PUBLIC ECONOMICS –Fall Term Test Solutions

November 2, 2016

Question 1 (worth 4 points)

1a) If the government chose to guarantee the debt of a very large financial institution, how might that affect the lending behaviour of the financial institution, and why? [Two sentences.] (2 points)

1b) Building on your answer to part 1a), what implications might this behaviour by the very large financial institution have today for government expenditure as a proportion of GDP, if the guarantee were announced today? [Two sentences.] (2 points)

Question 2 (worth 2 points)

In 2006, which spending category accounted for the largest share of government expenditures, and how much was it, to the nearest percent? (2 points)

Question 3 (worth 17 points)

3a) You are being offered a choice of $90 today or $100 in one year’s time, knowing that the rate of inflation will be 10 percent over the course of the year. Which choice should you take, assuming that the prevailing nominal interest rate is zero? Please show your calculations. (3 points)

3b) Would your answer to part 3a) change if the nominal interest rate were 3 percent? Why? Please explain. (3 points)

3c) Suppose that the government objective can be represented by the following payoff function:

R = G + a S,

where R measures overall government utility, G is the private payoff to the government, S represents the welfare of the general public, and a is a parameter measuring how much weight the government attaches to the general public’s interests.

Consider three alternative options:

i. Option 1 involves the government issuing nominal debt, then subsequently inflating the economy a lot. This yields a private payoff to the government of G₁ = 5 and a payoff to society,

S₁ = -20;

ii. Option 2 involves the government issuing nominal debt, then subsequently inflating the economy a moderate amount. This yields a private payoff to the government of G₂ = 4 and a payoff to society,

S₂ = -10;

iii. Option 3 involves the government issuing indexed debt, then subsequently keeping inflation low. This yields a private payoff to the government of G₃ = 2 and a payoff to society of

S₃ = 25.

If the parameter a were equal to 1/10, would the government choose the best course of action for society? Please explain, showing any relevant calculations. (6 points)

Question 4 (worth 3 points)

What is the break-even inflation rate (or BEIR)? (3 points)

Question 5 (worth 2 points)

What is a Giffen good? (2 points)

Question 6 (worth 14 points)

6a) Define competitive equilibrium in the pure exchange economy precisely. (4 points)

6b) What is a necessary condition for Pareto efficiency in an economy with both consumers and firms. Please be precise. (4 points)

6c) Demonstrate the First Welfare Theorem in an economy with both consumers and firms. Please explain clearly. (6 points)