Macro Economic Analysis Paper
Name: _________________________
(Last name, first name)
SID: _________________________
GSI: _________________________
Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Fall 2012
Exam #1 ANSWERS
Please sign the following oath:
The answers on this exam are entirely my own work. I neither gave nor received any aid while taking this exam. I will not discuss the questions on this test until after 5:00 p.m. on September 27, 2012.
_______________________________________
Signature
Any exam turned in without a signature will be assigned a grade of zero.
Exam Instructions
1.
When drawing diagrams, clearly and accurately label all axes, lines, curves, and equilibrium points.
2.
Explanations should be written in pencil …show more content…
or black. Legibility is a virtue; practice good penmanship.
3.
Explanations should be succinct and to the point; make use of bullet points and common mnemonics.
4.
If you have a question, ask one of the GSIs. The GSIs have not seen the exam beforehand and can only provide general guidance. You are totally responsible for your answers regardless of what a GSI has said to you.
5.
If you need to re-draw a diagram and/or need more room to write your answers, use pages 2, 12, 13 and/or 14.
6.
If you finish your exam before 4:55 p.m. you may turn in your exam and quietly exit the room.
7.
If you finish your exam after 4:55 p.m., close your exam packet but remain seated until time is called.
8.
When time is called, STOP writing, immediately CLOSE your exam packet and TURN IN your exam. You WILL
BE PENALIZED if you continue to write past the official end of the exam.
Do NOT open this test until instructed to do so.
Exam #1 (Fall 2012)
1/10
A. Multiple Choice Questions (30 points). Circle the letter corresponding to the best answer (3 points each).
1.
The difference between inventories and inventory investment is that:
a.
b.
c.
d.
e.
2.
Suppose that the government announces a large tax increase on workers’ wages to take effect in 2 years. What would happen to current employment and the real wage?
a.
b.
c.
d.
3.
The real wage.
The real rental price (or cost) of capital.
The share of labor income in national income.
The share of capital income in national income.
If consumers (but not businesses) believe that a recession will occur next year, then what would happen to the real interest rate and investment this year?
a.
b.
c.
d.
5.
Both employment and the real wage would increase.
Both employment and the real wage would decrease.
Employment would increase and the real wage would decrease.
Employment would decrease and the real wage would increase.
Suppose that the economy is in equilibrium when an earthquake destroys one-quarter of the capital stock while not affecting the labor force which remains fixed. Once the economy has adjusted to its new equilibrium with a smaller capital stock, which of the following has decreased?
a.
b.
c.
d.
4.
Inventories are the stock of unsold goods while inventory investment is a flow that indicates productive activity. Inventories are measured at the end of the year while inventory investment is measured at the beginning of the year.
Inventories measure the total amount of capital goods while inventory investment measures the change in the amount of capital goods.
All of the above.
None of the above.
Both the real interest rate and investment would increase.
Both the real interest rate and investment would decrease.
The real interest rate would increase but investment would decrease.
The real interest rate would decrease but investment would increase.
Suppose that consumers have perfect foresight about future taxes. Then, a reduction in taxes this year that is accompanied by an exactly offsetting increase in future taxes would cause:
a.
b.
c.
d.
e.
A leftward shift of both the desired saving function and the desired investment function.
A rightward shift of both the desired saving function and the desired investment function.
A leftward shift of the desired saving function but no shift of the desired investment function.
A rightward shift of the desired saving function but no shift of the desired investment function.
No shift of either the desired saving function or the desired investment function.
Exam #1 (Fall 2012)
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6.
Two competing explanations for why poor countries remain poor are (1) the poor quality of their institutions and
(2) poor geography. The facts that Las Vegas is situated in a desert but has been one of the fastest growing cities in the U.S. and Argentina was once quite prosperous but now is poor suggests:
a.
b.
c. …show more content…
d.
7.
The Solow and Romer models reach the same conclusions with respect to:
a.
b.
c.
d.
8.
The rate of inflation.
The economy’s long-run growth rate.
The impact of a change in the national saving rate.
The impact of a change in the labor force growth rate.
People tend to save very little once they retire. Over the next couple of decades, a large portion of the U.S. population—the baby boom generation—will retire. If investment and the government budget balance remain constant, then:
a.
b.
c.
d.
9.
Neither institutions nor geography are important.
