Economics 816 Final

Prof. Bryan Caplan

Spring, 1999




        You have 2 hours, 30 minutes to complete this exam.

        You may use any books, notes, or other materials that you wish, but avoid spending too much time on any one question.

        Partial credit may be awarded on all questions.

        The maximum possible number of points is 200.

        Spend 6-7 minutes on each T/F/Explain question, and about 13 minutes on each short answer question.

        You should have 10 pages, counting this one.


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 twelve propositions is true or false. Using 2-3 sentences AND/OR equations, explain your answer.


1. Credit market regulations fix the nominal rate of interest at 2%.


True, False, and Explain: Under these conditions, the quantity of money demanded is a function of the nominal rate, not inflation.











Questions 2 and 3 refer to the following facts:


Here is the data for U.S. M2 growth from 1939-1947:



M2 growth




















"Velocity rose by a fifth from 1940 to 1942... then declined by over a third to 1946." (Friedman and Schwartz, A Monetary History of the United States)


Note: Velocity began to rise again mildly in 1946-1949.


2. True, False, and Explain: The behavior of velocity is precisely what basic monetary theory would predict in circumstances described.







3. True, False, and Explain: One theoretically sound explanation for the behavior of velocity is that U.S. military spending massively increased in early 1942, and remained high through 1945.













4. True, False, and Explain: "People form so-called 'rational' expectations of the value of x by figuring out the E(x|information available at time t). But this is irrational because all past experience shows that scientific knowledge tends to advance; what we think we know today will in the future be shown to be invalid."












5. True, False, and Explain: Eichenbaum (1997) maintains that New Keynesians and RBC theorists have found that, empirically, fiscal policy has no real effect.














Questions 6 and 7 refer to the following model:


Central bank's loss function: ;

AS function:


6. True, False, and Explain:












7. True, False, and Explain: With rational expectations, the equilibrium inflation rate in this model is infinite.











8. True, False, and Explain: Alesina and Sachs' political business cycle model implies that an election's result will not generate a macroeconomic shock if the electoral race was at a "dead heat" on election day (i.e., on election day, each candidate had a 50/50 probability of victory).











9. "Under the gold standard, population growth would not be deflationary, because both more goods and more money (gold) would be produced."


True, False, and Explain: This quote is incorrect if there are constant returns to scale in production of both gold and goods.













10. Selgin and White derive the following (corrected) equation in the course of their proof that free banking stabilizes nominal GDP:




Suppose reserve regulations fix the value of M. R, b, sx, and k are also fixed.


True, False, and Explain: Under these circumstances, a negative velocity shock increases the level of output.











11. Bernanke (1995) estimates the following coefficients for the regression of international macro variables on his ONGOLD dummy.



Nominal wages


Real Wages





True, False, and Explain: If labor market rigidities were responsible for current high unemployment in Europe, then if one regressed modern macro data on the variable STRICTREG (=1 if a country has strict labor labors, and 0 otherwise) one would expect to see exactly the same pattern for nominal wages, real wages, and employment.












12. "Donald Wittman (1995) has recently argued that the neoclassical model of political processes purports to demonstrate democratic inefficiencies, but when pushed to its logical conclusion shows the opposite: democratic bargaining, like economic bargaining, yields the best possible outcome given the constraints... [I]f the full costs of any action are taken into account - including the costs associated with achieving an alternative arrangement of affairs - then at any point individuals are doing the best they can given the situation." (Peter Boettke, "Is There An Intellectual Market Niche for Austrian Economics?")


True, False, and Explain: Boettke correctly describes the thesis of Wittman's "Why Democracy Is Efficient."












Part 2: Short Answer

(20 points each)

In 6-8 sentences AND/OR equations, answer all four of the following questions.


1. Under a mandatory 100% reserves regime, banks of course hold all of their assets as (non-interest-bearing) cash. Under free banking, assume that banks would hold 10% of their assets as cash, and lend the rest out at a 5% real rate of interest.


Both sorts of banks would implicitly charge 3% annually in fees, which they deduct from any interest they pay on deposits.


Fill in empty cells in the table below showing consumer's nominal and real rates of return under 100% reserve banking and free banking for different inflation rates. (Assume inflation has no effect on real rates).



100% Reserves

Free Banking


Nominal Return


Real Return

Nominal Return


Real Return























































2. Bordo and Kydland (1995) argue that under the classical gold standard, governments deflated in order to preserve their credibility: If they resumed payment by devaluing the currency instead of deflating back to par, people would be much less willing to lend during the emergency. Why, however, didn't governments just devalue their currencies and then pay bondholders a compensatory premium over the face value? Can Caplan's "Logic of Collective Belief" explain why?







3. Consider a simple model of reputation and monetary policy in which the public only trusts the central bank if inflation is always ZERO. Otherwise, they expect the CB to play the non-cooperative inflation rate . Each turn the CB sets p=0 and the public expects it to, the CB's single period utility is vc; each turn the CB sets p>0 and the public does not expect it, the CB's single period utility is vd; each turn the CB sets p>0 and the public does expect it, the CB's single period utility is vp. The values of these utilities are:


; ; .


First explain the components of vc, vd, and vp. Then write down a single inequality that characterizes the conditions under which the cooperative equilibrium is sustainable with rational agents and an infinite horizon. Do NOT solve this equation.





4. Write the most convincing Wittmanian critique of Higgs (1985) that you are able to.