ECON 330D2: Macroeconomic Theory Midterm Exam 1 Section 2 February, 2021 This is a take home exam. Once you start the exam, you will have 90 minutes to submit your solutions. You will need to submit your solution before 9am EST on Feb 18, 2021 at the latest. Late submissions will not be accepted. The exam consists of two questions (with subquestions), covering material from chapters 9, 10 and 11. I recommend that for each question, you answer all subquestions on paper, scan or photograph your answers, combine them into a single pdf file, and upload that file as a response to the question. You have a grace period of 15 minutes to deal with this processing. The weight of each question is indicated on the exam. The exam is self-contained. Therefore, neither I nor the TA will answer questions during the exam. (Unless there is a major technical problem.) By submitting your answers, you agree to the following: “Your electronic submission of this exam certifies that you have not, nor will you, consult with any other person about the exam, or any other subject related to it. Students who consult will be subject to disciplinary action as per the Student Code of Conduct.” Economics 330D2 Winter 2021 Midterm Exam Question 1 (60 points) Using the intertemporal model, analyze the coronavirus crisis. You could think of the crisis as the result of three shocks: • A purely medical shock: workers getting sick and not being able to produce output • Public and and private containment measures: school and factory closures, travel restric- tions, and quarantines. • Beliefs and expectations about the future. Use graphs and explanations in answering these three questions: 1. Describe in detail how ND, NS, YD and YS are affected by the shocks. Also, determine the total effect of these changes on current aggregate output, current employment, the current real wage, current real interest rate, current consumption, and current investment. If some changes are ambiguous, make assumptions and justify them well. (20 points) Answer: • NS shifts left because people are not able to go to work • ND shifts left because firms are not hiring and YS shifts left because of less N and maybe lower supply of inputs. • Yd shifts left because of less consumption and investment (mobility restrictions, quar- antines and uncertainty about the future) • What happens to r is uncertain and therefore the adjustment to NS is also uncertain. 2. Assume that due the negative economic shock, some individuals in the economy have important financial problems and are not able to repay their credits. Banks do not know a priori which individuals will be able to repay and which not. Using the intertemporal model, explain how this can affect the economy. Describe in detail how an increase in credit market frictions affects ND, NS, YD and YS. Also, determine the effects of this on current aggregate output, current employment, the current real wage, current real interest rate, current consumption, and current investment. In answering this question, focus only on the effect of a change in credit market frictions. (20 points) Answer: The answer is the same as the increase in credit market constraints that we saw in chapter 12: • YD shifts left because of less consumption • NS shifts right because of hire desire to work • Ys shifts left because of more N • We will assume that the change in Yd is larger than the change in Ys. Then r decreases and this shifts NS to the left. 3. Suppose that, in response to the increase in credit market frictions, the government de- creases current taxes while holding government spending in the present and the future constant. Determine the effect of this on current aggregate output, current employment, the current real wage, current consumption, and current investment. (20 points) Answer: Here Ricardian equivalence does not hold. The answer is the same as in question 1.2. but in opposite direction. 1 Economics 330D2 Winter 2021 Midterm Exam Question 2. A (40 points) 1. An old person and a young person both win a lottery worth the same dollar value. Ac- cording to the life cycle model, whose current consumption will increase by more? How do you know? (10 points) Answer: The young person will want to smooth consumption over more periods. The old person will want to consume more in the current period. 2. Explain verbally and graphically why many economists argue that Social Security has had a negative effect on the capital stock. (10 points) Answer: With Social Security the old individuals will be able to sustain teh same amount of consumption with less capital since their consumption does not come from capital income, it comes from taxes paid by the young. Since there is more consumption, Yd shifts to the left, the r increases and this reduces investment. 3. Explain the extent to which you agree with this statement: Ricardian equivalence shows that government deficits do not matter. (10 points) Answer: The current deficit does not matter for current consumption but the lifetime budget constrain matters. Some students may have answered that with credit market constraints, Ricardian equivalence does not hold and then government deficits matter. This is not full points, but it is also a good answer. 4. How do changes in r provide information about the scarcity of resources today relative to tomorrow? (10 points) Answer: If preferences of today versus tomorrow change, or output today vs the future changes, then r changes. Question 2. B (40 points) 1. Suppose that the representative consumer we study wins a lottery and is given the choice between receiving, with certainty, $10 today and $0 tomorrow, or $5 today and $5 tomor- row. Explain which she would choose and why. (10 points) Answer: The consumer chooses $10 today and $0 tomorrow because future income is discounted. 2. Suppose the generosity of social security benefits increase. How would this affect the consumption of someone in their prime working years? (10 points) Answer: This consumer will have to pay more taxes but will need to save less, so heshe will not be affected. 3. Politicians often talk about how tax cuts will stimulate consumption. Discuss why this claim is incomplete. (10 points) Answer: Temporary tax cuts will stimulate consumption only if Ricardian equivalence does not hold. 2 Economics 330D2 Winter 2021 Midterm Exam 4. Describe why a permanent change in taxes has a larger effect on consumption than a one-time change in taxes. (10 points) Answer: A permanent change in taxes will be associated to a change in government spend- ing. A change in G will change lifetime income and therefore will affect consumption. 3
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