Econ 352 Intermediate Macroeconomics

Purdue University 2015 spring

Xiaoxiao Li (Maya)

Midterm 1
Feb 24th 2015

Name:

Student ID:

Section:

Section 0002: 7:30 8:45 am

Please write done all of the information above and bubble them in the scantron before you start the
exam.

No notes, any related materials or electronic devices besides non-graphic calculator are permitted.

Cheating is strictly forbidden. Penalties associated with any sorts of cheating are severe.

Exam time: 7:30 8:45 am

Use your sharp mind and Trust yourself ! Good luck !

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 Part II Grade
This exam consists two parts: part I MC (1 correct answer only) and part II written question. Please
answer all questions. You have 1 and 15 min to complete the test. The maximum number of points is 100.
(The formulas are on page 13. Last few pages are scratch papers. You can tear them off.)

Part I. Multiple choice (40 points) Please make sure you bubble your answer in the scantron.

From May to September 1980, about 125,000 Cuban immigrants arrived in Miami on a flotilla of privately
chartered boats. The result was a 7 percent increase in the labor force of Miami. Their arrival was the
consequence of Cuban president Castro's declaration on April 20, 1980, that Cubans wishing to immigrate
to the United States were free to leave from the port of Mariel which is later known as the Mariel boatlift.
Use above information to answer question 1-4.

1. Suppose Miamis production function is Cobb-Douglas Y K L(1 ) with parameter 0.3 . In

our LR national income model, what happens to total output (in percent) in Miami?
A. It increases by 7 percent.
B. It increases by 4.85 percent.
C. It increases by 2.05 percent.
D. It does not change.

2. Now, still using LR national income model, what about real wage change (in percent) in Miami?
A. It increases by 7 percent.
B. It decreases by 7 percent.
C. It increases by 2 percent.
D. It decreases by 2 percent.
E. It does not change.

3. Using knowledge about LR unemployment, how does such a massive influx of Cuban immigrants
affect the natural rate of unemployment in Miami?
A. It increases frictional unemployment.
B. It contributes to structural unemployment.
C. Both A and B.
D. It does not affect the natural rate of unemployment. It only creates SR cyclical unemployment.

4. Suppose the growth rate of labor force increases 7 percent in Miami permanently as a result,
using the Solow Model with population growth, which of the following statement is correct?
A. This change of labor market in Miami has no effect on capital accumulation in steady-state.
B. This change of labor market in Miami increases income per capita in steady-state.
C. The influx of Cuban immigrants results a lower level of capital per capita in steady-state.
D. The influx of Cuban immigrants has a growth effect in income per capita in Miami.
E. None of above.

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5. In a classical model with fixed income, a reduction in the government budget deficit will lead to:

A. a higher real interest rate and lower investment level in private sector.
B. a lower real interest rate and higher investment level in private sector.
C. a higher real interest rate but same investment level in private sector.
D. a lower real interest rate but same investment level in private sector.
E. no change in real interest rate and investment level in private sector.

6. Between 1880 and 1896, the price level in the United States fell 23 percent unexpectedly. This
movement was ____ for bankers of the Northeast (lender) and ____ for farmers of the South and
West (borrower) ?

A. bad; bad
B. good; good
C. bad; good
D. good; bad

7. If the Feb announces that it will raise the money supply in the near future, but it does not yet
change the money supply today. Then,

A. both the nominal interest rate and the current price level will decrease.
B. the nominal interest rate will increase and the current price level will decrease.
C. the nominal interest rate will decrease and the current price level will increase.
D. both the nominal interest rate and the current price level will increase.
E. None of above.

8. Workers unemployed as a result of wage rigidity are:

A. actively searching for a job to match their skills.

B. not eligible to receive unemployment insurance benefits.
C. waiting for a job to become available.
D. relocating to another part of the country as a result of sectoral shifts.
E. none of above.

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9. The amount of education a typical person receives varies substantially among countries.
Comparing a country with a highly educated labor force (country H) and a country with a less
educated labor force (country L) where education affects only the level of the efficiency of labor
and the two countries are otherwise the same (same saving rate, depreciation rate, population
growth rate and technological progress), which of the following statement is correct?

A. The rate of growth of total income is higher in country H.

B. The level of income per effective worker is higher in country H.
C. The rate of growth of income per worker is higher in country H
D. The level of income per worker is higher in country H.
E. All of above.

10. If all wage income is consumed, all capital income is saved, and all factors of production earn their
marginal products, then,

A. the economy will reach a steady-state of capital stock equal to the Golden Rule level.
B. the economy will reach a steady-state of capital stock below the Golden Rule level.
C. the economy will reach a steady-state of capital stock above the Golden Rule level.
D. Wherever the economy starts out, it will not grow.
E. None of above.