Geography is far more important than institutions.
Geography has no effect at all on economic growth.
Institutions are far more important than geography.
The current account balance will increase.
The current account balance will decrease.
There will be no effect on the current account balance.
What happens to the current account balance is indeterminate.
Alan Greenspan, former Chairman of the Federal Reserve System, once maintained that lower inflation reduces the pricing power of business firms. This forces the firms to increase productivity to maintain profits. This view:
a.
b.
c.
d.
Is an implication of the Equation of Exchange.
Is an implication of the Quantity Theory of Money.
Is a contradiction of the Quantity Theory of Money.
Is a contradiction of the long-run neutrality of money.
10. Suppose that an economy described by the Solow model is at its steady state with its labor force growing by 2% per year when the central bank firmly commits to a policy of growing the money supply by 5% per year. An earthquake then destroys one-quarter of the capital stock. According to the quantity theory of money, as the economy recovers from the earthquake:
a.
b.
c.
d.
e.
Inflation remains steady at its initial rate.
Inflation initially accelerates and continues at a faster rate.
Inflation initially decelerates and continues at a slower rate
Inflation initially accelerates but then decelerates back to its initial rate.
Inflation initially decelerates but then accelerates back to its initial rate.
Exam #1 (Fall 2012)
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B. Analytical Questions (70 points). Answer BOTH of the following questions based on the standard models of analysis developed in class. The information in the various parts of the questions is sequential and cumulative.
1.
Desired Saving – Desired Investment Model (35 points). Assume that the world is composed of only two large open economies—the U.S. and China— with perfect capital mobility and that the U.S. engages in large persistent net foreign borrowing.
a.
Based only on this information, use an open economy Desired Saving – Desired Investment Model diagram for each country (the U.S. on the left,
China on the right) to clearly and accurately show each economy’s initial (1) equilibrium real interest rate, (2) desired saving, (3) desired investment, (4) net exports. These diagrams should be drawn in BLACK.
China
The U.S.
r
I
D
S
0
D
S
0
D
I
D
0
I
D
S D0
1
S D1
2
rW0 rW1 rW2
NX1
NX1
NX2
NX2
S1
S0 S2
I0
NX0
Exam #1 (Fall 2012)
I1 I2
S D, I D
I0
I1 I2
S0
S2 S1
NX0
4/10
S D, I D
b. Now suppose that China experiences a large increase in its total factor productivity, a gain that also increases the expected future marginal product of capital that results in an increase in China’s net export balance. Incorporating only this new information, clearly and accurately show in your diagrams above what effects, if any, this would have on each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and (4) net export balance. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if anything, happens to each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and
(4) net export balance. Be sure to explain why these effects take place and what causes them.
If China experiences a large increase in its total factor productivity it also experiences an increase in its level of economic output and income. As a result of the increase in income there is also an increase in China’s national saving at every real interest rate level. This can be represented by a rightward shift of China’s desired saving function from SD0 to SD1. The global supply of loanable funds has increased.
If the increase in total factor productivity also increases the expected future marginal product of capital, China’s desired investment would increase at every real interest rate level. This can be represented by a rightward shift of China’s desired investment function from ID0 to ID1. The global demand for loanable funds has increased.
If China’s net export balance increases then China must increase its net foreign lending.
Thus, the increase in the global supply of loanable funds must be greater than the increase in the global demand for loanable funds. i.e., the rightward shift of China’s desired saving function from SD0 to
SD1 must be greater than the rightward shift of China’s desired investment function from ID0 to ID1.
At the world real interest rate rW0, the global supply of loanable funds now exceeds the global demand for loanable funds. This excess supply of loanable funds causes the equilibrium world real interest rate to decline from rW0 to rW1.
As a result of the decline in the equilibrium world real interest rate from rW0 to rW1 and the increase in China’s desired saving function from SD0 to SD1, desired saving has increased from S0 to
S1. As a result of the decline in the equilibrium world real interest rate from rW0 to rW1 and the increase in China’s desired investment function from ID0 to ID1, desired investment has increased from I0 to I1. Because desired saving has increased by more than desired investment, the net export balance (which is a surplus) has increased from NX0 to NX1, i.e., net foreign lending by China has
increased.
