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Econ 471/571 Answer Key for Midterm 2A Spring 2014




Question;Econ;471/571;Answer Key for;Midterm 2A;Spring 2013;Part;I;(22 points total) The Government Budget Constraint: Illustrations;0. (6 points) For this question, assume;that the Central Bank of Oregon is committed to constant prices ? its;a. What is Oregon?s projected basic;deficit for 2015 (in dollars)? $;b. What;is Oregon?s projected total deficit for 2015 (in dollars)?;c.;How much new debt will Oregon?s Treasury;issue(?BT);during 2015? $;d.;How much of the new debt issued by Oregon?s Treasury during 2015 will be;purchased by the Central Bank of Oregon? $;e.;How much of the new debt will be;purchased by Oregon?s public(?B)? $;f.;Oregon?s federal debt at the end of 2015;(B2015);will be $ ___.;2.;(4 points) Suppose that Oregon continues pursue this set of policies;(including target inflation of zero) indefinitely. Then;a.;Oregon?s total deficit;will [remain;unchanged, increase by declining amounts;i, decrease, decline;in real terms] over time.;b. Oregon?s;federal debt will [remain;unchanged, increase by declining amounts;decrease, decline in real terms];over time.;?3. (9 points) Now return to the;beginning of the year 2015 and consider a different policy scenario. Oregon?s;population has elected new deranged leaders who;?;Default on the federal;debt, so that Oregon begins 2015 with B=0.;?;Do not change;taxes or government spending (T and G remain at 60B and 39B in;real terms).;? Recognize;that they have blown their credit rating, so debt financed spending is not an;option.;?;Pass legislation;requiring the central bank to purchase any government debt issued by the;Treasury in its entirety.;a. What is;Oregon?s projected total deficit for 2015 (in dollars)? $;b. How much new;debt will Oregon?s Treasury issue (?BT);during 2015? $;c.;How much of the new debt issued by Oregon?s Treasury during 2015 will be;purchased by the Central Bank of Oregon? $;d. By how much;will high-powered money increase during 2015? $;e. The inflation;rate in Oregon over the year 2015 will be ____%.;f.;The consequences for Oregon in subsequent years of continuing to pursue this;set of policies will be continuing inflation at [an increasing;constant];rate.;4.;(3 points) Finally, suppose that Oregon had not defaulted on its;federal debt in the previous question, but had simply switched from debt;finance to pure money finance in 2015. Then the real value of Oregon?s debt;would [increase;remain constant] over time.;In;answering the questions in this section, use the life-cycle theory of;consumption and assume that;(i);the expected lifespan of the household;is 2 years;(ii);the household's earning span is also 2;years (sadly, no retirement);(iii);the household's income is 200 schmoos in;the first period of life and 55 schmoos in the second period (Y1=200;and Y2=55);(v);the interest rate is constant at r =;10%;(vi);the household enters life with no assets;and leaves no bequests;(vii);the household plans to;consume the same amount, C, in every period of life;1.;(3 points) What is the present value of the household's disposable;income stream (its remaining lifetime wealth, RLW) at the beginning of life?;(Don't forget to take account of the taxes in the first period of life.);2. (3;points) Find the household's level of consumption in each of the two;periods of life.;3.;(4 points) Record the amounts of the household's income, consumption;saving, and assets in each of the two periods of life in Table 1 below.;Table;1: Tax Finance;Period 1;Period 2;Non-Interest;Income (Y);Less Taxes (T);Disposable;Income (YD);Consumption;(C);Savings;(S): YD + Interest income - C;Assets;(A): A(t) = A(t-l) + S;Lifetime;Wealth (Period 1 only);Now;suppose that the government chooses to finance its spending in period 1 by;issuing debt. It eliminates the tax of 40 schmoos on the household in the first;period of life. Instead, it sells a bond with a face value of 40 schmoos and a;maturity of one period. The bond pays the market interest rate of 10%.;Accordingly, the household correctly anticipates that it will be taxed 44;schmoos in the second period of life so that the government can pay the;interest and the principal due on its debt in period 2.;4.;(10 points) Record the household?s income, consumption, savings, and;assets