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UGBA 101B
Macroeconomic Analysis
Professor Steven Wood
Summer 2008

Exam #1 ANSWERS
Please sign the following oath:
The answers on this test are entirely my own work. I neither gave nor received any aid while taking this
test. I will not discuss the questions on this test until after 5:30 p.m. on June 10, 2008.
______________________
Signature
Any test turned in without a signature indicating that you have taken this oath will be assigned a grade of
zero.
Graph Instructions
When drawing diagrams, the following rules apply:
1.

Completely, clearly and accurately label all axes, lines, curves, and equilibrium points.

2.

The original diagram and any equilibrium points MUST be drawn in black or pencil.

3.

The first change in any variable, curve, or line and any new equilibrium points MUST be drawn in red.

4.

The second change in any variable, curve, or line and any new equilibrium points MUST be drawn in blue.

5.

The third change in any variable, curve, or line and any new equilibrium points MUST be drawn in green.

Do NOT open this test until instructed to do so.

Good Luck!

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A. Multiple Choice Questions. Circle the letter corresponding to the best answer. (3 points each; total of 30 points.)
1.

A technological breakthrough in using photons for computers will increase the productivity of those working
with computers a hundredfold. You would expect this breakthrough to shift the:
a.
b.
c.
d.

2.

A permanent increase in the real wage has a _______ income effect on labor supply than a temporary
increase in the real wage, so labor supply is _______ with a permanent wage increase than for a temporary
wage increase.
a.
b.
c.
d.

3.

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.

Desired national saving would increase unambiguously if there were:

a.
b.
c.
d.

5.

Larger; more.
Larger; less.
Smaller; more.
Smaller; less.

A bird flu epidemic causes many people to flee the country but does not affect labor demand significantly
because almost all the goods produced within the country are exported. What happens to current employment
and the real wage?
a.
b.
c.
d.

4.

Labor demand curve to the right, increasing the quantity of labor demanded at any given real
wage.
Labor demand curve to the left, reducing the quantity of labor demanded at any give real wage.
Labor supply curve to the right, reducing the quantity of labor demanded at any given real wage.
Labor supply curve to the left, increasing the quantity of labor demanded at any given real wage.

An increase in both current output and expected future output.

An increase in both expected future output and government purchases.
An increase in both expected future output and the expected real interest rate.
A decrease in both government purchases and expected future output.

If the government reduces the effective tax rate on capital, then the real interest rate _______ and saving
_______.
a.
b.
c.
d.

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Falls, decreases.
Falls; increases.
Rises; increases.
Rises; decreases.

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6.

When a temporary beneficial supply shock hits a small open economy, it causes the current account to
_______ and investment to _______.
a.
b.
c.
d.

7.

When a temporary adverse supply shock hits a large open economy, it causes the current account balance to
_______ and investment to _______.
a.
b.
c.
d.

8.

Fall; fall.
Rise; remain unchanged.
Fall; remain unchanged.
Rise; fall.

A new pollution law requires businesses to pay for inspections of their factories by independent pollutionmonitoring firms. What effect is this likely to have?
a.
b.
c.
d.

9.

Fall; fall.
Rise; remain unchanged.
Fall; remain unchanged.
Rise; fall.

Increase productivity.
Increase the capital stock.
Decrease productivity.
Increase the demand for labor in those firms.

The information technology (IT) revolution has led to an increase in productivity but also an increase in the
rate of depreciation because computers have to be replaced more often that other types of equipment.
Overall, then:
a.
b.
c.
d.

Income-per-worker will increase.

Income-per-worker will decrease.
There is no effect on income-per-worker.
The effect on income-per-worker is indeterminate.

10. Suppose that an economy described by the Solow model is initially in steady state with an economic growth
rate of 3%. An earthquake then destroys one-half of the capital stock and kills one-half of the labor force.
After the earthquake:
a.
b.
c.
d.

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The growth rate of income-per-worker initially increases but then is zero at the new steady state.
The growth rate of income-per-worker initially decreases but then is zero at the new steady state.
The growth rate of income-per-worker decreases permanently.
The growth rate of income-per-worker does not change but economic output declines.

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B. Answer BOTH of the following questions in the space provided. (35 points each, total of 70 points.)
1.

Sd Id Open Economy Model. Suppose that the world economy is composed of only two large, openeconomy countriesChina and Eurolandand that the China is running a substantial current account
surplus.
Based only on this information, use a 2 country Sd Id Open Economy diagram to accurately and
clearly show:

a.

i.

The initial equilibrium situation in both countries (in black),

ii.

The short-run effects in both countries on desired national saving, desired investment, and
the current account balance as well as the effect on the world real interest rates of a
decrease in government spending in the China with no Ricardian equivalence.

Euroland

China
Sd

Sd

Sd

CA > 0
rw
rw

rw
CA < 0

CA > 0

rw

CA < 0

Id

Id

Sd, Id

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Sd, Id

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b.

