move the economy to full
employment, though the full effect isn’t felt until May 2012. Assume also that in March 2012
there is an unexpected drop in oil prices which lowers input prices. In this event, policy
implemented by the Fed will result in an equilibrium which is:
a) at full employment
b) below full employment
c) above full employment
d) in line with the NAIRU
4. Under the classical view of the labor market, suppose the equilibrium wage level is $5.05.
Then the Congress passes a minimum wage law requiring the wages should be no lower than
$4.75. What will happen in the labor market?
a) Minimum wage is a price floor, therefore it will create a positive unemployment rate.
b) Minimum wage is a price ceiling, therefore it will create a shortage in labor market.
c) Minimum wage is a price floor, however, the policy here will not create unemployment
since it is not binding.
d) Minimum wage is a price ceiling, however, the policy here will not create
unemployment since it is not binding.
e) None of the above
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5. An increase in the required reserve ratio will cause the _____ curve to shift _____ and an
increase in government spending will cause the _____ curve to shift _____.
a) aggregate demand; left; aggregate supply; right
b) aggregate demand; not at all; aggregate supply; right
c) aggregate demand; left; aggregate demand; right
d) aggregate demand; not at all; aggregate demand; right
e) none of the above
6. Assume the economy currently has high unemployment (above the natural rate of
unemployment) and the factories have excess capacity. If the Fed increases the money
supply, then in the short run we can expect to see
a) a large increase in real GDP and a small increase in the overall price level
b) a small increase in real GDP and a large increase in the overall price level
c) a small increase in real GDP and a small decrease in the overall price level
d) a small decrease in real GDP and a small increase in the overall price level
7. Which of the following statement is true?
a) A negative cost shock leads to inflation and an increase in the output at the same time.
b) A negative cost shock leads to stagflation, and it is always a good idea to engage in
contractionary (monetary or fiscal) policy to counteract this.
c) A negative cost shock leads to stagflation, the government and the Fed can engage in
expansionary policy to counteract the inflation and decrease in output at the same time,
so the government and the Fed should always implement expansionary policy under this
situation
d) A negative cost shock leads to stagflation, the government and the Fed can engage in
expansionary policy to counteract the downward trend in output yet it tends to cause
even higher inflation, thus it is ambiguous whether it is a good idea to implement
expansionary policy under a situation like this.
8. If an individual receives an increase in their wage and we observe that they cut back their
hours of work and increase their hours of leisure, we can conclude that:
a) the income effect and the substitution effect acted in opposite directions and the income
effect dominated
b) the income effect and the substitution effect acted in opposite directions and the
substitution effect dominated
c) the income effect and the substitution effect acted in the same direction
d) None of the above
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9. Suppose that at the current interest rate, there is an excess supply of money.
information, we know that there will be pressure for
a) bond prices to decrease and the interest rate to increase.
b) bond prices to decrease and the interest rate to decrease.
c) bond prices to increase and the interest rate to increase.
d) bond prices to increase and the interest rate to decrease.
e) the money demand function to shift to the right.
Given this
10. The life-cycle theory of consumption says
a) that all wealth should be consumed during the life-cycle because you only live once.
b) that households make lifetime consumption decisions based on their expectations of
lifetime income.
c) that households consume an amount less than their incomes during their prime working
years and an amount greater than their incomes during their early working years and after
they have retired.
d) that households consume an amount equal to their disposable income (salary minus taxes)
during their working years and then use money received from the government as their
only consumption after they have retired.
e) Both b and c
f) Both b and d
11. Which of the following will break down the negative relationship between the unemployment
rate and the inflation rate as predicted by the conventional short run Phillips Curve?
a) Demand-pull inflation
b) Cost-push inflation
c) The negative relationship between the unemployment rate and the inflation rate never
breaks down
d) None of the above
12. In thinking about the reading focused on Social Security, what does the implicit rate of return
that individual workers receive refer to?
a) It is the interest rate that the saved contributions of individual workers receive each year
as the funds are invested until the individual worker begins receiving payments when
they retire or become disabled.
b) It is a rate of return that is based on the prevailing rates of interest in the market.
c) It is the rate that the Social Security trust funds earn on their assets.
d) It is the interest rate that workers would (hypothetically) have to earn on their
contributions to pay exactly for all the benefits they and their families will receive over
the course of their lives.
