This part of the written comprehensive exam in Economics is divided into two parts, macro and micro, which are given equal weight in your final Economics comprehensive grade.
Answer each part in a separate bluebook. Be sure to put your identification number on each bluebook. In addition, put "Micro" on the cover of the bluebook containing the micro part and "Macro" on the other bluebook.
Your answers will be graded on the basis of the CONTENT and PRESENTATION of the economic analysis. The Macro part is an ESSAY, so you should be sure to take time to organize your ideas and present them in coherent form. Your answer should include appropriate verbal, graphical, and mathematical reasoning. The Micro part is composed of a series of specific questions. Please number each answer in your bluebook and write coherently and legibly.
Remember, the Macro and Micro sections are equally weighted, so you should allocate your time efficiently.
Use the 30 minute reading period to read the entire exam carefully, underlining important information. You may write notes on the exam but we will only evaluate answers in the blue book.
You have until 12:00 PM to complete the exam. Good luck.
Many members of the new Congress regard reduction of the federal budget deficit as their top priority. This question asks you to evaluate the shortrun consequences of deficit reduction. Specifically, what are the comparative static consequences of the government reducing, in 1997, its budget deficit by reducing government expenditures on goods and services if the Fed adheres to a nominal money supply target? Assume in your answer that the public expects output prices to be the same in 1997 as existed in 1996. Provide a literate explanation using appropriate graphs (refer to specific points and numbers in your graphs in your essay for concreteness). Examine the shortrun effects on prices, real GDP, employment, interest rates, exchanges rates, the composition of GDP, and private savings. Employ IS, LM, balance of payments equilibrium conditions, aggregate demand [D(P)], aggregate supply [S(P)], foreign exchange demand, and supply graphs and analysis in developing your answer. Explain in words how and why agents respond to produce the graphical illustration.
Your answer will be evaluated on the clarity, coherence, and completeness of your
answer as well as on the conclusions and graphs.
The assumption that inflation expectations are given and not affected by the policy and the shortrun orientation implies that the aggregate supply curve, S(P), is given for 1997. If a sticky price model like the NAIRU model is assumed, movement along it will occur as demand changes but the supply curve will not shift in response to the difference in demand. Similarly, if one assumes a rational expectations with asymmetric expectations errors, the unforecasted change in G produces a shift in D(P) along S(P) but no shift in S(P). The question does not ask about subsequent periods for which supply curves would reflect the differential experience in this shortrun and altered expectations. Unless some clear argument to the contrary is provided, this should be positively sloped.
The summary story that complements the graphs is that the decrease in G reduces expenditures at each r, P, e (e is defined here as the number of $ it takes to purchase a unit of foreign currency, e.g. $/£). The decrease in G then causes production to temporarily exceed the amount demanded, inventories accumulate, firms reduce production, and hence gross and disposable income declines. The decline in income affects the quantity of money demanded, import demand, and consumption expenditures.
The fall in income infers fewer real balances desired, so wealth owners attempt to convert more of their wealth into the form of bonds; this drives up bond prices and down interest rates. In the constant money stock case, the quantity of nominal money and bonds demanded are the same before and afterwards, and the lower expected return on bonds (due to the higher price) induces the public to hold more nontransactions balances. This decline in the interest rate feeds over into the foreign exchange market as will be discussed below.
The drop income reduces consumption purchases of domestic goods and the reduction in purchases of foreign produced goods; hence imports decline and net exports, NX, rise (see movement up the initial NX function). As income falls, savings decline along with consumption. As the interest rate declines so does the cost of capital and investment spending rises but not sufficiently to offset the decline in C and G so that total expenditures fall.
The drop in the domestic interest rate relative to world interest rates, induces foreign and domestic wealthowners to demand fewer US bonds and more foreign bonds. To shift into (say) £ assets, £ must be purchased. Hence there is an increase in the demand for £s decrease in the supply of £s occurs since foreign investors desire fewer US bonds and hence sell fewer £s. Also, because of the lower import demand, fewer £ are demanded. This causes the exchange rate to rise ($/£); the pound appreciates and the dollar depreciates. Since £s cost more, foreign goods are relatively more expensive so US imports fall and US exports rise; NX increases (NX vs X shifts up).
