AMERICAN UNIVERSITY
Department of Economics


Comprehensive Examination January 2011
MA Theory Page 1 of 5

Instructions: You must answer both the microeconomic and macroeconomic sections of the exam. Each section receives equal weight in the grading. Plan to spend about two hours on each section. Make sure you follow the directions in each section carefully.

MICROECONOMICS SECTION
Directions: Answer all questions from Part A (Short Answer) and Part B (Long Answer). Show all of your work.

Part A: Answer all questions (15 minutes each – 60 minutes total).
1. True, False, Uncertain and Explain. Suppose that the only way to reduce pollution from paper production is to reduce output. The government imposes a tax on the monopoly producer of paper that is equal to the marginal harm from the pollution. The tax will raise welfare in society. Explain your answer using a well-annotated graph.

2. A firm has a production function defined by the equation:


Where K is the number of units of capital and L is the number of units of labor used by the firm. Calculate the firm’s long-run cost function, assuming that the price of capital is r and the price of labor is w. Explain in words and illustrate on a well-annotated graph why the short-run cost of producing q units will be higher than the long-run costs of producing the same number of units if the number of units of capital is fixed at K* in the short-run.

3. John usually buys one pizza and two sodas from the cafeteria at lunch. The cafeteria announces a new special…all pizzas after the first pizza are half price. Graph the original and new budget constraints. Will Ralph alter his consumption bundle based on the new special? Is he better off under the new special? Explain your answer.

4. Lori, who is risk averse, has two pieces of jewelry, each worth $1,000. She wants to send them to her sister, but is concerned about the safety of shipping them. Specifically, she believes that there is probability p that the jewelry won’t arrive safely. Is her expected utility higher if she sends the two articles together or if she ships them together? Explain your answer

Part B: Answer all questions (30 minutes each – 60 minutes total).
1. Sue consumes only peanut butter sandwiches with exactly 2 tablespoons peanut butter and one tablespoon jelly. Her total utility can be described by the equation:


Where b is the number of tablespoons of peanut butter and j is the number of tablespoons of jelly. The price of peanut butter and jelly is defined by pb and pj, respectively.
  1. If Sue has w dollars of income, calculate her Marshallian, x(p,w), demands for peanut butter and jelly, as well as her indirect utility function, v(p,w). Illustrate your answer on a well annotated indifference curve graph. Is peanut butter a normal or inferior good? Please explain your answer.
  2. Calculate Sue’s hicksian demand for peanut butter and jelly, h(p,u), as well as her expenditure function, e(p,u).
  3. Is Sue’s hicksian demand for peanut butter more or less elastic than Sue’s Marshallian demand? Why?
  4. The U.S. sugar quota has caused an increase in the price of jelly to qj. How much money would you have to give Sue to ensure that she is at least as well off as before the price increase? In other words, calculate Sue’s compensating variation associated with the price change, and illustrate your answer on a well annotated indifference curve/budget constraint graph.

2. The current market for mushrooms is characterized by the demand function:

There are currently 20 identical firms producing mushrooms, each with the cost function:

Where w is the wage rate for mushroom pickers.
  1. If the market for mushrooms is perfectly competitive, and the wage rate of mushroom pickers is $1.00, what is the current (short-run) market equilibrium price and quantity?
  2. Calculate the long-run equilibrium market price and quantity, along with the number of firms in the industry. Again, assume that the wage rate of mushroom pickers is $1.00.
  3. Assuming that this is a constant cost industry, calculate the long-run supply function of the industry as a function of the wage rate (w). How does this supply function change with an increase in the wage rate? If the wage rate is a function a total industry output, how would this change the long run supply function? Explain your answer.

MACROECONOMICS SECTION

Directions: Answer two (2) questions from part A (short-answer questions), one (1) question from part B, and one (1) question from part C. Show all your work.