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13. Consider the money market and assume money supply is vertical and money demand is
downward sloping. Suppose the public suddenly decides to change its preferences and hold
more money balances than before, no longer trusting bond and equity markets as much as
they used to. At the same time, suppose the Fed engages in an open market operation and
buys up securities from the public. As a consequence,
a) r* must increase, and M* must increase.
b) r* might increase or might decrease, and M* must increase.
c) r* must not change, and M* must not change.
d) r* must decrease, and M* must increase.
e) r* must increase, and M* might increase or might decrease.
14. Social security can be considered as a(n):
a) Pay-as-you-go system
b) Defined-benefit pension
c) Defined-contribution pension
d) Individual savings account for retirement
e) Both a and b
f) Both c and d
15. If the very long-run aggregate supply curve is vertical, then the multiplier effect of a change
in net taxes on aggregate output, in the very long run,
a) depends on the price level
b) is one
c) is zero
d) is infinitely large
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Part II: Short Answer questions. 17 points
1. Life-cycle theory of consumption (9 points)
John Jacob Jingleheimer Schmidt, often called JJ by his friends, is 35 years old. He has
$60,000 in assets (wealth) and has no debts or liabilities. He recently visited a psychic
and discovered that he will work at his present job at a local hardware store until he can
retire at 65 years old and then will live for 10 more years, during which he earns nothing,
before he dies. His salary each year for the rest of his time working at the hardware
store is $20,000. (There are no taxes.) He wants to distribute his consumption over
the rest of his life in such a way that he consumes the same amount each year. He
cannot consume in total more than his current wealth plus the sum of his income for the
rest of his working life (the next 30 years). In planning for his future, JJ has decided
that he would like to leave each of his two children an inheritance of $10,000. Assume
that the rate of interest is zero.
a)
How much will JJ consume this year and next year?
How did you arrive at your
answer? (3 points)
b)
Suppose that JJ wins a small stakes lottery for $40,000 the day after making his
above plan. (Thus, his income in this year is $60,000; but in all succeeding years,
his income is $20,000.) By how much does his consumption increase this year and
next year? (2 points)
c)
Now suppose that JJ did not actually win the lottery.
Instead, he is told that when
he retires from his job at the hardware store at age 65, he will get a lump sum
payment of $40,000 from a secret trust fund established by his long lost Uncle Louie.
Plot on a graph JJ’s income, consumption, and wealth from the time he is 35 until he
is 75 years old. How much does JJ consume this year and next year? (4 points)
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2. School of economic thought (8 points)
Suppose there is a major recession in the United States which causes output and
employment to go down and economists from different schools of thought are asked
what new policies the government should announce to make the situation better.
a) What would a Keynesian economist tell them to do and why? (4 points)
b) What would a new classical economist tell them to do and why? (4 points)
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Part III: Long Answer questions (Newspaper Analysis)
1. “Labor Market and Sticky Wage” (19 points)
According to the article, Ford Contract on Edge, from the WSJ on Oct. 15, please answer
the following questions.
DETROIT—Ford Motor Co.'s tentative labor agreement gained support Friday after
workers at two assembly plants and a transmission factory endorsed the accord, shifting
toward approval after several rejections. …
The Flat Rock, Mich., plant stands to gain new production and a more secure future from
approval. The endorsements represented important wins after several Ford plants in
Illinois and Michigan had rejected the four-year agreement. Workers at a pair of Ohio
engine plants and a Michigan transmission factory also supported the contract. …
"I was going to vote 'yes' for the new guys, but I'm going to vote 'no,'" said Richard Royal,
a 50-year Ford veteran. "The salaried [employees] get bonuses, stock options. We didn't
get anything for cost of living."
But Vincent Williams, a 17-year veteran, said he approved of the deal. "The whole country
is going through a rough time. We're blessed to have any bonus at all." …
A defeat would be a "calamity" for the UAW and the U.S. labor movement given America's
disenchantment with unions, said Gary Chaison, a labor professor at Clark University in
Worcester, Mass. UAW workers would be seen turning down a contract that pays each
worker a $6,000 signing bonus plus $1,500 in payments over the next four years to cover
the cost of inflation, all at a time when jobs are scarce, he said.
Ford workers who have opposed the contract say it lacks a real wage increase to fight
inflation for current employees, any increase for pensioners, and keeps unwanted
changes made in 2009 to absentee policy, break time and holiday scheduling. …
"There is this thing called public perception. If we do not accept this contract, we will look
bad to everyone," said UAW member William Coltrane, a Ford millwright. "People are
losing jobs, people are taking pay cuts. I did not have to take a pay cut, and I still have
great medical. It's a very well negotiated contact."
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a)
William Coltrane mentions that people are losing jobs and people are taking pay
cuts.