The decrease in G lowers the IS curve (r,x such that unplanned inventories are zero); while the depreciation of the dollar offsets part of this in the shortrun, there is a net inward movement in IS. The decrease in IS is associated with a decrease in aggregate demand, D(P).
The comparative decline in output results in a decline in the demand for labor. The wage rate is lower compared to the no shock case and firms sell at lower prices. We move down the S(P) curve. In nonclearing labor market models this is interpreted as involuntary unemployment. Or the lower employment may be voluntary with actual real wages higher than the expected real wage, as in New Classical models.
With the lower prices, the real money supply increases, even though the nominal money stock is fixed. Hence the LM curves increases; this movement in LM does not shift D(P) again, but is associated with a movement along the new D(P) due to lower G and higher NX. It may also be argued that the reduction in the domestic price level increases the real exchange rate at each nominal exchange rate, leading to greater NX (real e = e$/£ €(P£/P$)).
The net equilibrium requires that product market equilibrium hold (be on IS), that financial market equilibrium hold (be on LM), and that balance of payments equilibrium hold (BP=0). Since the US is a large open economy, the combinations of interest rate and income that produce equality of capital account and current account balances will be positively sloped for a given exchange rate. There is high but imperfect capital mobility which permits the US interest rate to deviate some from the world interest rate. If income declines so that NX falls, rise in the current account balance, a lower interest rate is required to produce a lower capital inflow. Hence BP slopes up for a given exchange rate, expectations of future exchange rates, etc.
In this case, the decrease in G resulted in a depreciation in the dollar which increased NX so that the set of interest rates for which balance of payments equilibrium (r,X) holds are now lower than initially.
We end up on a lower IS, higher LM and higher (rightward movement) BP curve.
These intersect at the output at which D(P)' = S(P). Which gives (compared to no
shock case) a lower income/output, lower interest rate, lower price level, higher
exchange rate, lower C, higher NX, lower S, and higher I.
WASHINGTON (Reuter) - U.S. tobacco companies will manufacture a record number of cigarettes this year, largely to meet burgeoning overseas demand, the government said Monday.
The Agriculture Department estimated U.S. cigarette production would climb to 760 billion cigarettes in 1996, the highest on record, and up from roughly 747 billion cigarettes made the prior year.
Americans smoked about 487 billion cigarettes in 1996, the department said. Consumption has remained about the same for the past four years.
However, U.S. cigarette exports grew by 12.5 percent to 260 billion in 1996. Exports have been trending upwards strongly since the mid-1980s. By comparison, in 1985 U.S. cigarette exports rang in at 58.9 billion.
QUESTION 1: Economics is the study of the allocation of scarce resources to
competing ends. Exactly what is the allocation problem faced by society with respect to
cigarettes?
SOCIETY'S PROBLEM IS TO DETERMINE HOW MUCH OF ITS SCARCE RESOURCES WILL BE DEVOTED TO THE PRODUCTION OF CIGARETTES. IN 1996, 760 BILLION CIGARETTES WERE PRODUCED, WHICH REQUIRED A CERTAIN AMOUNT OF LAND, LABOR, AND CAPITAL. THAT IS A SOLUTION TO THE ALLOCATION PROBLEM OF "INFINITE WANTS AND SCARCE RESOURCES," BUT IS IT THE BEST SOLUTION? SOCIETY'S "PROBLEM" IS TO FIND THE BEST SOLUTION.
QUESTION 2: Markets as an allocation mechanism require sellers and buyers for each
product. For buyers, the demand curve for each product shows optimal quantity
demanded as a function of price. In deciding how many cigarettes to buy at a given price,
the smoker acts as if he or she solves the following constrained optimization problem:
max Utility=f(C, OG)
C, OG
s.t. PCC + POGOG = M
where C = number of Cigarettes
OG = index of Other Goods
PC, POG = Price of Cigarettes, Price of Other Goods
M = Income
Illustrate the consumer choice problem graphically. Label everything carefully.
QUESTION 3: Cigarette manufacturers are especially interested in the price elasticity of demand and advertising elasticity of demand for cigarettes. Define these two elasticities, then provide a numerical guess of the value of these two elasticities for the US cigarette market. Finally, briefly explain your reasoning for the sign (positive or negative) and magnitude (actual numerical value) of each guess.
