Midterm Two Answers
Economics 100b; Spring 1996
Part I. Multiple Choice (12 1/2 minutes; 25 points)
1. Assuming no population growth and no increase in the efficiency of
labor, the steady-state level of capital per worker is calculated by:
a. dividing the depreciation rate by the savings
b. looking for the intersection of the y=f(k) line with the "dk"
c. dividing the savings rate by the depreciation rate.
d. using the multiplier to determine the level of investment
consistent with full employment.
- c. dividing the savings rate by the depreciation rate.
2. The Golden Rule level of capital accumulation is the steady state
a. the highest growth rate of output
b. the highest level of output per worker
c. the highest level of depreciation per worker
d. the highest level of consumption per worker
- d. the highest level of consumption per worker: there is no
growth path with higher consumption per worker in every
3. The Solow growth model predicts that countries with higher
population growth rates will have
a. lower growth rates of output
b. higher growth rates of output per worker
c. the same growth rate of total output, but a lower level of
d. none of the above
4. In the Solow growth model, persistent increases in standards of
living are due to:
a. technological progress
b. faster labor force growth
c. higher levels of net exports
d. a larger initial stock of capital per worker
5. Today, America's capital stock is below the Golden Rule level. We
know this because:
a. The return on investment is greater than the sum of
the deprecation rates and the growth rates of population and labor
b. The U.S. runs a persistent trade deficit.
c. The U.S. has not yet converged to its steady-state growth
d. We don't know this; the capital stock is above the Golden Rule
6. In the 1950s, the Federal Reserve bought and sold gold on demand
at a price of $35 an ounce; the Bank of England bought and sold gold
on demand at a price of 14 pounds, 11 shillings, 8 pence an ounce.
The dollar-pound sterling exchange rate was thus:
a. impossible to determine from the information
b. $5 to the pound sterling.
c. About $2.40 to the pound sterling.
d. About $0.45 to the pound sterling.
7. If national output is $7,000 billion a year, and domestic spending
on all goods and services is $7,200 billion a year, then net exports
b. -$200 billion a year
c. +$200 billion a year
d. it depends on the real interest rate.
8. In a small open economy with a floating exchange rate, fiscal
a. has powerful effects on employment, but not on
output or the exchange rate
b. has powerful effects on the exchange rate, but not on employment
c. has powerful effects on output, but not on employment or the
d. has powerful effects on all three macroeconomic variables.
- b (the LM* curve is unchanged as the IS* curve shifts out).
9. Monetary policy has the largest effects on output in a:
a. small open economy with a fixed exchange rate
b. small open economy with a floating exchange rate
c. large open economy with a fixed exchange rate
d. closed economy
- b (in a closed economy changes in interest rates mean that
output does not increase by the full shift in the LM curve; in an
open economy output does increase by the full shift in the LM
10. Imposing high tariffs (and making no other changes in government
tax and spending policy) in a floating exchange rate system will:
a. boost net exports because the additional tariff
collections will reduce the government deficit and increase total
b. have no effect on net exports, but lower the exchange rate
c. lead to a recession
d. require a tighter monetary policy.
- a (remember, a tariff is a tax--the government collects it. So
an increase in tariffs will reduce the deficit and so boost
Part II. Short Answer (3 sentences per question; 12 1/2 minutes;
1. What is the Mundell-Fleming model?
- The Mundell-Fleming model is the generalization of the
short-run IS-LM framework to the case of a "small open economy":
imports and exports depend on the exchange rate, and international
capital mobility means that domestic interest rates are set by
conditions on the world's capital market. It is usually analyzed
by means of a graph with the exchange rate on the vertical and
output on the horizontal axis.
2. What does it mean to analyze a situation as if the economy were
"small and open"? When is this assumption a good one? When is this
assumption a bad one?
- (i) domestic monetary or fiscal policies have no effect on the
world rate of interest; (ii) investors and speculators in
international currency markets place their money where it will
earn the highest rate of return (so it is impossible for, say, the
domestic interest rate to differ from the world interest rate for
any reason other than expected exchange rate changes). This
assumption is a good one when the economy is in fact small and
open. It is a bad one when international capital mobility is low,
or when domestic policies have large effects on the outside world.