Part A (Short Answer): ANSWER TWO (2) OF THE FOLLOWING QUESTIONS. Answer in about 2 paragraphs EACH, with any necessary equations, graphs, or both. (20 minutes each)

  1. How could “quantitative easing” by the central bank be used to augment traditional monetary policy? What sorts of conditions would enhance its effectiveness?
  2. Define the neutrality of money. Does it hold in both the short run and the medium run? Explain why or why not.
  3. Explain the difference between the nominal and the real exchange rate. Which is most relevant for goods market equilibrium in an open economy? Explain.
  4. In the Solow growth model, is it always a good idea for an economy to try to achieve the “golden rule” level of capital per worker? Explain.
  5. Will a fiscal contraction have a larger short-run effect on output when the economy is in a “liquidity trap” than when it isn’t? Explain carefully using appropriate graphs.
  6. Discuss two of the economic dangers of persistent federal budget deficits and growing federal debt in the U.S. economy.
  7. Could an increase in the target rate of inflation from 2% to 5% help to reduce the chance of another “Great Recession”? Explain why or why not.


Part B: ANSWER ONE (1) QUESTION. (40 minutes)
  1. Use the Solow growth model (neoclassical growth model) to derive the equation for the steady-state equilibrium. Assume initially that the growth rate of the labor force (gN) and the growth rate of technical progress (gA) are both equal to zero.
    a. Use equations and a graph to show the impact of an increase in the saving rate on the level of output per worker and the growth rate of output per worker. Explain all reasoning and all details about the transition from the initial equilibrium to the new equilibrium
    b. Assess the overall impact of the move to the higher saving rate. [Who gains and who loses?]
    c. Next, assume the both gN and gA are positive. Derive the new steady-state condition and draw a new graph of the steady-state condition. Carefully label all elements of the new graph, including the axes.
    d. If there is a fall in gA, what is the impact on the level of output per worker and the growth rate of output per worker? Show the change on the graph and on the growth rates.
    e. The Solow model is often criticized for its treatment of technical progress. What is the basis for the criticism?

2.
  • a. Derive the IS and LM equations for the open economy.
  • b. Use the short-run model, augmented by the uncovered interest parity condition, to graphically analyze the following events (separately):
    • (i) contractionary monetary policy in a flexible exchange rate system.
    • (ii) contractionary monetary policy in a fixed exchange rate system.
    • (iii) a rise in foreign interest rates in a flexible exchange rate system.
  • c. Summarize the effects on real GDP, home interest rates, the nominal exchange rate and the trade balance. Include all actions taken by the central bank (if any) in each part by showing the changes on the central bank’s balance sheet.


Part C: ANSWER ONE (1) QUESTION. (40 minutes)
1.
  • a. Explain how expansionary monetary policy affects the economy under normal circumstances in the short run and the medium run. Assume the economy was operating BELOW the natural rate of output at the start of your analysis. Use the closed economy IS-LM and AD-AS model in your answer.
  • b. Is there a reason to believe the central bank encountered a liquidity trap as it pursued expansionary policy from 2007 to 2010? How does this affect the impact on output? Show this on the appropriate graph.
  • c. Does your analysis suggest that a combination policy was needed to achieve the goals of the policymakers? Suggest a specific combination policy that may have been beneficial. Show this policy on the appropriate graph and include a detailed explanation.

2.
  • a. Use the aggregate demand (AD) and aggregate supply (AS) model to analyze the following events (together):
    • (a) an increase in the markup rate, μ, caused by a higher price of energy
    • (b) the fiscal expansion that has been in place for the past two years.
  • Assume the economy begins at the natural level of output (YN). Include a discussion of the underlying relationships by using a graph of the labor market (wage setting and price setting) and the goods-financial markets (using the closed economy IS-LM graphs). Show the short run equilibrium, the medium run equilibrium and the nature of the adjustment process. A detailed explanation is the most important part of your answer.

  • b. How would you advise policymakers to adjust fiscal policy (if at all), given your analysis in part (a)? Explain in detail.