Exam 1 Econ 304 Chuderewicz Spring 2014 Name Last 4 PSU ID PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET THANKS AND GOOD LUCK Total Points for exam 235 Test time 120 minutes Approximately one minute for every two points To help with time management if spreading time evenly Question 1 50 points 25 minutes Question 2 50 points 25 minutes Question 3 1 35 points 17 minutes Question 3 2 45 points 22 minutes Question 4 55 points 27 minutes 1 Please answer all questions You must show all work or points will be taken off 1 50 points total Suppose we have Dagwood who has a current income of 400K and expected future income of 200K He has zero in current wealth and zero in expected wealth Dagwood s behavior is consistent with the life cycle theory of consumption For one he perfectly smoothes consumption and two since he is in his peak earning years he is saving now so that he can maintain his current level of consumption in the future Given that Dagwood faces a real interest rate of negative 3 0 03 Please answer the following questions a 5 points Calculate Dagwood s optimal consumption bundle showing all work Then draw a completely labeled graph the two period consumption model depicting this initial optimal consumption bundle as point C A 10 points for a completely labeled graph be sure to label the no lending no borrowing point s NL NB and the slope of the budget constraint s 2 b 5 points Now Dagwood goes to the doctor and finds out that he is not as healthy as he thought too many eating binges The doctor tells him that he is fine now but next period he is likely to be ill and that if you had anything in life that you really wanted to do as in leisure you should do it now As a result Dagwood s preferences change so that he prefers to consume like our friend Homer that is Dagwood prefers to consume twice as much today relative to next period Resolve for Dagwood s optimal consumption bundle given these new preferences and label as point C B c 5 poiints Ben Bernanke and the Fed are finally happy with the way the economy is headed and to be honest is now fearful of overheating As such the Fed tightens and the real rate of interest rises to 7 0 07 Given his change in preferences as above in part b recalculate the optimal bundle for Dagwood and add this point to your graph and label as point C C 3 d 5 points Is Dagwood better off worse off or is there no change in welfare due to the rise in the real rate of interest Explain the intuition using the income and substitution effects if relevant e 5 points In the space below derive and draw Dagwood s savings function this is after Dagwood went to the doctor i e use the information from parts b and c only f 5 points Given your results from part d and e above what are the implications as to the power of monetary policy with regard to influencing consumption Assume that there are many consumers in the economy just like Dagwood after he went to the doctor Please explain 4 g 10 points How would your answers in part d and e change if Dagwood would have never gone to the doctor and maintained his perfect smoothing preferences as in part a You need not do the calculations just explain with words Be specific and refer to the income and substitution effects and whether or not they work in the same or opposite directions and why Also be sure to comment on how the savings function for Dagwood would change relative to one you drew in part e given that he never went to the doctor Note this answer is worth 10 points 5 2 50 points total You own a fleet of offshore fishing boats and you need to determine how many fishing poles 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 fishing pole costs 2000 fishing hours this is your output and the rate of depreciation is 18 0 18 The real interest rate is 2 02 And the expected marginal product of capital is given by MPKf 1000 20K There is no tax on capital so tao 0 a What is the tax adjusted user cost of capital and what is this user cost expressed in Show work 5 points b How many fishing poles should you buy to maximize profits Show work 5 points Draw a uc K graph depicting the state of affairs and label this initial profit maximizing condition as point A A correctly drawn and completely labeled diagram is worth 10 points 6 c Now conditions change The following two shocks occur simultaneously i the US appreciates and since you buy your poles from abroad the poles become cheaper and now cost 1900 fishing hours ii the expected marginal product of capital changes and is now MPKf 1100 20K Resolve for K and show as point B on your uc K diagram 5 points d Given the two shocks as above explain the intuition underlying the change in the profit maximizing level of fishing poles i e why does the firm change its behavior making sure you refer to the firm s profit maximizing condition write it out Be specific and write this like you were a professional economist Be sure to compare the actual user cost to the actual MPKf after the shocks holding K constant at its level from part b 10 points e Suppose that the Federal Reserve had a goal to get the capital stock the number of fishing poles purchased back to its initial level as in part b Given the two shocks as above what would they have to do to the real rate of interest to achieve their objective Please show all work and I am looking for a specific number i e r Please add this development to your diagram as point C 5 points 7 f Finally draw a desired investment diagram completely labeled with the relevant shift variables noted next to the function in parentheses depicting the initial equilibrium as point A simply draw a negatively sloped ID curve going through point A Label the initial level of desired investment as IdA Note importantly that we do not have numbers for desired investment but that s ok we are focusing on the change in desired investment Then show as point B the level of desired investment after the change in the price of capital and the change in the expected MPK Finally show how the Fed policy maps to your investment diagram and label as point C with the corresponding level of investment labeled as IdC A completely labeled and correct diagram is worth 10 points make sure you include the relevant shift variables in …