Economics 311 Midterm Answers

Prof. Bryan Caplan

Fall, 1999

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 imposes strict economy-wide price maxima and maintains a high rate of growth for the money supply.

T, F, and Explain: These policies will create a surplus of goods.

FALSE. Price MAXIMA create shortages, not surpluses, and these surpluses will intensify as the growth in the money supply proceeds.





2. T, F, and Explain: Countries with low Aggregate Labor Demand and high Aggregate Labor Supply will have high levels of involuntary unemployment.

FALSE. As long as real wages are flexible, neither low Aggregate Labor Demand nor high Aggregate Labor Supply create involuntary unemployment. It does however mean that real wages will be LOW.






3. The government proposes two methods of funding $1000 worth of spending. The first method is to tax each family $1000 today. The second method is to borrow $1000 today by issuing bonds to be repaid by raising taxes 40 years from now (when the kids of today will be the taxpayers).

T, F, and Explain: In "The Arithmetic of Government Debt," Landsburg essentially says that IF parents care about their kids, then from the parents' point of view, the PDV of these two funding methods is identical.

TRUE. In both cases, the PDV of the burden is -$1000. This is obvious for the tax case. For the debt case, as Landsburg points out, parents who were concerned about their kids' welfare would have to save $1000 today to increase their kids' inheritance by enough to pay off $1000*(1+r)40 forty years from now.

4. T, F, and Explain: Increases in the demand for loanable funds, holding all other variables fixed, raise real interest rates and nominal interest rates.

TRUE. If the demand for loanable funds increases, real interest rates rise. Holding expected inflation fixed, this means that nominal interest rates rise by the same number of percentage points.







5. The government deregulates the supply of money substitutes at the same time that it increases the money supply.

T, F, and Explain: These policies will increase the value of money and therefore lower the price level.

FALSE. Both deregulated of money substitutes and increase in money supply REDUCE the value of money and therefore RAISE the price level.







6. "Now comes demobilization. You point out to me a surplus of a hundred thousand workers, intensified competition, and the pressure it exerts on wage rates. That is what you see.

"But here is what you do not see... You do not see that before, as well as after, the demobilization there are a hundred million francs corresponding to the hundred thousand men; that the whole difference consists in this: that before, the country gives the hundred million francs to the hundred thousand men for doing nothing; afterwards, it gives them money for working."

T, F, and Explain: Bastiat is saying that reductions in unproductive government spending increase AS and do NOT decrease AD.

TRUE. Saying that there are a hundred million francs "before, as well as after, the demobilization" means that AD doesn't change if spending and taxes fall. Saying that after the demobilization, the soldiers will work instead of doing nothing means AS increases.




Part 2: Short Answer

(20 points each)

In 4-6 sentences, answer both of the following questions.

1. Per-capita income, population, and price levels have ALL risen considerably in most wealthy countries over the last two centuries. Using AD and AS diagrams to illustrate your claims, give the most internally consistent and factually accurate explanation of these facts that you can. (Hint: You may want to appeal to historical facts discussed in your assigned reading).

As the Simon volume shows, and as the first week of lectures explained, AS has massively increased during the past two centuries. There has been a "virtuous spiral" of population and ideas that has allowed a larger population to live at a much higher level. By itself, this tends to make the price level fall. What must be inferred, then, is that AD has increased by even more than AS has increased. There are two obvious factors behind this: (a) Governments have continuously increased the money supply, and (b) There has been a great deal of innovation in the supply of money substitutes.










2. Explain why Landsburg ("Why Taxes Are Bad") says that "if I let the dollar go, my losses are offset by others' gains." Illustrate your conclusion with (a) an AD-AS diagram AND (b) a money supply/money demand diagram.

Landsburg says that if $1 is destroyed, the money supply falls infinitesimally, leading to a microscopic rise in the value of money. As a result, the real value of all remaining dollars in the world slightly rises. Flipping perspectives, when the money supply falls by $1, AD slightly declines, so the price level falls, and again, the real value of all remaining dollars rises. With a vertical AS curve, it should be clear that losing money can't make the world poorer, though it can make one person poorer.