Economics 219

Practice Midterm #2

Part I: True, False or Uncertain and Explain (5 points each)

1)      A transfer program such as social security or welfare is simply redistributing income from one group to another so there’s no reason to believe that interest rates or employment will be affected.

2)      Paying down the national debt will necessarily lower interest rates in the United States.

3)      Public Goods such as Public Television can be efficiently provided and priced by the private sector.

4)      Government spending “crowds out” private investment by raising interest rates.

5) Tax revenues always increase when the tax rate is increased.

Part II: Short Answer  

6)      (5 points) Suppose that the Federal Reserve makes an $10M open market purchase of government bonds.  What effect does this have on the monetary base? What should happen to the price level?

7)      (5 points) Suppose that a drop in productivity lowers real income in the US.  What should happen to the demand for money and prices is the US?  If the goal of the Fed is to maintain a constant price level, how should they react to this productivity decline?

8)  ( 5 points) True or False and explain: Scrooge Mcduck is a fabulously wealthy businessman who keeps a vault full of cash so that he can bathe in money every night.  When Scrooge hoards cash he benefits nobody but himself.  It would be better for the rest of us if he would spend some of that money.

9)      (10 points) During WWII, prisoners of war often used cigarettes as money.  Do cigarettes satisfy the criterion for money? Explain.  What is a drawback to using cigarettes as currency?

10)      (10 points) Suppose that the Federal Reserve was following a Gold standard.  How would the Fed need to respond to the following events? What would be the impact on the economy?

a)      An evil super villain builds a gold machine and floods markets with new gold. (As in “Hudson Hawk”)

b)      A terrorist steals all the gold from the NY Fed and blows it up (as in “Die Hard with a Vengeance” – although the terrorist didn’t really blow up the gold!)

11)      (15 points) The Federal Reserve has three instruments of monetary policy.  For each instrument, explain:

a)      The impact on the Fed’s balance sheet and the monetary base

b)      The impact on the money multiplier

c)      The impact on the M1 money supply

12)      (15 points) Suppose that the government decided to switch from an income tax to a national sales tax (consumption tax).  That is, assume that government spending stays the same, but rather than taxing a percentage of a person’s income, the government taxes a percentage of a person’s annual consumption expenditures.

a)      Analyze the effect of this switch in tax policy on labor markets.  What happens to employment and the real wage

b)      Analyze the effect on the goods market.  What happens to consumption, investment, output, and interest rates?

c)      If the Fed’s role was top maintain a constant price level, what would the appropriate monetary response be?

13)      (15 points) The country of Geneseo currently has a tax code with the following properties: a zero tax rate on income less than $5,000, a 10% tax rate those with taxable income between $5,000 and $10,000, a 20% tax rate on those with income between $10,001 and $30,000, a 30% tax rate on those with income between $30,001 and $50,000, and a 40% tax rate on anyone with taxable income over $50,000.. They are considering the adoption of a flat tax with a $10,000 deduction and a flat tax rate of 25%.

a)      Consider an individual with an annual income of $20,000.  Calculate his marginal and average tax rates under both tax codes.  What would be the effect of the change in the tax code on his labor supply?

b)      Suppose that median income in the country of Fredonia is $30,000. How would the change in the tax code affect aggregate employment?  Explain.

14)  (15 points) An alternative theory of economic fluctuations is known as “political business cycles”.  This hypothesis suggests that business cycles are caused by regular changes in fiscal policy.  For example, politicians running for re-election would like to give the economy a “boost” by increasing government spending. Suppose that the government decides to temporarily increase spending.  Assume that this spending is totally wasteful.  Also assume that the government finances this spending by running a deficit (it would not be very prudent to raise taxes in an election year!)

a)      How would this spending affect the labor market?  What happens to employment and the real wage?

b)      What would be the effect on the goods market? (Output, investment, consumption, and interest rates

c)      Assuming the money supply is unchanged, what should happen to prices?

d)      Does this increase in spending generate correlations that “look like” a business cycle?  Why or why not?