Eco317 Exam

Intermediate Macroeconomic Theory Economics 317: Sections A & B Pre-Midterm Exam: Fall 2013

Directions: Please answer all questions. Your answers should be as thorough and as precise as possible. If necessary you may continue your answer to any question at the back of the page.

This exam is based on the following description of 317land. 317land is a monetary economy in which the typical household has production opportunities summarized by the production function yt = f(lt). In addition, households have access to a competitive commodity or goods market and to a perfect credit or bond market. The bonds in 317land are one period bonds that pay real interest at rate R. Assume that the typical household in 317land has an infinite planning horizon and seeks to maximize horizon long utility given by U = u(c1, l1) + 1/(1+) u(c2, l2) + 1/(1+)2 u(c3, l3) +. . . . , where c and l represent consumption and work effort and  is the subjective rate of time preference.

1. In class we noted that in order to maximize horizon-long utility households in an economy like 317land will have to allocate resources optimally along three dimensions. Fundamental economic principles instruct that optimizing households’ allocation of resources along these dimensions will be guided by the fundamental principle that the optimal level of a good service or activity is the level at which marginal benefit is equal to marginal costs. Prove that optimizing households behave in this manner by answering questions (a), (b), and (c) below. For the purposes of this question (i.e. only question # 1) restrict attention to two periods.

(a) Explicitly identify one of the dimensions along which the household in 317land must oprimize and use whatever combination of graphical and other exposition you deem appropriate to convincingly prove or demonstrate that the household’s optimal choice is consistent with the fundamental principle articulated above. (25 points)

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1 (a) cont’d

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(b) Given your answer to (a) explicitly identify another dimension along which the household in 317land must oprimize and use whatever combination of graphical and other exposition you deem appropriate to convincingly prove or demonstrate that the household’s optimal choice is consistent with the fundamental principle articulated above. (25 points)

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(c) Given your answers to (a) and (b), explicitly identify the third dimension along which the household in 317land must oprimize and use whatever combination of graphical and other exposition you deem appropriate to convincingly prove or demonstrate that the household’s optimal choice is consistent with the fundamental principle articulated above. (25 points)

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2. (a) Write a clear statement in words that defines permanent income and summarize your statement with an equation. (5 points)

(b) What is the central hypothesis, tenet, or point of the permanent income hypothesis? (5 points)

(c) Suppose 317land is hit by a natural disaster and as a result the representative household’s current income falls by $10,000 dollars. Evaluate the effects of this shock on the representative household’s current consumption by doing the following.

(i) Assuming that households behave according to the permanent income hypothesis, thoroughly derive the marginal propensity to save that is applicable in this case. (N.B. Avoid vigorous assertion.) (15 points)

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(i) cont’d

(ii) Calculate the exact amount by which current savings will change if the real interest rate is 3 percent. (show your work) (5 points)

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