Using a graph that depicts the classical view of the labor market, show why
(in the current recession) we are seeing this occur and explain it in words. (Show
the classical labor market before the recession and during the recession.) (6 points)
b)
Here, this union is trying to reach a contract agreement where employees will
receive a promised increase in their wages over the next few years to keep up with
inflation.
If wages increase at the same rate as inflation, this keeps the real wage
constant.
Using a graph that depicts the classical view of the labor market, show
what the keeping the real wage constant means for the economy in the current
recession and explain it in words. What happens to unemployment? (7 points)
c)
The union contract is an example of an explicit contract and it is one reason that
the real wage could remain constant.
What are two other potential reasons for
real wages to remain constant, even during a time of recession, and explain what
they are? (6 points)
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2. “Aggregate Demand and Aggregate Supply” (19 points)
According to the article, U.S. Michigan Consumer Sentiment Index Unexpectedly Falls,
from Bloomberg News on Oct. 14, please answer the following questions.
Oct. 14 (Bloomberg) -- Confidence among U.S. consumers unexpectedly dropped in
October as Americans' outlooks for the economy and their finances slumped to the
lowest level since 1980.
The Thomson Reuters/University of Michigan preliminary index of consumer sentiment
decreased to 57.5 this month from 59.4 in September. The median estimate of
economists surveyed by Bloomberg News called for a reading of 60.2. The gauge of
consumer expectations for six months from now, which more closely projects the
direction of consumer spending, dropped to 47, the lowest since May 1980.
Consumers may be questioning the recovery's durability as incomes stagnate, home
prices fall and policy makers debate ways to strengthen the recovery. Faster job growth
may hold the key to bigger gains in consumer spending that accounts for about 70
percent of the economy.
……
Inflation Expectations
Consumers in today's confidence report said they expect an inflation rate of 3.2 percent
over the next 12 months, compared with 3.3 percent in the prior survey.
Over the next five years, the range tracked by Federal Reserve policy makers, Americans
expect a 2.7 percent rate of inflation, the lowest since September 2010, after 2.9 percent
last month.
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a)
Please use 3 panel diagrams and the graph of aggregate demand and aggregate
supply to illustrate the result of decrease in consumer spending. Can a decrease in
consumer spending explain lower inflation expectations? (11 points)
b)
List 2 events which lead the aggregate demand curve to shift to the right. (4 points)
c)
List 2 events which lead the aggregate supply curve to shift to the right. (4 points)
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Multiple Choice Answer
1.B
2.C
3.C
4.C
5.C
6.A
7.D
8.A
9.D
10.E
11.B
12.C
13.B
14.E
15.C
Short essay 1 answer
Answer:
a. JJ will consume $16,000 each year, so he will consume $16,000 this year and $16,000
next year (since he will consume the same amount each year). I arrived at my answer
by knowing that he wanted to have $20,000 left in his account to give to his kids when he
dies. Then his lifetime consumption (or budget constraint) will be the following:
𝐵 ≤ $60,000 + ($20,000)(30)
𝐵 ≤ $60,000 + $600,000
𝐵 ≤ $660,000
He will leave $20,000 behind for his kids, so he wants to spend the rest of the money
($640,000) over the next 40 years that he is alive. This leaves him with an average of
$16,000 per year to consume.
𝐶=
$640,000
= $16,000/𝑦𝑒𝑎𝑟
40 𝑦𝑒𝑎𝑟𝑠
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b. His annual saving each year is $4,000 during the years that he is working. This is also
equal to the annual increase in his wealth. During the years that he doesn’t work, his
annual saving is
-$16,000 which is equal to the annual decrease in his wealth during the years in which he
doesn’t work.
During the 30 years that he is working:
𝑆𝑎𝑣𝑖𝑛𝑔 = 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝑆𝑎𝑣𝑖𝑛𝑔 = $20,000 − $16,000
𝑆𝑎𝑣𝑖𝑛𝑔 = $4,000
During the 10 years that he is not working (dissaving):
𝑆𝑎𝑣𝑖𝑛𝑔 = 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝑆𝑎𝑣𝑖𝑛𝑔 = $0 − $16,000
𝑆𝑎𝑣𝑖𝑛𝑔 = −$16,000
After JJ turns 65 and he retires, that is when his wealth will start to decline. That is
because this is the first time that his consumption is greater than his income. When he
dies, he will have $20,000 left in wealth by design because he wanted to leave $10,000 to
each of his two kids so he needed to have that much left in wealth to be able to do that.
He doesn’t have more than that left because there was no reason not to consume the rest
of it.