In the U.S., the decline in the equilibrium world real interest rate from rW0 to rW1 will decrease desired saving along the desired saving function SD0 from S0 to S1 and increase desired investment along the desired investment function ID0 from I0 to I1. Because desired investment has increased and desired saving has decreased, the net export balance (which is a deficit) has declined from NX0 to NX1, i.e., net foreign borrowing by the U.S. has increased.
Exam #1 (Fall 2012)
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d. Subsequently, there is an increase in the U.S. national saving rate although the U.S. continues to engage in net foreign borrowing. Incorporating only this new information, clearly and accurately show in your diagrams above what effects, if any, this would have on each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and (4) net export balance. These effects should be drawn in BLUE.
e.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if anything, happens to each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and
(4) net export balance. Be sure to explain why these effects take place and what causes them.
An increase in the U.S. national saving rate increases desired saving at every real interest rate level.
This can be represented by a rightward shift of the U.S. desired saving function from SD0 to SD2.
The global supply of loanable funds has increased.
At the world real interest rate rW1 the global supply of loanable funds has increased while the global demand for loanable funds has not changed. As a result, the global supply of loanable funds now exceeds the global demand for loanable funds. This excess supply of loanable funds causes the equilibrium world real interest rate to decline from rW1 to rW2.
As a result of the increase in the U.S. national saving rate and the decline in the equilibrium world real interest rate from rW1 to rW2, desired saving in the U.S. has increased from S1 to S2 and desired investment in the U.S. has increased along the desired investment function ID0 from I1 to I2. Because desired saving has increased by more than desired investment, the net export balance (which is a deficit) has decreased from NX1 to NX2, i.e., net foreign borrowing by the U.S. has decreased.
In China, the decline in the equilibrium world real interest rate from rW1 to rW2 has decreased desired saving along the desired saving function SD1 from S1 to S2 and has increased desired investment along the desired investment function ID1 from I1 to I2. As a result of the decrease in desired saving and increase in desired investment, the net export balance (which is a surplus) has decreased from NX1 to NX2, i.e., net foreign lending by China has decreased.
Exam #1 (Fall 2012)
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2.
The Solow Growth Model (35 points). In 2004, the U.S. economy was at its steady state.
a.
Based only on this information, use a Solow Growth Model diagram to clearly and accurately show the economy’s initial (1) economic output-per-worker, (2) investment-per-worker, (3) capital-to-labor ratio, and (4) steady state. This diagram should be drawn in BLACK.
Y/L, I/L, IB/L
Y/L = A0 * f(K/L)
(Y/L)B
(Y/L)A
Y/L = A1 * f(K/L)
(Y/L)C
IB/L = (δ0 + gL0) * K/L
IB/L = (δ0 + gL1) * K/L
(Y/L)B
(Y/L)A
(Y/L)C
“A”
“B”
I/L = s0 * A1 * f(K/L)
“C”
(K/L)A (K/L)C
Exam #1 (Fall 2012)
I/L = s0 * A0 * f(K/L)
(K/L)B
K/L
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b. Beginning in 2005, the country’s large baby boom generation, which is a large proportion of the total labor force, will be retiring in large numbers. This process with take place over the next 20 years.
Incorporating only this new information, clearly and accurately show in your diagram above what effects, if any, the retirement of the baby boom generation will have on the economy’s equilibrium level of (1) economic output-per-worker, (2) investment-per-worker, (3) capital-to-labor ratio, and (4) the steady state. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagram above. Discuss what, if anything, happens to (1) the level of output-per-worker, (2) the capital-to-labor ratio, and (3) the steady state. Be sure to explain why these effects take place and what causes them.
Because the retirement of the baby boom generation is a process that will take place over the next
20 years, this results in a decrease in the labor force growth rate from gL0 to gL1. This can be represented by a downward rotation of the balanced investment-per-worker line from IB/L = (δ0 + gL0) * K/L to IB/L = (δ0 + gL1) * K/L where gL1 < gL0.
At the initial steady state capital-to-labor ratio, (K/L)A, actual investment-per-worker is now greater than balanced investment-per-worker, i.e., I/L > IB/L. As a result, the capital-to-labor ratio will increase.
As the capital-to-labor ratio increases, economic output- and income-per-worker increases along the per-worker production function Y/L = A0 * f(K/L), actual investment-per-worker and savingper-worker increases along the per-worker investment function I/L = s0 * A0 * f(K/L), and balanced investment-per-worker increases along the new, lower per-worker balanced investment function
IB/L = (δ0 + gL1) * K/L.