DEFINITIONS:
PRICE ELASTICITY OF DEMAND IS THE PERCENTAGE CHANGE IN QUANTITY
OF CIGARETTES DEMANDED FOR A GIVEN PERCENTAGE CHANGE IN PRICE
OF CIGARETTES.
ADVERTISING ELASTICITY OF DEMAND IS THE PERCENTAGE CHANGE IN QUANTITY OF CIGARETTES DEMANDED FOR A GIVEN PERCENTAGE CHANGE IN ADVERTISING.
NUMERICAL GUESSES:
PRICE ELASTICITY OF DEMAND = - 0.5
ADVERTISING ELASTICITY OF DEMAND = 1.2
REASONING FOR SIGN:
PRICE ELASTICITY OF DEMAND IS NEGATIVE BECAUSE AS THE PRICE
RISES, QUANTITY DEMANDED FALLS.
ADVERTISING ELASTICITY OF DEMAND IS POSITIVE BECAUSE AS
ADVERTISING INCREASES, QUANTITY DEMANDED RISES.
REASONING FOR MAGNITUDE:
PRICE ELASTICITY OF DEMAND IS CLOSE TO ZERO BECAUSE AS THE PRICE
RISES, QUANTITY DEMANDED DOESN'T FALL BY VERY MUCH.
ADVERTISING ELASTICITY OF DEMAND IS GREATER THAN ONE BECAUSE
AS ADVERTISING INCREASES, QUANTITY DEMANDED RISES A LOT.
[ACTUALLY, IT TURNS OUT THAT ADVERTISING BY CIGARETTE COMPANIES AFFECTS THE SHARE OF THE MARKET EACH COMPANY GETS, BUT NOT THE TOTAL AMOUNT OF CIGARETTE CONSUMPTION.]
[Use the information provided below to answer questions 4, 5 and 6.]
In an attempt to more than wildly guess the price elasticity of demand for cigarettes,
someone has collected data on quantity demanded of cigarettes (in packs) and price
(cents/pack) in California from 1960 to 1989 in order to estimate the following model:
Q Cig Demanded per capitai = 0 + 1RealPrice of Cigi + 2RealIncome per capitai + i
(Real price and real income are expressed in terms of 1980 dollars.)
After correcting for first-order autocorrelation, the estimated equation (with SEs in parentheses) is:
Predicted Q = 228 - 0.33RealPrice - 0.0061RealIncome per capita
(12.78) (0.11) (0.0008)
QUESTION 4: Why are real price of cigarettes and real income used in estimating the equation instead of their nominal counterparts?
SINCE THE DATA IS TIME SERIES FROM 1960 TO 1989, INFLATION IS A CONFOUNDING FACTOR IF NOMINAL VALUES ARE USED. BY USING REAL VALUES, THE EFFECT OF PRICE CHANGES ARE REMOVED.
QUESTION 5: Calculate the price elasticity of demand at the average Q, 122 packs,
and average RealPrice, 90 cents/pack.
PRICE ELASTICITY OF DEMAND
= % CHANGE Q / % CHANGE REALP
= (CHANGE Q/Q) / (CHANGE REALP/REALP)
= CHANGE Q/CHANGE REALP x P/Q
FROM THE EQUATION, CHANGE Q/CHANGE REALP = - 0.33, SO
PRICE ELASTICITY OF DEMAND
= - 0.33 x 90/122
= - 0.24
THE PRICE ELASTICITY OF DEMAND IS - 0.24. THAT IS THE ANSWER.
QUESTION 6: Many people believe that cigarette smoking is an all-or-nothing
proposition that is not influenced at all by price. They argue that the addictive nature of
nicotine means that smokers will continue to smoke the same amount regardless of how
much price increases. Does the estimated equation above support the hypothesis that
the market (inverse) cigarette demand curve is perfectly inelastic?
(HINT: A perfectly inelastic demand curve drawn as Q*=f(P) has zero slope, dQ*/dP = 0.)
