Exam 1 Econ 304 Chuderewicz Fall 2010 Name Last 4 PSU ID Section Hosler Sparks please circle one PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET THANKS AND GOOD LUCK 1 Please answer all questions You must show all work or points will be taken off 1 60 points total Homer Simpson does not abide by the life cycle theory of consumption Homer has a let s live life like it s our last day mentality and thus he prefers to consume more today relative to the future In particular Homer prefers to consume exactly twice as much today c relative to consumption next period cf Homer s current income 250K and his future expected income 150K He has no wealth neither current nor expected since he lives like today is his last Homer faces a real interest rate of 0 10 Please answer the following questions a 5 points State clearly what the slope of any budget line represents in general and then refer to this specific case i e what is the slope of Homers budget constraint and what does this mean exactly Be specific 5 points Cf 1 r y a yf af 1 r C Intercept Slope Slope represents trade off or relative price of current consumption in terms of future consumption in this case if Homer consumes one more unit of current consumption he is giving up 1 1 units of future consumption so 1 r units of future consumption is the price of one unit current consumption b 5 points Solve for Homer s optimal consumption basket today C and his optimal consumption basket next period Cf Please provide a completely labeled graph depicting these results and label this initial point as C A C 265 6 Cf 132 8 2 10 points for a completely labeled graph be sure to label the no lending no borrowing point NL NB Use space above c 5 points Now Ben Bernanke and the Fed is not happy with the state of the economy i e we are not at NAIRU and therefore conduct massive amounts of open market purchases and some how get the real rate of interest all the way down to 0 00 that is correct zero percent Resolve for Homer s optimal basket given the Fed s expansionary policy and label as point C B on your diagram C 266 6 Cf 133 33 d 5 points Did the Fed policy work as in stimulating the economy That is did the Fed policy successfully increase consumption which represents about 70 of the economy assume the economy is made up with a bunch of Homers just like this one Be sure to define what the income and substitution effects are and how they play a role in determining whether or not the Fed policy is successful as defined by increasing consumption Also comment on whether these income and substitution effects work in the same or opposite direction i e is it a tug of war or do they work in the same direction in this particular case Discuss e 5 points Given the Fed s behavior i e r 0 Homer becomes more cautious since he is thinking that if interest rates are this low something must be wrong He grabs an economic textbook and reads about the life cycle theory of consumption and along with discussions with his wife Marge he decides to change his preferences to be consistent with perfect consumption smoothing just like Dagwood was in our HW problem Resolve for Homers optimal basket and label as point C C on a NEW diagram C 200 Cf 200 3 DRAW A NEW DIAGRAM DEPICTING THIS NEW INITIAL POINT 10 points for a completely labeled graph be sure to label the no lending no borrowing point NL NB Use the space below f 5 points Now Ben Bernanke is monitoring the economic situation given that he and the Fed lowered rates and sees that consumption has gone down Why exactly has consumption gone down use the terms saver and borrower in your answer and does Homer s behavior have anything to do with going to AA Alcoholics Anonymous as in the Colbert movie clip we watched in class Discuss g 5 points Given the fall in consumption Ben and the Fed expand again and get real interest rates all the way down to 0 05 negative 5 but use decimals as we always do Resolve for Homer s new optimal consumption point and label as point C D on the new diagram above C 198 7 Cf 198 7 h 5 points Did this latest expansionary monetary policy work in term of increasing consumption assume there are a bunch of Homers that have changed preferences like this Homer did Why or why not explain using the income and substitution effects If you were advising Ben Bernanke and the Fed what would you tell him to do to raise consumption and why Discuss 4 2 50 points total You are entering the spray painting business and you need to determine how many spraying machines you need to buy to maximize profits Please answer the following questions given the information below Please be sure to SHOW all work A brand new spraying machine costs 1000 units of output and the rate of depreciation is 10 0 10 we assume that you can purchase fractions of machines The real interest rate is 10 10 And the expected marginal product of capital is given by MPKf 800 10K The firm also faces a tax rate on gross revenue what we call tao 20 20 a 5 points What is the tax adjusted user cost of capital Show work 5 points uc 250 b 5 points How many spraying machines should you buy to maximize profits Show work 5 points K 55 Draw a uc K graph depicting the state of affairs and label this initial profit maximizing condition as point A Use the space below A correctly drawn and completely labeled diagram is worth 10 points Use space above 5 We talked in class about how the US Congress decided not to vote on whether to extend the Bush tax cuts that are set to expire Let us assume that the Government lets them expire and since many small businesses file as individuals or close to it they now face a higher tao 50 50 We also find that the firm s expected MPK function has changed and is now equal to MPKf 600 10K Assume these two events happen simultaneously please answer the following questions c 5 points Name and support two reasons why the expected MPK function would change like this Be sure to relate one of your reasons to the real world as best you can Discuss d 5 points Re solve for the new profit maximizing level of capital stock and label on your diagram as point B uc 400 K 20 e 5 points Now the Fed does not like these developments and lowers the real rate to 1 0 01 Given all these changes the change in MPK the …