Because of diminishing returns to capital, the increases in balanced investment-per-worker are greater than the increases in actual investment-per-worker so that eventually actual investmentper-worker equals balanced investment-per-worker, establishing a new steady state at “B” and stabilizing the capital-to-labor ratio at (K/L)B.
Because the capital-to-labor ratio has increased from (K/L)A to (K/L)B, the per-worker production function indicates that economic output- and income-per-worker has increased from (Y/L)A to
(Y/L)B and actual investment-per-worker has increased from (I/L)A to (I/L)B.
Exam #1 (Fall 2012)
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d. In addition, the retirement of the baby boom generation will reduce the average age of the workforce.
Research has shown that there is a strong positive correlation between job skills and the average age of the working population. Incorporating only this new information, clearly and accurately show in your diagram above what effects, if any, this would have on the economy’s equilibrium level of (1) economic output-per-worker, (2) investment-per-worker, (3) capital-to-labor ratio, and (4) the steady state. These effects should be drawn in BLUE.
e.
Provide an economic explanation of what you have shown in your diagram above. Discuss what happens to (1) the level of output-per-worker, (2) the capital-to-labor ratio, and (3) the steady state. Be sure to explain why these effects take place and what causes them.
If there is a strong positive correlation between job skills and the average age of the labor force, then the retirement of the baby boom generation, which reduces the average age of the labor force, also reduces the average level of job skills in the economy, causing a decline in total factor productivity. This can be represented by a downward rotation of the per-worker production function from Y/L = A0 * f(K/L) to Y/L = A1 * f(K/L) and a downward rotation of the per-worker investment and saving function from I/L = s0 * A0 * f(K/L) to I/L = s0 * A1 * f(K/L) where A1 < A0.
At the capital-to-labor ratio (K/L)B, actual investment-per-worker is now less than balanced investment-per-worker, i.e., I/L < IB/L. As a result, the capital-to-labor ratio will decline.
As the capital-to-labor ratio decreases, economic output- and income-per-worker decreases along the new, lower per-worker production function Y/L = A1 * f(K/L), actual investment-per-worker and saving-per-worker decreases along the new, lower per-worker investment function I/L = s0 * A1
* f(K/L), and balanced investment-per-worker decreases along the per-worker balanced investment function IB/L = (δ0 + gL1) * K/L.
Because of diminishing returns to capital, the decreases in balanced investment-per-worker are greater than the decreases in actual investment-per-worker so that eventually actual investmentper-worker equals balanced investment-per-worker, establishing a new steady state at “C” and stabilizing the capital-to-labor ratio at (K/L)c.
[Depending on the magnitude of the shifts, steady state “C” may be to the left, equal to, or to the right of steady state “A”. I have drawn the last situation.]
Because the capital-to-labor ratio has decreased from (K/L)B to (K/L)C, the new, lower per-worker production function indicates that economic output- and income-per-worker has decreased from
(Y/L)B to (Y/L)C and actual investment-per-worker has decreased from (I/L)B to (I/L)C.
[Again, depending on the magnitude of the shifts, economic output-per-worker and actual investment-per-worker in steady state “C” may be lower than, equal to, or higher than in steady state “A”. I have drawn the last situation.]
Exam #1 (Fall 2012)
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f.
Discuss the rate of economic growth at (1) the initial steady state, (2) the final steady state, and (3) during the transition period from the initial steady state to the final steady state. Be sure to explain why these effects take place.
At the initial steady state “A” the economy is growing as fast as the labor force, i.e., gY(“A”) = gL0.
At the final steady state “C”, the economy is still growing as fast as the labor force, i.e., gY(“C”) = gL1. However, because the labor force growth rate slowed, i.e., gL1 < gL0, the economy is growing more slowly at steady state “C” than it was at steady state “A”, i.e., gY(“A”) < gY(“C”).
During the transition period from steady state “A” to steady state “C”, economic output-perworker is declining. As a result, the economy is growing more slowly than the (now more slowly growing) labor force, i.e., gY < gL1.
[Depending on the magnitude of the shifts, economic output-per-worker at steady state
“C” could be higher, the same, or lower than in steady state “A”. This will determine whether economic growth during the transition period is greater than, equal to, or less than the new, slower labor force growth rate.]