A PERFECTLY INELASTIC DEMAND CURVE TRANSLATES INTO THE NULL HYPOTHESIS THAT THE TRUE, EXACT PARAMETER ON REALP IS ZERO, IMPLYING THAT THE - 0.33 VALUE THAT WE GOT IN OUR SAMPLE WAS DUE TO CHANCE ALONE. THE NULL IS REJECTED IN THIS CASE BECAUSE THE REPORTED SE OF 0.11 MAKES THE SAMPLE ESTIMATE 3 SES AWAY FROM THE VALUE EXPECTED UNDER THE NULL. IT IS EXTREMELY UNLIKELY THAT THE NULL IS TRUE AND THAT OUR SAMPLE RESULT WAS GENERATED BY CHANCE ALONE. THE ESTIMATED EQUATION DOES NOT SUPPORT THE HYPOTHESIS THE CIGARETTE DEMAND IS PERFECTLY INELASTIC.
QUESTION 7: Most people are aware that cigarettes (like alcohol and gasoline) carry
per unit taxes‹Indiana taxes cigarettes at 15.5¢/pack while several northeastern
states apply taxes of over 50 cents on each pack of cigarettes. If the objective of the
taxing authority is to minimize deadweight loss, explain (using supply and demand
analysis) why products with low price elasticities are singled out to be taxed.
WITH ELASTIC DEMAND, CETERIS PARIBUS, A TAX DRIVES Q FAR FROM THE MAXIMIZING CONSUMERS AND PRODUCERS SURPLUS SOLUTION AND, THUS, GENERATES A LARGE DEADWEIGHT LOSS. IF DEMAND IS INELASTIC, HOWEVER, THE FIGURE AT THE RIGHT CLEARLY SHOWS THAT Q IS RELATIVELY UNCHANGED AND DEADWEIGHT LOSS (THE AREA OF THE TRAINGLE) IS QUITE SMALL.
QUESTION 8: Opponents of cigarette smoking claim that "second hand smoke" hurts
non-smokers and, therefore, the market inefficiently allocates resources in the case of
cigarette output. Use the supply and demand graph below to explain the "market
failure" argument in the case of cigarettes by showing the deadweight loss and explaining
what this means:
We now turn to the market for the key input in cigarettes: tobacco. The U.S.
government restricts the production of tobacco by setting a quota on the total amount
that can be produced in a given year. This quota is set below the quantity that would be
produced in a free market, which means that the price of tobacco is higher than it would
be in a free market. The price at which tobacco sells is called the support price, because
the government in effect holds up the price.
Within every tobacco-producing county, the government sets an overall production limit by issuing a certain number of permits to produce tobacco, with each permit allowing a farmer to produce one pound of tobacco in the current crop year. These permits are distributed to the farmers in the county. The farmers are allowed to buy and sell permits, but only within the county. For example a farmer with 5000 permits could sell 4000 permits, retaining only 1000 for him or herself. This farmer could then harvest only 1000 pounds of tobacco that year. These permits are called "quota", which is confusing because quota is both the name for the overall limit on production and for the individual permits to produce within that limit. The price of the quota is called the "lease rate," because they confer the right to harvest tobacco during a given period. The lease rate is measured in $ per pound of tobacco.
The following material is adapted from a 1995 article in the Journal of Political Economy by Rucker, Thurman, and Sumner.
QUESTION 9: Given demand for tobacco, draw a supply and demand graph (with clearly labelled x and y axes) that shows how the government policy determines the support price for tobacco.
A SIMPLE ANSWER IS THAT THE MAERKET EXISTS BECAUSE THERE ARE BUYERS AND SELLERS OF QUOTA WHO ARE ABLE TO MAKE MUTUALLY BENEFICIAL EXCHANGES‹I.E., THE SELLER VALUES THE QUOTA LESS THAN WHAT HE GETS FOR IT, WHILE THE BUYER VALUES THE QUOTA MORE THAN WHAT HE GETS FOR IT. BUT A BETTER ANSWER IS TO NOTE THAT THE REASON FOR THIS IS THAT: "The marginal cost of producing tobacco in a county is upward sloping because of heterogeneous land and specific human capital." THAT MEANS SOME FARMERS ARE LOWER COST PRODUCERS THAN OTHERS AND THEY WILL BE THE BUYERS IN THE MARKET FOR QUOTA.