Economics 311 Money and Income

Economics 311Money and Income First Exam-Spring 2001 Department of Economics College of Business and Economics California State University-Northridge Professor Kenneth Ng Sunday, November 30, 2014

Question 1 • Read the following article. Half the points will be awarded for a correct graph and half will be awarded for a written explanation of your answer. • Using production functions and indifference curves graphically show the effect of the changes described in the article on the labor/leisure decision. Use the graph provided below and be sure to label both axes. Assume leisure is a normal good. • What will happen to GDP and unemployment as a result of the changes described in the article? Explain.

Output Using production functions and indifference curves graphically show the effect of the changes described in the article on the labor/leisure decision. Use the graph provided below and be sure to label both axes. Assume leisure is a normal good. The drop in the stock market will cause a parallel shift in the production function (solid to dotted) because the wage rate is unchanged by a change in stock values. If leisure is a normal good, there will be a wealth effect causing the consumption of leisure to decline and work effort to increase (l1 to l2). This will cause unemployment and overall income to fall. Y before crash Y after crash 0 l1 l2 Work Effort

Question 2 • Read the following article. Half the points will be awarded for a correct graph and half will be awarded for a written explanation of your answer. • Using production functions and indifference curves graphically show the effect of the Bush’s proposed changes in the tax code. Use the graph provided below and be sure to label both axes. Assume leisure is a normal good. • What will happen to GDP and unemployment as a result of the changes described in the article? Explain. • Will the proposed changes cause a wealth or substitution effect? Explain and show on your graph. • Does it make a difference if leisure is an inferior good? Explain and show on your graph.

Output • Using production functions and indifference curves graphically show the effect of the Bush’s proposed changes in the tax code. Use the graph provided below and be sure to label both axes. Assume leisure is a normal good. • What will happen to GDP and unemployment as a result of the changes described in the article? Explain. • Will the proposed changes cause a wealth or substitution effect? Explain and show on your graph. • . C Y after cut B Y before cut A The change in the tax code will cause a proportional improvement in the PF (red solid to red dotted). This will cause a wealth effect because the same level of work effort produces more output and a substitution effect because an additional hour of work will produce more additional output. The movement from A to B shows the substitution effect. The movement from B to C shows the wealth effect. 0 l1 l2 Work Effort

Question 3 • Consider the changes in both of the previous articles on the pattern of consumption chosen by households over time. Draw the persons’ inter-temporal budget constraint and show the pattern of consumption chosen over time. Be sure to label both axes. • Using the graph below show the effect of the drop in stock prices if the change is viewed as permanent. What will happen to bond prices and interest rates? • Using the graph below show the effect of the drop in stock prices if the change is viewed as temporary. What will happen to bond prices and interest rates? • In which case, will there be a greater effect on work effort today. Explain. • Now consider the effect of the proposed changes in the tax code. Draw the person inter-temporal budget constraint and the pattern of consumption chosen over time. • Using the graph below show the effect of the change in the tax code if it is viewed as permanent. What will happen to bond prices and interest rates? Explain. • Using the graph below show the effect of the change in the tax code if it is viewed as temporary. What will happen to bond prices and interest rates? • In which case, will there be a greater effect in credit markets. Explain.

Future Consumption Effect of a temporary vs. permanent drop in stock prices. The household starts at A. The crash lowers current income to Y crash. If the drop is temporary, the household will expect to earn Y start in the future and the households pattern of earnings over time is represented by point B and their inter-temporal budget constraint by the solid blue line. The permanent income hypothesis says that people like an even pattern of consumption over time. If the stock market crash is viewed as temporary, the household expects to earn more n the future than in the present. They will respond by trying to consume the consumption pattern represented by point C. This will involve borrowing (selling bonds). A B Y start C Y crash D 0 Y crash Ystart Present Consumption

Future Consumption Effect of a temporary vs. permanent drop in stock prices. If the drop in stock prices is viewed as permanent, current and future income will drop to Y crash. This is depicted by point D in the graph. The permanent income hypothesis says that people like an even pattern of consumption over time. Since income today had dropped and future income has also dropped, there will be no change in the net borrowing of the household. There will be greater effect on work today in the drop in the stock market is viewed as permanent because the wealth effect will be greater from a permanent than a temporary drop in wealth. B A Y start C D Y crash 0 Y crash Ystart Present Consumption

Future Consumption Effect of a temporary vs. permanent drop in tax rates. The household starts at A. The drop in tax rates increases current income to Y tax change. If the drop is temporary, the household will expect to earn Y start in the future and the households pattern of earnings over time is represented by point B and their inter-temporal budget constraint by the solid blue line. The permanent income hypothesis says that people like an even pattern of consumption over time. If the stock market crash is viewed as temporary, the household expects to earn more n the future than in the present. They will respond by trying to consume the consumption pattern represented by point C. This will involve lending (buying bonds). D Y tax change C A B Y start 0 Y tax change Present Consumption Y start

Future Consumption Effect of a temporary vs. permanent drop in tax rates. If the drop in tax rates is viewed as permanent, current and future income will increase to Y tax change. This is depicted by point D in the graph. The permanent income hypothesis says that people like an even pattern of consumption over time. Since income today has increased and future income is also expected to increase, there will be no change in the net borrowing of the household. There will be a greater effect in credit markets if the change in the tax code is viewed as temporary. D Y tax change C A B Y start 0 Y tax change Present Consumption Y start

Summary Statistics

Mandatory one week cooling off period.Questions regarding the exam will be handled only in office hours beginning next Tuesday.BB4262, TTH 12:30-1:30 PM, T 9:30-10:30 AM

Economics 311 Money and Income