Exam #1 (Fall 2012)
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(Last name, first name)
SID: _________________________
GSI: _________________________
Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Fall 2012
Exam #1 ANSWERS
Please sign the following oath:
The answers on this exam are entirely my own work. I neither gave nor received any aid while taking this exam. I will not discuss the questions on this test until after 5:00 p.m. on September 27, 2012.
_______________________________________
Signature
Any exam turned in without a signature will be assigned a grade of zero.
Exam Instructions
1.
When drawing diagrams, clearly and accurately label all axes, lines, curves, and equilibrium points.
2.
Explanations should be written in pencil …show more content…
or black. Legibility is a virtue; practice good penmanship.
3.
Explanations should be succinct and to the point; make use of bullet points and common mnemonics.
4.
If you have a question, ask one of the GSIs. The GSIs have not seen the exam beforehand and can only provide general guidance. You are totally responsible for your answers regardless of what a GSI has said to you.
5.
If you need to re-draw a diagram and/or need more room to write your answers, use pages 2, 12, 13 and/or 14.
6.
If you finish your exam before 4:55 p.m. you may turn in your exam and quietly exit the room.
7.
If you finish your exam after 4:55 p.m., close your exam packet but remain seated until time is called.
8.
When time is called, STOP writing, immediately CLOSE your exam packet and TURN IN your exam. You WILL
BE PENALIZED if you continue to write past the official end of the exam.
Do NOT open this test until instructed to do so.
Exam #1 (Fall 2012)
1/10
A. Multiple Choice Questions (30 points). Circle the letter corresponding to the best answer (3 points each).
1.
The difference between inventories and inventory investment is that:
a.
b.
c.
d.
e.
2.
Suppose that the government announces a large tax increase on workers’ wages to take effect in 2 years. What would happen to current employment and the real wage?
a.
b.
c.
d.
3.
The real wage.
The real rental price (or cost) of capital.
The share of labor income in national income.
The share of capital income in national income.
If consumers (but not businesses) believe that a recession will occur next year, then what would happen to the real interest rate and investment this year?
a.
b.
c.
d.
5.
Both employment and the real wage would increase.
Both employment and the real wage would decrease.
Employment would increase and the real wage would decrease.
Employment would decrease and the real wage would increase.
Suppose that the economy is in equilibrium when an earthquake destroys one-quarter of the capital stock while not affecting the labor force which remains fixed. Once the economy has adjusted to its new equilibrium with a smaller capital stock, which of the following has decreased?
a.
b.
c.
d.
4.
Inventories are the stock of unsold goods while inventory investment is a flow that indicates productive activity. Inventories are measured at the end of the year while inventory investment is measured at the beginning of the year.
Inventories measure the total amount of capital goods while inventory investment measures the change in the amount of capital goods.
All of the above.
None of the above.
Both the real interest rate and investment would increase.
Both the real interest rate and investment would decrease.
The real interest rate would increase but investment would decrease.
The real interest rate would decrease but investment would increase.
Suppose that consumers have perfect foresight about future taxes. Then, a reduction in taxes this year that is accompanied by an exactly offsetting increase in future taxes would cause:
a.
b.
c.
d.
e.
A leftward shift of both the desired saving function and the desired investment function.
A rightward shift of both the desired saving function and the desired investment function.
A leftward shift of the desired saving function but no shift of the desired investment function.
A rightward shift of the desired saving function but no shift of the desired investment function.
No shift of either the desired saving function or the desired investment function.
Exam #1 (Fall 2012)
2/10
6.
Two competing explanations for why poor countries remain poor are (1) the poor quality of their institutions and
(2) poor geography. The facts that Las Vegas is situated in a desert but has been one of the fastest growing cities in the U.S. and Argentina was once quite prosperous but now is poor suggests:
a.
b.
c. …show more content…
d.
7.
The Solow and Romer models reach the same conclusions with respect to:
a.
b.
c.
d.
8.
The rate of inflation.
The economy’s long-run growth rate.
The impact of a change in the national saving rate.
The impact of a change in the labor force growth rate.
People tend to save very little once they retire. Over the next couple of decades, a large portion of the U.S. population—the baby boom generation—will retire. If investment and the government budget balance remain constant, then:
a.
b.
c.
d.
9.