Provide a brief economic explanation of the changes you showed in your diagrams above. For each
country, be sure to explain what happens (and why) to the level of desired national saving, desired
investment, and the current account balance between the initial and final short-term equilibrium
situation. Also be sure to explain what happens (and why) to the world interest rate.
Because both China and Euroland are large, open economies, there will be a single world
interest rate, rw. At the world interest rate rw, China initially has a current account surplus
that is identical (in absolute value) to Euroland current account deficit.
If China decreases government spending with no Ricardian equivalence, then desired national
saving in China increases and shifts the China Sd curve to the right. At the initial world
interest rate, China now has an excess of desired national saving over desired investment, i.e.
Sd > Id.
As China lend this excess saving abroad, it increases both Chinas financial and capital
account deficit because China buys more foreign assets and Chinas current account surplus.
As a result of the increased global saving, the world interest rate declines. As the world
interest rate declines desired national saving decreases and desired investment increases in
both China and Euroland.
The net result for China is increased desired national saving, increased investment, and a
larger current account surplus.
The net result for Euroland is decreased national saving, increased desired investment, and a
larger current account deficit.

c.

How would your answers above be different if complete Ricardian equivalence DOES hold?
If Ricardian equivalence did hold then taxpayers would anticipate future reductions in taxes.
Lower expected future taxes would increase expected future disposable income and increase
current consumption expenditures. This would reduce desired national saving.
However, the reduction in private saving would be less than the increase in government
saving because of the change in the expected future taxes works through the marginal
propensity to consume. Consequently, desired national saving in China would still increase
although not by as much as without Ricardian equivalence. Thus, there is still an excess of
desired national saving over desired investment at the initial world interest rate.
As a result of the increased global saving, the world interest rate declines. As the world
interest rate declines desired national saving decreases and desired investment increases in
both China and Euroland.
The net result for China is increased desired national saving, increased investment, and a
larger current account surplus but these changes would be smaller than with no Ricardian
equivalence.
The net result for Euroland is decreased national saving, increased desired investment, and a
larger current account deficit but these changes would be smaller than with no Ricardian
equivalence.

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2.

Solow Growth Model. According to some economists, lower marginal tax rates stimulate faster growth in
the labor force, a higher private saving rate, and higher productivity. They further believe than any effect
from the change in government saving would be greater than any effect from the change in private saving.
a.

Suppose that this theory is correct, that the economy can be described by the Solow Growth Model,
and that the economy is initially at a steady state. Based only on this information, use a Solow
Growth Model diagram to accurately and clearly show:
i.

The economys initial steady state,

ii.

The effect of on the economys capital-to-labor ratio and income-per-worker from a

reduction in marginal tax rates, and

iii.

The economys final steady state.

Y/N, S/N, Ib/N

Y/N

(Y/N)B
(Y/N)
Y/N
(Y/N)A
Ib/N
Ib/N

S/N
S/N
S/N
S/N

(K/N)A (K/N)B

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K/N

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b.

Provide a brief economic explanation/description of:

i.

The capital-to-labor ratio, the level of income-per-worker, and the rate of economic growth
at the economys initial steady state,

ii.

Why you made the changes you showed in your diagram above,

iii.

The adjustment process that occurs during the transition period from the economys initial
steady state to its final steady state, and

iv.

The capital-to-labor ratio, the level of income-per-worker, and the rate of economic growth
at the economys final steady state.

The economy begins at steady state A with a capital-to-labor ratio of (K/N)A and incomeper-worker of (Y/N)A. The economy is growing at the same rate as the labor force, i.e.,
(Y/Y)A = (N/N)A.
The government then cuts marginal tax rates, which has four effects.
First, the cut in marginal tax rates reduces government saving, SG, and shifts the
savings function down.
Second, the cut in marginal tax rates leads to an acceleration in labor force growth,
N/N, and rotates the balanced investment line higher.
Third, the cut in marginal tax rates increases the private saving rate, s, and shifts the
saving function up (but by less than downward shift due to the reducing in
government saving).
Fourth, the cut in marginal tax rates leads to higher productivity, A, and shifts both
the production function and saving function up.
As a result of these four changes a new steady state is created at B. This steady state may or
may not be higher than steady state A depending on how far the production function and
saving function shift up. [In my diagram, steady state B is higher than steady state A so
that both (Y/N)B and (K/N)B are higher than they were at steady state A.]
At the initial capital-to-labor ratio, (K/N)A, Y/N has increased because of the upward shift in
the production function. In addition at (K/N)A, Ia/N is now greater than Ib/N because of the
effect of the net upward shift in the saving function on Ia/N is greater than the effect of the
upward rotation of the balanced investment line on Ib/N. Consequently, K/N will increase and
Y/N will increase along the new, higher production function. This will continue until the
economy reaches steady state B where both K/N and Y/N are higher than they were at
steady state A.
At steady state B the capital-to-labor ratio has increased to (K/N)B and income-per-worker
have increased to (Y/N)B. At steady state B, the pace of economic growth is equal to the rate
of labor force growth, i.e., (Y/Y)B = (N/N)B, which is faster than at steady state A because
of the acceleration in labor force growth, i.e., (N/N)B > (N/N)A.

THE END
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