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Part II. Written question (60 points)

You must show all your work to receive full credit. Correct answer without any work or explanation will
not receive full credit.

1. Neoclassical Model (20 points)

Consider an economy described by the following equations:

Y 5, 000
C 500 0.5(Y T)
I 2, 000 100r
G 1, 000
T 1, 000

Where real interest rate is in percent.

a. In this economy, compute private saving, public saving, and national saving. Make sure
you use formulas or definitions and show your work to get full credit. (6 points)

S pri Y T C
5, 000 1, 000 (500 0.5 (5, 000 1, 000))
1,500

S pub T G
1, 000 1, 000 0

S S pri S pub 1,500

b. Find the equilibrium interest rate and investment level. Make sure you show your work
to get full credit. (4 points)

S I in equilibrium
1,500 2, 000 100r
r 5 percent

I 2, 000 100 5 1,500

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 c. Now suppose technological innovation increases investment demand by expanding the
investment curve outwards to I 3, 000 100r . Compute new national saving and
equilibrium interest rate and investment level. Make sure you show your work to get full
credit. (6 points)

S Y C G 1,500 which is unchanged

S I after technological innovation change

1,500 3, 000 100r
r 15 percent

I 3, 000 100 15 1,500

d. Graphically illustrate the effect of technological innovation on equilibrium outcome.

Make sure you label the axes and equilibrium outcome clearly. (2 points) Describe the
results (comparison of b and c for real interest rate and investment) and intuition in
words. (2 points).
r

S=Y-C-G=1,500

15
%

I=3,000-100r

5%

I=2,000-100r
I
1,500
Technological innovation increases investment demand which drives up the real interest rate
from 5% to 15% while investment level stays at 1,500 since the national saving is fixed at the
maximum level. Notice if national saving curve is upward sloping (for instance, if consumption
also depends negatively on real interest rate), then the investment level would increase
instead.

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2. The money supply (M) fell from 1929 to 1933 in Great Depression because both the currency-
deposit ratio (cr) and the reserve-deposit ratio (rr) increased as indicated in the following
table. Use the model of the money supply and the data provided below to answer the
following hypothetical questions about this episode. (20 points)

August 1929 March 1933 % change

M = C+D 26.5 19.0 28.3%
C : currency 3.9 5.5 41.0
D : deposit 22.6 13.5 40.3
B = C+R 7.1 8.4 18.3
C 3.9 5.5 41.0
R : reserves 3.2 2.9 9.4
m 3.7 2.3 37.8
rr 0.14 0.21 50.0
cr 0.17 0.41 141.2

a. Please explain intuitively what caused the increase in currency-deposit ratio (cr) and the
reserve-deposit ratio (rr) and use the model of the money supply to explain how do those changes
lead to the decline of money supply. Please provide intuition. (6 points)

The money supply decline in Great Depression is mainly because the money multiplier falls so
much. In fact, the monetary base rose 18 percent over this period. Instead, the money supply fell
because the money multiplier fell 38 percent. The money multiplier fell because the currency
deposit and reservedeposit ratios both rose substantially.

Most economists attribute the fall in the money multiplier to the large number of bank failures in
the early 1930s. From 1930 to 1933, more than 9,000 banks suspended operations, often
defaulting on their depositors. The bank failures caused the money supply to fall by altering the
behavior of both depositors and bankers.

Bank failures raised the currencydeposit ratio by reducing public confidence in the banking
system. People feared that bank failures would continue, and they began to view currency as a
more desirable form of money than demand deposits. When they withdrew their deposits, they
drained the banks of reserves. The process of money creation reversed itself, as banks responded
to lower reserves by reducing their outstanding balance of loans.

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In addition, the bank failures raised the reservedeposit ratio by making bankers more cautious.
Having just observed many bank runs, bankers became apprehensive about operating with a small
amount of reserves. They therefore increased their holdings of reserves to well above the legal
minimum. Just as households responded to the banking crisis by holding more currency relative
to deposits, bankers responded by holding more reserves relative to loans. Together these
changes caused a large fall in the money multiplier.

b. Now we want to decompose the two channels through which the money multiplier changed
and investigate them one by one. Firstly, what would the money multiplier and therefore money
supply in 1933 be if the currency-deposit ratio (cr) had risen from 1929 to 1933 but the reserve-
deposit ratio (rr) had remained the same? Please use the data in the table to provide numerical
evaluation. (Note: monetary base changed from 1929 to 1933) (6 points)

To determine what would happen to the money supply if the currency-deposit ratio (cr) had risen
but the reserve-deposit ratio (rr) had remained the same, we need to recalculate the money
multiplier and the therefore the money supply. That is, the hypothetical money multiplier in 1933
is:

cr1933 1 0.41 1
Hypo1
m1933 2.56
cr1933 rr1929 0.41 0.14

Therefore, if only the currency deposit ratio (cr) had risen, the money supply in 1933 would be:

Hypo1
M1933 m1933
Hypo1
B1933 2.56 8.4 21.504

Therefore, under such circumstances, the money supply would have fallen from 26.5 in 1929 to
21.504 in 1933.