Neither institutions nor geography are important.
Geography is far more important than institutions.
Geography has no effect at all on economic growth.
Institutions are far more important than geography.
The current account balance will increase.
The current account balance will decrease.
There will be no effect on the current account balance.
What happens to the current account balance is indeterminate.
Alan Greenspan, former Chairman of the Federal Reserve System, once maintained that lower inflation reduces the pricing power of business firms. This forces the firms to increase productivity to maintain profits. This view:
a.
b.
c.
d.
Is an implication of the Equation of Exchange.
Is an implication of the Quantity Theory of Money.
Is a contradiction of the Quantity Theory of Money.
Is a contradiction of the long-run neutrality of money.
10. Suppose that an economy described by the Solow model is at its steady state with its labor force growing by 2% per year when the central bank firmly commits to a policy of growing the money supply by 5% per year. An earthquake then destroys one-quarter of the capital stock. According to the quantity theory of money, as the economy recovers from the earthquake:
a.
b.
c.
d.
e.
Inflation remains steady at its initial rate.
Inflation initially accelerates and continues at a faster rate.
Inflation initially decelerates and continues at a slower rate
Inflation initially accelerates but then decelerates back to its initial rate.
Inflation initially decelerates but then accelerates back to its initial rate.
Exam #1 (Fall 2012)
3/10
B. Analytical Questions (70 points). Answer BOTH of the following questions based on the standard models of analysis developed in class. The information in the various parts of the questions is sequential and cumulative.
1.
Desired Saving – Desired Investment Model (35 points). Assume that the world is composed of only two large open economies—the U.S. and China— with perfect capital mobility and that the U.S. engages in large persistent net foreign borrowing.
a.
Based only on this information, use an open economy Desired Saving – Desired Investment Model diagram for each country (the U.S. on the left,
China on the right) to clearly and accurately show each economy’s initial (1) equilibrium real interest rate, (2) desired saving, (3) desired investment, (4) net exports. These diagrams should be drawn in BLACK.
China
The U.S.
r
I
D
S
0
D
S
0
D
I
D
0
I
D
S D0
1
S D1
2
rW0 rW1 rW2
NX1
NX1
NX2
NX2
S1
S0 S2
I0
NX0
Exam #1 (Fall 2012)
I1 I2
S D, I D
I0
I1 I2
S0
S2 S1
NX0
4/10
S D, I D
b. Now suppose that China experiences a large increase in its total factor productivity, a gain that also increases the expected future marginal product of capital that results in an increase in China’s net export balance. Incorporating only this new information, clearly and accurately show in your diagrams above what effects, if any, this would have on each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and (4) net export balance. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if anything, happens to each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and
(4) net export balance. Be sure to explain why these effects take place and what causes them.
If China experiences a large increase in its total factor productivity it also experiences an increase in its level of economic output and income. As a result of the increase in income there is also an increase in China’s national saving at every real interest rate level. This can be represented by a rightward shift of China’s desired saving function from SD0 to SD1. The global supply of loanable funds has increased.
If the increase in total factor productivity also increases the expected future marginal product of capital, China’s desired investment would increase at every real interest rate level. This can be represented by a rightward shift of China’s desired investment function from ID0 to ID1. The global demand for loanable funds has increased.
If China’s net export balance increases then China must increase its net foreign lending.
Thus, the increase in the global supply of loanable funds must be greater than the increase in the global demand for loanable funds. i.e., the rightward shift of China’s desired saving function from SD0 to
SD1 must be greater than the rightward shift of China’s desired investment function from ID0 to ID1.
At the world real interest rate rW0, the global supply of loanable funds now exceeds the global demand for loanable funds. This excess supply of loanable funds causes the equilibrium world real interest rate to decline from rW0 to rW1.
As a result of the decline in the equilibrium world real interest rate from rW0 to rW1 and the increase in China’s desired saving function from SD0 to SD1, desired saving has increased from S0 to
S1. As a result of the decline in the equilibrium world real interest rate from rW0 to rW1 and the increase in China’s desired investment function from ID0 to ID1, desired investment has increased from I0 to I1. Because desired saving has increased by more than desired investment, the net export balance (which is a surplus) has increased from NX0 to NX1, i.e., net foreign lending by China has
increased.
