Eriks Final Macro Winter 2013 Name (print): _______ANSWERS___________________________

E am Ass!mptions
"#ese ass!mptions #ol$ t#ro!%#o!t t#e EN"&RE e am (!nless tol$ ot#er'ise)

1) we always start at Y*,

2)

all variables (consumption, investment, etc.) are real variables, unless otherwise stated,

3)

Capital (K) is i!ed in both the short and lon" run, but is allowed to chan"e in the really lon" run.

#)

$% is i!ed (at &ero), unless otherwise instructed,

')

no policy response ta(es place, unless otherwise instructed,

))

consumers are non*li+uidity constrained, non*,icardian -./ (who have lon" lives such that 00 is lar"e), unless otherwise instructed,

1)

all shoc(s to the economy are permanent and une!pected, unless otherwise stated,

2) 4)

3!pected in lation has no e ect on money demand, Chan"es in $ have no e ect on investment demand,

15) 67-, oil prices, consumer con idence, business con idence, chan"es in the stoc( mar(et, chan"es in population, and chan"es in value o leisure (i.e., all e!o"enous variables) only chan"e when . tell you they chan"e.

((W#en $isc!ssin% lon% r!n c#an%es) compare t#e initial con$ition o* t#e econom+ to '#ere it 'ill en$ !p in t#e lon% r!n (!nless tol$ ot#er'ise),

-art &: .ircle t#e "r!e Ans'ers (2/ points total) 3 points eac#)

-arts A0E (1!estions A 2 E all #a3e t#e *ollo'in% 4ack%ro!n$ in*ormation) 8uppose the economy starts at Y* and all consumers are Keynesian who make their consumption decisions out of current income (not wages) . S!ppose t#at %o3ernment spen$in% (5) permanentl+ $ecreases6 (6his is similar to the current se+uester situation). 7or each o the +uestions below, you are to assess '#at e**ect a permanent $ecrease in 5 #as on t#e econom+ . 9hen answerin" the +uestions, ma(e the ollowin" additional assumptions: ;ssume there are no other policy chan"es (i.e., < is held i!ed). For 7e+nesians) ass!me . 8 9: ('#ere 9: 8 $isposa4le income), ;ssume there is no income e ect on labor supply or Keynesians. ;. 9hat happens to both investment and consumption in the short run= i. ii. >oth investment and consumption increase. .nvestment alls and consumption remains the same.

iii, .ons!mption *alls an$ in3estment increases, iv. v. >oth consumption and investment all. Consumption increases and investment can either increase or decrease.

&n t#e s#ort r!n) t#e &S c!r3e 'ill s#i*t le*t (as 5 an$ . $ecrease in t#e s#ort r!n), "#is 'ill ca!se t#e ;M c!r3e to s#i*t o!t (as - $ecreases res!ltin% *rom A: s#i*tin% le*t), "#e le*t'ar$ s#i*t o* t#e &S c!r3e an$ t#e ri%#t'ar$ s#i*t o* t#e ;M c!r3e implies !nam4i%!o!sl+ t#at r *alls, "#at means & 'ill $e*initel+ increase in t#e s#ort r!n, . *alls in t#e s#ort r!n 4eca!se . 8 4 (90"), As 9 *alls) . 'ill $e*initel+ $ecrease *or 7e+nesian cons!mers,

>.

9hat happens to both nominal wa"es (9) and $ between the short run and the lon" run= i. ii. >oth $ and 9 increase between the short run and the lon" run. $ increases and 9 remains constant between the short run and the lon" run.

iii. $ remains constant and 9 alls between the short run and the lon" run. #

iv. 3,

$ remains constant and 9 increases between the short run and the lon" run. N increases an$ W *alls 4et'een t#e s#ort r!n an$ t#e lon% r!n,

W $ecreases 4eca!se o* t#e sel*0correctin% mec#anism, &n t#e s#ort r!n) N < N( (an$) conse=!entl+ 9 < 9(), Workers 'ill 4e o** t#eir la4or s!ppl+ c!r3e, >nce t#e sel*0correctin% mec#anism kicks in (per t#e pro4lems instr!ctions)) W 'ill $ecrease makin% it less e pensi3e *or *irms to #ire la4or, "#e $ecrease in W 'ill ca!se N to increase (an$ 9 to ret!rn to 9(), So) 4et'een t#e s#ort r!n an$ t#e lon% r!n) W 'ill $ecrease an$ N 'ill increase,

'

-art & (contin!e$): .ircle t#e "r!e Ans'ers (2/ points total) 3 points eac#) C. ?iven the Keynesian consumers described above, how would the ma"nitude o the chan"e in investment (.) between the initial condition and the lon" run compare to the ma"nitude o the chan"e in "overnment spendin" (?) over the same period= i. 6he absolute value o the chan"e in investment between the initial condition and the lon" run will be less than the absolute value o the chan"e in "overnment spendin".