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c. Secondly, what would the money multiplier and therefore the money supply in 1933 be if the
reserve-deposit ratio (rr) had risen from 1929 to 1933 but the currency-deposit ratio (cr) had
remained the same? Please use the data in the table to provide numerical evaluation. (Note:
monetary base changed from 1929 to 1933 using the data provided.) (6 points)

Similarly, if the reserve-deposit ratio (rr) had risen but the currency-deposit ratio (cr) had
remained the same, the hypothetical money multiplier in 1933 is:

cr1929 1 0.17 1
Hypo2
m1933 3.09
cr1929 rr1933 0.17 0.21

Therefore, the money supply in 1933 would be:

Hypo2
M1933 m1933
Hypo2
B1933 3.09 8.4 25.96

Therefore, under such circumstances, the money supply would have fallen from 26.5 in 1929 to
25.96 in 1933.

d. Based on your answer to b and c, which of the two channels was more responsible for the
decline in the money supply? (2 point)

From the calculations, it is clear that the decline in the currency-deposit ratio (cr) was most
responsible for the drop in the money multiplier and therefore money supply. In other words, the
reduction in public confidence in the banking system explains most of the fall in money supply in
Great Depression.

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3. The Solow Model with population growth rate and technological progress (20 points)

Suppose an economy is described by the flowing CobbDouglas production function

Y K ( EL)1 , so that the capital share in output is constant.

a) For this economy, what is the per effective worker production function f (k ) (2 points)
and marginal product of capital using f (k ) (1 points)?

Y K ( LE ) 1

Y K ( LE ) 1 K LE 1

LE LE LE LE

Y K
y k f (k )
LE LE

Therefore,
1 k y
MPK k
k k

b) Use the production function you derived in a to solve for the steady-state value of y as
a function of all other exogenous variables s, n, g , . (3 points)

in steady state , k 0

sy ( n g )k 0
sk ( n g )k
1
s 1
k
n g

Therefore,

s 1
y k
n g

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c) Two neighboring economies have the above production function with 0.5 but with
different parameter values (all in percent). (The numbers are chosen to be approximately
realistic descriptions of developed and developing countries.) Find the steady-state value
of k , y and c for each economy (6 points) and provide some intuition about the
difference between the two (2 points).

Developed economy A Developing economy B

(all in percent) (all in percent)

Saving rate s 28 10

Population growth rate n 1 4

Technological growth rate g 2 2

Depreciation rate 4 4

Developed economy A: (3 points)

1 1
s 1 0.28 10.5
k A 16
n g 0.04 0.01 0.02

y A k A 16
0.5
4

c A (1 s ) y A 0.72 4 2.88

Developing economy B: (3 points)

1 1
s 1 0.10 10.5
k B 1
n g 0.04 0.04 0.02

yB k B 1

1
0.5

cB (1 s ) yB 0.90 1 0.9

Since developing country has much lower saving rate but much higher population growth
rate, it results lower income per effective worker and consumption per effective worker
therefore lower level of living standard given any level of technology. (2 points)

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d) Discuss at least two policy implication from Solow Model that can improve the living
standard of developing country and use graphs to support your intuition. (6 points)

Increase saving rate (2 points)

The Solow model predicts that countries with higher rates of saving and investment
will have higher levels of capital and income per effective worker and therefore higher
level of income per capita in the long run given any level of technology.

Reduce population growth rate (2 points)

The Solow model predicts that countries with lower population growth rates will have
higher levels of capital and income per effective worker and therefore higher level of
income per person in the long run given any level of technology.

Graph: If you get it wrong and still dont understand, you can come and talk to me. (1
point for each graph)

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 Formula
cr 1
Money theory: M m B , where m
cr rr

Quantity equation: M V P Y

M
Inflation model: L (r E , Y )
P
U s
Unemployment model:
L sf

The Cobb-Douglas production function is:

Y F (K, EL) K (EL)1

For any variables X and Y,

percentage change in (X * Y ) = percentage change
in X + percentage change in Y
percentage change in (X/Y ) = percentage change in
X - percentage change in Y

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