In the U.S., the decline in the equilibrium world real interest rate from rW0 to rW1 will decrease desired saving along the desired saving function SD0 from S0 to S1 and increase desired investment along the desired investment function ID0 from I0 to I1. Because desired investment has increased and desired saving has decreased, the net export balance (which is a deficit) has declined from NX0 to NX1, i.e., net foreign borrowing by the U.S. has increased.
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d. Subsequently, there is an increase in the U.S. national saving rate although the U.S. continues to engage in net foreign borrowing. Incorporating only this new information, clearly and accurately show in your diagrams above what effects, if any, this would have on each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and (4) net export balance. These effects should be drawn in BLUE.
e.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if anything, happens to each country’s (1) real interest rate, (2) desired saving, (3) desired investment, and
(4) net export balance. Be sure to explain why these effects take place and what causes them.
An increase in the U.S. national saving rate increases desired saving at every real interest rate level.
This can be represented by a rightward shift of the U.S. desired saving function from SD0 to SD2.
The global supply of loanable funds has increased.
At the world real interest rate rW1 the global supply of loanable funds has increased while the global demand for loanable funds has not changed. As a result, the global supply of loanable funds now exceeds the global demand for loanable funds. This excess supply of loanable funds causes the equilibrium world real interest rate to decline from rW1 to rW2.
As a result of the increase in the U.S. national saving rate and the decline in the equilibrium world real interest rate from rW1 to rW2, desired saving in the U.S. has increased from S1 to S2 and desired investment in the U.S. has increased along the desired investment function ID0 from I1 to I2. Because desired saving has increased by more than desired investment, the net export balance (which is a deficit) has decreased from NX1 to NX2, i.e., net foreign borrowing by the U.S. has decreased.
In China, the decline in the equilibrium world real interest rate from rW1 to rW2 has decreased desired saving along the desired saving function SD1 from S1 to S2 and has increased desired investment along the desired investment function ID1 from I1 to I2. As a result of the decrease in desired saving and increase in desired investment, the net export balance (which is a surplus) has decreased from NX1 to NX2, i.e., net foreign lending by China has decreased.
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2.
The Solow Growth Model (35 points). In 2004, the U.S. economy was at its steady state.
a.
Based only on this information, use a Solow Growth Model diagram to clearly and accurately show the economy’s initial (1) economic output-per-worker, (2) investment-per-worker, (3) capital-to-labor ratio, and (4) steady state. This diagram should be drawn in BLACK.
Y/L, I/L, IB/L
Y/L = A0 * f(K/L)
(Y/L)B
(Y/L)A
Y/L = A1 * f(K/L)
(Y/L)C
IB/L = (δ0 + gL0) * K/L
IB/L = (δ0 + gL1) * K/L
(Y/L)B
(Y/L)A
(Y/L)C
“A”
“B”
I/L = s0 * A1 * f(K/L)
“C”
(K/L)A (K/L)C
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I/L = s0 * A0 * f(K/L)
(K/L)B
K/L
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b. Beginning in 2005, the country’s large baby boom generation, which is a large proportion of the total labor force, will be retiring in large numbers. This process with take place over the next 20 years.
Incorporating only this new information, clearly and accurately show in your diagram above what effects, if any, the retirement of the baby boom generation will have on the economy’s equilibrium level of (1) economic output-per-worker, (2) investment-per-worker, (3) capital-to-labor ratio, and (4) the steady state. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagram above. Discuss what, if anything, happens to (1) the level of output-per-worker, (2) the capital-to-labor ratio, and (3) the steady state. Be sure to explain why these effects take place and what causes them.
Because the retirement of the baby boom generation is a process that will take place over the next
20 years, this results in a decrease in the labor force growth rate from gL0 to gL1. This can be represented by a downward rotation of the balanced investment-per-worker line from IB/L = (δ0 + gL0) * K/L to IB/L = (δ0 + gL1) * K/L where gL1 < gL0.
At the initial steady state capital-to-labor ratio, (K/L)A, actual investment-per-worker is now greater than balanced investment-per-worker, i.e., I/L > IB/L. As a result, the capital-to-labor ratio will increase.
As the capital-to-labor ratio increases, economic output- and income-per-worker increases along the per-worker production function Y/L = A0 * f(K/L), actual investment-per-worker and savingper-worker increases along the per-worker investment function I/L = s0 * A0 * f(K/L), and balanced investment-per-worker increases along the new, lower per-worker balanced investment function
IB/L = (δ0 + gL1) * K/L.