(Insert graph here.)
c. His consumption in each year increases by $1,000, so his consumption this year will
increase by $1,000 and his consumption next year will increase by $1,000. This is
because JJ prefers to smooth his consumption such that it is the same in each year.
New lifetime consumption (budget constraint):
𝐵 ≤ $60,000 + $40,000 + ($20,000)(30)
𝐵 ≤ $100,000 + $600,000
𝐵 ≤ $700,000
He leaves $20,000 for his kids which leaves him $680,000 to spend over 40 years.
𝐶=
$680,000
= $17,000/𝑦𝑒𝑎𝑟
40 𝑦𝑒𝑎𝑟𝑠
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Previously, he was consuming $16,000/year and so now his consumption has increased
by $1,000/year.
d. JJ will consume $17,000 each year, so he will consume $17,000 this year and $17,000
next year (since he will consume the same amount each year). It doesn’t matter when
the $40,000 arrives because he will smooth his consumption across his entire lifetime.
Life Cycle Consumption Graph
200,000
180,000
160,000
140,000
Dollars
120,000
Consumption
100,000
Income
80,000
Wealth
60,000
40,000
20,000
0
35
40
45
50
55
60
65
70
75
Short essay 2 answer
a. Keynesian would urge government to implement fiscal policy to stimulate aggregate
demand and thus push the economy out of recession and reduce the unemployment. The
Keynesian theory is based on the labor market inefficiency caused by existence of sticky
wage. Once recession happens and labor demand decrease, sticky wage keeps unit of labor
supplied from moving toward the new equilibrium output at full employment. Alternatively
speaking, sticky wage keep aggregate supply curve from shifting to the left, and hence short
run output level converges to long run output at very slow speed. Given this, Keynesian
economists consider increasing government spending an idea way to help economy recover.
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b. New classical economists would tell government do nothing in the recession and emphasize
government should work on long run development and growth, for example corporate tax.
The theory is rooted on rational expectation which implies firms should have well
knowledge about supply and demand of labor market such that firms are able to make wage
rate converging to new equilibrium (wage) price fast. Put it in other words, new classical
school consider labor market is efficient and short run disequilibrium output should move to
output at full employment fast. This school thinks any government intervention may
exaggerate the business cycle fluctuation because of recognition, implementation and
response lags, so the best way to deal with recession is doing nothing and let market clears
by itself.
Long essay 1 answer
Answers:
a. Because of the current recession, we saw a decrease in the demand for labor
causing the labor demand curve to shift to the left. We see that this leads to a
decrease in the equilibrium wage and a decrease in the equilibrium quantity of
labor. Thus, this is why we would expect to see people who are losing their
jobs and people who are taking pay cuts.
(graph should have S and D labels)
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b. As before, we have a graph where the labor demand curve shifts to the left
because of the recession. However, the labor union contract requires that wages
remain at the previous level. This creates a situation where there is more labor
supplied than labor demanded. The difference between the labor supplied and
the labor demanded is unemployment and we see that unemployment in the
economy will be increased.
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c. There are more than two other potential reasons for real wages to remain constant,
even during times of recession:
i.
Social, or implicit, contracts – it is taboo to lower someone’s wage, so
firms do not do it even though they are not forbidden from doing so.
ii.
Efficiency wage theory – firms want the best employees and want less
turnover, so they pay employees more than the market rate to retain their
best employees.
iii.
Imperfect Information – Firms don’t know what the market equilibrium
wage is so they unknowingly offer a wage that is above it.
iv.
Minimum wage laws – this makes it illegal to lower the wage below the
minimum wage set by law, even if the equilibrium market wage is below
it.
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v.
Sticky Wages may be an answer, though social contracts and explicit
contracts are supposed to be examples of this – basically says that it is
very difficult to adjust wages downward (though movements upward are
generally quite easy).
vi.
Note: Explicit contracts are not supposed to be an option here because
that is what the labor union contract is an example of.
Long essay 2 answer
(a)
Original equilibriums under 2 price systems (P1,P2) are drawn above. Given a price level,
decreased consumption spending will shift AE to lower level, and we can find a
corresponding new equilibrium level of income, interstate rate and investment. So
decreasing consumption spending reduces the output under every price level; therefore
we can conclude that drop of consumption causes downward shift of AD. Holding AS
fixed, we can conclude equilibrium price level will decrease.
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This explains why people lower there expectation of inflation because, as AD curve shifts
to the left, the price level decrease, which offsetting the inflation triggered by other
events.
(b) Expansionary fiscal policy and monetary policies generally are able to shift AD curve
to the right.
(c) Many reasons can shift the AS to the right, which includes (but not limit to)
technology improvement or good weather.
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