in each of the two periods of life in Table 2 below.;Table;2: Bond Finance;Period 1;Period 2;Non-Interest;Income (Y);Less Taxes (T);Disposable;Income (YD);Consumption;(C);Savings;(S): YD + Interest income - C;Assets;(A): A(t) = A(t-l) + S;Lifetime;Wealth (Period 1 only);5. (5 points) Based on your work;above and/or on the reading you have done for this class, evaluate the;following assertion as ?true?, ?false?, or ?uncertain?. Explain briefly (25;words, more or less).;Under;the assumptions of Ricardian equivalence, a switch from tax finance to bond;finance will have no effect on the IS curve and (therefore) no effect on;aggregate demand.;Part;III:(29;points total)Circle;the word or phrase in each set ofsquare brackets that best completes;the statement.;1.;(8 points) The Government;Budget Constraint.;a.;Ceteris paribus, a central bank that sets a high target rate of;inflation will monetize;less, no more or less] debt than a central;bank that sets a low target rate of inflation.;b.;Ceteris paribus, a country with a low inflation rate will experience;growth in its federal debt that is [smaller,, no different];than a country with a high inflation rate.;c.;Turkey has been in the news over the past year due to large deficits and;alarming increases in its federal debt. Ceteris paribus, if Turkey were;to raise taxes (T) by enough to fully cover government spending on goods and;services (G), it?s federal debt would [stop growing, begin to decline,].;d. Ceteris paribus, one would;expect countries with relatively large amounts of production that do not pass;through legal markets (e.g., home production, illegal drugs, etc.) to rely on;bond and/or money finance;less than, to the same degree as] countries in which;production is predominately legal market activity.;2. (8 points) Keynesian;Consumption Theory. Circle the word or phrase in each set of square;brackets that best completes the statement. As in the previous question, these;are ceteris paribus statements.;Keynesian;consumption theory;a.;predicts that households with high disposable income will consume a fraction of;their income that [is;higher,i, is no different;may be higher or lower] than households with;low disposable income. In the usual linear representation of the Keynesian;consumption function, this corresponds to a [zero;negative, unsigned];intercept term (C).;b.;led to predictions of (low;investment spending, excessive consumption spending;following WWII.;c. predicts that a switch from;tax-finance to bond-finance will cause [, a fall;no change];in consumption spending and, therefore, aggregate demand.;d.;predicts that taking income from the rich and giving it to the poor will raise;consumption and, therefore, aggregate demand. ];3. (8 points total);The Life Cycle Hypothesis;Suppose;that unanticipated federal legislation imposes mandatory retirement for all;workers at age 50, effective immediately. Based on Mankiw?s version of the;life-cycle theory of consumption, one would expect that over the next year;a.;the consumption spending of households already retired at the time of the;legislation [will;rise, will fall,, may rise or fall].;b.;the consumption spending of working households under the age of 50 [will rise;will be unaffected, will rise or be unaffected;c. the consumption spending of younger;working households will be affecteds;more, no;differently] than the consumption spending of older;working households.;d. aggregate;demand [will;rise,, will be unaffected, may rise or fall].;4. (5;points) Interpreting Empirical Evidence;a.;Using the spectacular skills acquired in EC 320, you have estimate the;following consumption function using 70 years of time series data on real;aggregate consumption and disposable income;C = (.9)DI;Based;on this result, you conclude that the APC [rises, falls;t];as disposable income rises.;This;consumption function is [consistent,];with Keynesian consumption theory and;not consistent] with the life-cycle hypothesis.;b.;Next you estimate a consumption function using U.S. data taken from a;cross-section survey of households and find that;C = 4,000 +;(.75)DI;The;results of this cross-section survey are [, not consistent];with Keynesian consumption theory and [ not consistent];with the life-cycle hypothesis.


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