3. What is the "capital account"?
- or "net foreign investment." Any trade balance--any surplus or
deficit of exports over imports--must be financed somehow. If
foreigners buy more dollars' worth of U.S. products than they sell
to the U.S., someone must loan them the difference. If foreigners'
sell more dollars' worth of products to the U.S. than they buy,
they must invest the difference somewhere. The capital account or
net foreign investment is thus equal to the trade balance, and
amounts to the necessary financing for the trade balance.
4. In advanced post-industrial economies, is more economic growth
generated by better technology and labor efficiency, or by increased
investment in physical capital?
- Better technology and labor efficiency. Increased capital
intensity plays a relatively small role in post-industrial growth.
Note, however, that it plays a large role in industrial growth.
Part III. International Economics (12 1/2 minutes; 25 points)
Suppose that the United States can be best modeled as a small
open economy. Suppose that annual national product is $7,000 billion
a year, with both government spending and taxes at $1,400 billion a
year, with private investment equal to (in billions):
1400 - 140*(r-2%)
where the real interest rate is measured in percent per year.
Suppose, further, that the government spending and investment
multipliers are equal to 2; that the initial equilibrium exchange
rate is $1 equals 100 yen; and that net exports (in billions) are
NX = 7*(100 - e)
where e is the real exchange rate in yen.
Suppose that real interest rates in the rest of the world--which had
been averaging 2% per year--suddenly jump up to 5% per year as a
result of contractionary monetary policies adopted by the Bank of
Japan and the Bundesbank. The Under Secretary of the Treasury
for International Affairs declares that the continued world
leadership of the United States depends on keeping the dollar
exchange rate at or above 100 yen. The Chair of the CEA declares that
the right policy is to let the dollar fall so that any reduction in
investment is offset by an expansion of net exports, and that
monetary retriction abroad is not allowed to trigger a recession at
Your boss--the Secretary of Commerce, say--wants you to write a
brief memo telling her what is at stake. What shifts in
economic policy are required to carry out the Under Secretary of the
Treasury's and the CEA Chair's preferred policies? What effects do
these policies (and the increase in world interest rates) have on
other macroeconomic variables?
Is there a policy to both maintain the value of the dollar and avoid
a domestic recession? What is it?
- Start from the Mundell-Fleming IS*-LM* model with a fixed
exchange rate. The sudden rise in the world interest rate is
(under the fiction that the U.S. is a small open economy) a large
backward shift in the IS* curve--a fall in real GDP at a constant
exchange rate of some $840 billion a year (given the investment
demand curve and given a multiplier of two)
The CEA Chair wants the response to this shock to be to hold the
position of the LM* curve steady, so that the exchange rate falls,
net exports rise (by $420 billion), and real GDP stays constant.
In order to keep real GDP constant, the exchange rate would have
to fall to $1=40 yen.
The Under Secretary of the Treasury wants monetary policy
tightened to keep the exchange rate at $1 = 100 yen. But so doing
would translate all of the shift in the IS* curve into a fall in
output--and with current GDP of $7 trillion, an $840 billion fall
is a 12% decline in output, and is by Okun's Law about a 6
percentage-point rise in the unemployment rate: a truly fearsome
The way to avoid having to choose between these unpleasant
alternatives is to do something to move the IS* curve back to its
old position in spite of the high increase in overseas interest
rates. The obvious thing to do is to use fiscal policy: tax cuts
and spending increases to offset the backward shift in IS* and
keep short-run equilibrium at the same level of GDP and of the
Part IV. Long Run Growth (12 1/2 minutes; 25 points)
In Taiwan today, gross capital income is about 40% of GDP, the
savings rate is 30%, the average rate of growth of output is about 5
percent per year, the average rate of population growth is about 1
percent per year, and the depreciation rate is about 4 percent per
Suppose that Taiwan is able to maintain these investment, population
growth, depreciation, and labor efficiency growth rates far into the
1. What is the steady-state capital-output ratio?
2. What will the marginal product of capital (rate-of-return on
investment) be in this steady state?
- 40%/3 = 13.333% per year is r, the marginal product of
3. When Taiwan reaches its steady-state growth path, will its capital
stock be above or below the "Golden Rule" value?
4. What will the long-run rate of growth of total GDP be in the
steady state? What will the long-run rate of growth of GDP per worker
be in steady state?