Part 1: True, False, and Explain
(10 points each - 3 for the right answer, and 7 for the explanation)
State whether each of the following six propositions is true or false. In 2-3 sentences (and clearly-labeled diagrams, when helpful), explain why.
1. Suppose the government fixes strict economy-wide price floors and maintains a high rate of growth for the money supply.
T, F, and Explain: These policies will create, but gradually eliminate, a shortage of goods.
FALSE. Price floors create surpluses, not shortages. Once the price floor creates a surplus, money supply growth will increase AD, eventually eliminating the surplus (once the market-clearing price equals the price floor).
2. Suppose France deregulates its labor markets.
T, F, and Explain: France's Production Possibilities Curve shifts out.
FALSE. High unemployment due to labor market regulation means that France is not on the frontier of its PPC. It is producing less than it is able to produce because available resources are being wasted.
3. Suppose a labor union forces its members to work less, but encourages them to work harder when they are actually on the job.
T, F, and Explain: The effect on union members' real wages is ambiguous.
FALSE. Labor supply declines because workers work fewer hours; labor demand increases because each hour of work now produces more output. Both effects tend to raise real wages.
4. In the decade after World War II (1945-1955), an unusually large number of babies was born, the so-called "Baby-Boom Generation."
T, F, and Explain: The Permanent Income Hypothesis suggests that real interest rates would have been high in 1970, low in 2000, and will be high again by 2020.
TRUE. The PIH says that people borrow more and save less when they are young and old, and borrow less and more save when they are in their peak-earning middle years. Thus, when the boomers were 15-25 years old, and when they are 65-75, you would expect low savings and high real rates. But now, when they are 45-55, you would expect high savings and low real rates.
5. Imagine the government unexpectedly begins decreasing the level of the money supply at a rate of 3%/year.
T, F, and Explain: All else equal, the price level will be more than 3% lower one year later.
TRUE. Decreasing the money supply by 3% directly tends to decrease the price level by 3%. But this will also reduce nominal interest rates by reducing expected inflation, and money demand will accordingly increase because people forego less interest by holding money. Since money demand increases along with money supply decreasing, the price level will fall by more than 3%.
6. Suppose Caplan is correct about the social rate of return to education.
T, F, and Explain: Increasing spending on education will reduce AS and have no effect on AD.
TRUE. Increased spending on a socially wasteful activity just reduces AS; it induces fewer people to work without any offsetting increase in output. And since the money supply has not changed, there is no reason to expect AD to change.
Part 2: Short Answer
(20 points each)
In 4-6 sentences, answer both of the following questions.
1. "Real wages can never fall to the subsistence level, because employers compete with each other based on worker's marginal productivity." Critique this argument using ALD-ALS diagrams. Be sure to draw on Simon's historical evidence ("The Standard of Living Through the Ages" and "Long-Term Trends in the US Standard of Living").
Real wages CAN fall to the subsistence level even though employers compete. If labor productivity is low, so is labor demand, and there is nothing that precludes an equilibrium real wage at the subsistence level. Simon's historical evidence shows that in earlier periods of human history, wages were indeed very low, approaching the subsistence level.
2. Using both an AD-AS diagram AND a supply-and-demand for loanable funds diagram, carefully explain Bastiat's argument about "Thrift and Luxury" in his essay "What Is Seen and What Is Not Seen."
Bastiat tells the story of two brothers: Mondor the spendthrift, and Ariste, the saver. Both spend their inheritance on something: Mondor on personal consumption, Ariste on investments. If both brothers were like Ariste, then, AD would not change. But the supply of loanable funds would increase, reducing interest rates; and the long-run effect of this investment would be to increase AS.