Inflation in Mexico was 4.8% in 2017 (that is, from December 2016 to December 2017), 3.4% in 2018, 3.5% in 2019, and is expected to be 3% in 2020. If the price of a car increases at the rate of inflation every year, and the car cost 450,000 pesos in Mexico in December 2018, then
Inflation in Mexico was 4.8% in 2017 (that is, from December 2016 to December 2017), 3.4% in 2018, 3.5% in 2019, and is expected to be 3% in 2020. If the price of a car increases at the rate of inflation every year, and the car cost 450,000 pesos in Mexico in December 2018, then
a) what is the expected price of the car in Mexico in December 2020, and
b) what was the price of the car in Mexico in December 2017?
2. Suppose that inflation in Mexico is as described in the previous question, and suppose that expected inflation in Mexico at the beginning of 2019 was 3% and actual inflation in Mexico in 2020 turns out to be 1.5%. If the nominal interest rate on a one-year Mexican government bond was 7.9% at the beginning of 2019 and 6.5% at the beginning of 2020, then a) what is the ex post (realized) real interest rate on the bond for 2019,
b) what is the ex ante (expected) real interest rate on the bond in 2020, and
c) what is the ex post real interest rate on the bond in 2020? (3 points total).
3. In Italy, the job separation rate for employed workers is about 0.4% per month and the job finding for unemployed workers is about 1.3% per month.
a) According to the Classical theory of the natural rate of unemployment, what would we expect the natural rate of unemployment in Italy to be?
b) In the U.S., the job finding rate is much higher, about 28.2% per month. If Italy passed labor market reforms that made the job finding rate the same as in the U.S., what would the natural rate of unemployment in Italy be then?
4. What is the difference between fiat money and commodity money? Give an example of each.
5.
a) According to the U.S. Employment Report for March, how many jobs were gained or lost relative to February?
b) Why do economists think that number is not representative of how the U.S. labor market is actually responding to the coronavirus pandemic?
6. According to the textbook, what ended the German hyperinflation in 1923? Briefly explain.
7. In 2019, suppose that the Blaze Pizza at UTC had total sales of $1 million, spent $460,000 on labor, $150,000 on rent to the Irvine Company, $225,000 on pizza ingredients, $50,000 on plastic cups, forks, 1 plates, etc., and $40,000 on a new computer system that they expect will last for 5 years. How much value added did Blaze Pizza produce in 2019?
8. Suppose that, as a result of financial market strains due to the coronavirus pandemic, businesses’ and banks’ demand for cash increased dramatically.
a) If the Federal Reserve did nothing, what would happen to the total money supply in the U.S.? Briefly explain.
b) What did the Fed do in 2020 to counteract this effect?
9.
a) What are the three main interest rates that the Fed controls?
b) If a bank wants to borrow federal funds directly from the Fed, which interest rate would they pay?
10. Which interest rate can the Fed control more closely, the 3-month Treasury bill rate, or the 30-year mortgage rate? Briefly explain why.
11. Some politicians have argued for dramatically increasing U.S. government spending on social programs for the poor. In order to pay for these programs without raising taxes, they have argued that the U.S. Federal Reserve should just print the money, which could then be distributed to the poor. According to Classical Economics, what is the main problem with this plan? Briefly explain why.
12. Inflation in Mexico has been running at about 3% per year or a little above for a few years. The Banco de Mexico (Mexico’s central bank) has an official inflation target of 3%. (That means that when inflation is below 3%, they tend to lower interest rates and when inflation is above 3%, they tend to raise interest rates, everything else equal.) Suppose that the Mexican government passes a new law changing the Banco de Mexico’s official inflation target to 2%. According to the IS-MP model, what effect would you expect the new inflation target to have on the Mexican economy (in particular, Mexican output and real interest rate)? Draw a diagram to illustrate your answer.
Part II. Longer-Answer Questions (3 questions, 54 points total)
13. International Implications of the Coronavirus Pandemic. (18 points total).
a) Japan is an open economy that typically runs a trade surplus. Draw a loanable funds market diagram for Japan that correctly illustrates the relationship between savings, investment, and the world real interest rate in that country. (2 points).
b) Japan has had relatively few cases of the coronavirus disease, Covid-19, but many of Japan’s trading partners, like the U.S. and Europe, have been substantially affected. Suppose that, as a result of the decreased economic demand from these trading partners, Japanese businesses do not want to invest as much as before the pandemic. What would be the effect of this change in business demand on savings, investment, the real interest rate, and the real exchange rate in Japan (assuming that the only thing that 2 changes in the model is Japanese businesses’ demand for investment)? Draw a diagram or two to help illustrate your answer. (8 points). c) Let’s now study another effect of the pandemic on the Japanese economy. The weaker economies of Japan’s trading partners will tend to decrease the demand for Japan’s net exports. Assuming that everything else is held constant (including businesses’ investment demand, etc.), what is the effect of this lower demand for Japan’s net exports on Japanese saving, investment, the real interest rate, and the real exchange rate? Draw a diagram or two to help illustrate your answer. (8 points).
14. Infrastructure Spending. (24 points total). President Trump and some members of Congress have proposed a large increase in infrastructure spending by the government. This would represent a substantial increase in government spending. (Assume that taxes would be unchanged, so that the government spending would be financed by increased government deficits.)
a) According to the Keynesian Cross, what would happen to the short-run equilibrium in the U.S. goods market as a result of the increase in government spending? Draw a diagram to help explain your answer. (4 points).
b) If U.S. households’ consumption demand is described by the equation C = 120 + 0.85 (Y – T), and the increase in government spending is $500 billion, what would be the total effect of the increase in government spending on U.S. GDP? (4 points).
c) According to the IS-MP model, what would happen to the short-run equilibrium for U.S. output and the U.S. real interest rate? Draw a diagram to help illustrate your answer. (4 points).
d) According to the IS-MP model, what would happen to U.S. consumption, investment, government purchases, and taxes in the short run? Briefly explain your answer. (2 points).
e) According to Classical Economics, what would happen to U.S. output and the U.S. real interest rate as a result of the increase in government spending? (You can think of this as what would happen in the U.S. economy in the long run.) Draw a diagram to help illustrate your answer. (4 points).
f) According to Classical Economics, what would happen to U.S. consumption, investment, government purchases, and taxes in the long run? Briefly explain your answer. (2 points).
g) What is “crowding out”? Is there any evidence of crowding out in your answers to parts d and/or f, above? Briefly explain. (4 points).
15. Labor Markets. (12 points total). Suppose that the labor market in Chico, California, is in equilibrium, according to the Classical model, with an equilibrium wage of $12/hour. (For simplicity, let’s assume everyone in Chico gets paid this wage.)
a) If the minimum wage in California is $10/hour, would there be any unemployment in Chico, or would the unemployment rate be zero? Briefly explain. (4 points).
b) Suppose that the California economy suffers a large negative demand shock (due to the coronavirus pandemic, for example). Because of this labor demand shock, the long-run equilibrium wage in Chico is now $9/hour. What would we expect to happen to the unemployment rate in Chico in this case (assuming no other labor market distortions other than the minimum wage)? Draw a diagram to help explain your answer. (4 points).
c) Suppose that, instead, California’s economy suffers a smaller negative demand shock, which only pushes the long-run equilibrium wage in Chico down to $11/hour. Are there other labor market frictions that might affect the unemployment rate in this case? (You can assume that prices are fixed in this example, so that nominal wage frictions and real wage frictions are equivalent.) Briefly explain why, and use a diagram to help illustrate your answer. (4 points).
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