Because of diminishing returns to capital, the increases in balanced investment-per-worker are greater than the increases in actual investment-per-worker so that eventually actual investmentper-worker equals balanced investment-per-worker, establishing a new steady state at “B” and stabilizing the capital-to-labor ratio at (K/L)B.
Because the capital-to-labor ratio has increased from (K/L)A to (K/L)B, the per-worker production function indicates that economic output- and income-per-worker has increased from (Y/L)A to
(Y/L)B and actual investment-per-worker has increased from (I/L)A to (I/L)B.
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d. In addition, the retirement of the baby boom generation will reduce the average age of the workforce.
Research has shown that there is a strong positive correlation between job skills and the average age of the working population. Incorporating only this new information, clearly and accurately show in your diagram above what effects, if any, this would have on the economy’s equilibrium level of (1) economic output-per-worker, (2) investment-per-worker, (3) capital-to-labor ratio, and (4) the steady state. These effects should be drawn in BLUE.
e.
Provide an economic explanation of what you have shown in your diagram above. Discuss what happens to (1) the level of output-per-worker, (2) the capital-to-labor ratio, and (3) the steady state. Be sure to explain why these effects take place and what causes them.
If there is a strong positive correlation between job skills and the average age of the labor force, then the retirement of the baby boom generation, which reduces the average age of the labor force, also reduces the average level of job skills in the economy, causing a decline in total factor productivity. This can be represented by a downward rotation of the per-worker production function from Y/L = A0 * f(K/L) to Y/L = A1 * f(K/L) and a downward rotation of the per-worker investment and saving function from I/L = s0 * A0 * f(K/L) to I/L = s0 * A1 * f(K/L) where A1 < A0.
At the capital-to-labor ratio (K/L)B, actual investment-per-worker is now less than balanced investment-per-worker, i.e., I/L < IB/L. As a result, the capital-to-labor ratio will decline.
As the capital-to-labor ratio decreases, economic output- and income-per-worker decreases along the new, lower per-worker production function Y/L = A1 * f(K/L), actual investment-per-worker and saving-per-worker decreases along the new, lower per-worker investment function I/L = s0 * A1
* f(K/L), and balanced investment-per-worker decreases along the per-worker balanced investment function IB/L = (δ0 + gL1) * K/L.
Because of diminishing returns to capital, the decreases in balanced investment-per-worker are greater than the decreases in actual investment-per-worker so that eventually actual investmentper-worker equals balanced investment-per-worker, establishing a new steady state at “C” and stabilizing the capital-to-labor ratio at (K/L)c.
[Depending on the magnitude of the shifts, steady state “C” may be to the left, equal to, or to the right of steady state “A”. I have drawn the last situation.]
Because the capital-to-labor ratio has decreased from (K/L)B to (K/L)C, the new, lower per-worker production function indicates that economic output- and income-per-worker has decreased from
(Y/L)B to (Y/L)C and actual investment-per-worker has decreased from (I/L)B to (I/L)C.
[Again, depending on the magnitude of the shifts, economic output-per-worker and actual investment-per-worker in steady state “C” may be lower than, equal to, or higher than in steady state “A”. I have drawn the last situation.]
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f.
Discuss the rate of economic growth at (1) the initial steady state, (2) the final steady state, and (3) during the transition period from the initial steady state to the final steady state. Be sure to explain why these effects take place.
At the initial steady state “A” the economy is growing as fast as the labor force, i.e., gY(“A”) = gL0.
At the final steady state “C”, the economy is still growing as fast as the labor force, i.e., gY(“C”) = gL1. However, because the labor force growth rate slowed, i.e., gL1 < gL0, the economy is growing more slowly at steady state “C” than it was at steady state “A”, i.e., gY(“A”) < gY(“C”).
During the transition period from steady state “A” to steady state “C”, economic output-perworker is declining. As a result, the economy is growing more slowly than the (now more slowly growing) labor force, i.e., gY < gL1.
[Depending on the magnitude of the shifts, economic output-per-worker at steady state
“C” could be higher, the same, or lower than in steady state “A”. This will determine whether economic growth during the transition period is greater than, equal to, or less than the new, slower labor force growth rate.]
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