ii. 6he absolute value o the chan"e in investment between the initial condition and the lon" run will be "reater than the absolute value o the chan"e in "overnment spendin". iii, "#e a4sol!te 3al!e o* t#e c#an%e in in3estment 4et'een t#e initial con$ition an$ t#e lon% r!n 'ill 4e t#e same as t#e a4sol!te 3al!e o* t#e c#an%e in %o3ernment spen$in%, iv. .t is uncertain whether the absolute value o the chan"e in investment between the initial condition and the lon" run will be bi""er or smaller than the absolute value o the chan"e in "overnment spendin". &n3estment 'ill increase in t#e lon% r!n, &* 5 *alls 4+ ?) & 'ill increase 4+ ?, "#e reason is t#at 9 'ill not c#an%e in t#e lon% r!n (as A) 7 an$ N( $o not c#an%e) an$ . 'ill not c#an%e in t#e lon% r!n (4eca!se . is a *!nction o* 9 t#at $oes not c#an%e), So) like o!r stan$ar$ e amples) t#ere 'ill 4e per*ect cro'$in% in o* in3estment in t#e lon% r!n *rom a permanent $ecrease in %o3ernment spen$in%,

@.

9hat happens to real wa"es (9A-) and the real money supply (<A-) between the initial condition and the lon" run= i. >oth real wa"es and the real money supply are constant in the lon" run.

ii. >oth real wa"es and the real money supply all in the lon" run. iii. >oth real wa"es and the real money supply increase in the lon" run. i3, Real 'a%es are constant in t#e lon% r!n '#ile t#e real mone+ s!ppl+ increases, iv. ,eal wa"es increase in the lon" run while the real money supply is constant. vi. ,eal wa"es are constant in the lon" run while the real money supply alls.

W@- $oes not c#an%e (no c#an%e in la4or $eman$ or la4or s!ppl+ 2 so 'e 'ill ret!rn to t#e ori%inal W@-), )

M@- 'ill increase as - $ecreases an$ M is *i e$,

-art & (contin!e$): .ircle t#e "r!e Ans'ers (2/ points total) 3 points eac#)

3.

9hat happens to the ;@ and the .8 curves between the short run and the lon" run= i. $either the ;@ curve nor the .8 curve shi ts between the short run and the lon" run.

ii. 6he ;@ curve shi ts ri"ht between the short run and the lon" run while the .8 curve does not shi t between the short run and the lon" run. iii. 6he .8 curve shi ts ri"ht between the short run and the lon" run while the ;@ curve does not shi t between the short run and the lon" run. i3, Aot# t#e A: c!r3e an$ t#e &S c!r3e s#i*t ri%#t 4et'een t#e s#ort r!n an$ t#e lon% r!n,

As . ret!rns to its initial le3el (as 9 ret!rns to its initial le3el)) 4ot# t#e A: an$ &S c!r3es 'ill s#i*t ri%#t 4et'een t#e s#ort r!n an$ t#e lon% r!n, ((("#is onl+ #appens 'it# t#e 7e+nesian cons!mers((( . increases 4eca!se t#e sel*0correctin% mec#anism 'ill kick in an$ e3ent!all+ ret!rn 9 to its ori%inal le3el, "#e lon% r!n A: an$ &S 'ill still 4e to t#e le*t o* t#e ori%inal c!r3es (as 5 is lo'er), Note 0 per t#e pro4lem instr!ctions 0 . is a *!nction o* total income (9) N>" 'a%es (W@-),

-art & (contin!e$): .ircle t#e "r!e Ans'ers (2/ points total) 3 points eac#) -arts F0& (1!estions F 2 & all #a3e t#e *ollo'in% 4ack%ro!n$ in*ormation) 8uppose that Y B Y* in the short run. 7or each o the ollowin" +uestions, circle the answer that ma(es the +uestion true. ;"ain, there is only one true answer to each o the +uestion stems. ( Note: &t $oes not matter '#+ 9 is c!rrentl+ #i%#er t#an t#e potential le3el (9() '#en ans'erin% t#e =!estions 4elo'). For parts F0&) 'e 'ill ass!me t#at: .ons!mers are stan$ar$ non0li=!i$it+ constraine$ (non0Ricar$ian) -&B cons!mers, No polic+ takes place to ret!rn t#e econom+ to 9( (i,e,) t#e econom+ corrects itsel*),

W#en 9 C 9( t#en it m!st 4e tr!e t#at N m!st 4e %reater t#an N(, We kno' t#at in t#e s#ort r!n) 'orkers are o** o* t#eir la4or s!ppl+ c!r3e, "#e sel*0correctin% mec#anism tells !s t#at nominal 'a%es m!st increase 4et'een t#e s#ort an$ lon% r!n in or$er *or !s to 'alk 4ack !p t#e la4or s!ppl+ c!r3e to N( at W@-(, (;ike al'a+s) N *alls an$ W@- increases) As W increases) it 4ecomes more e pensi3e *or *irms to pro$!ce at eac# le3el o* o!tp!t so t#e SRAS 'ill s#i*t in !ntil 989(, As t#e SRAS c!r3e s#i*ts in) 'e kno' prices 'ill increase, As prices increase) M@- 'ill *all '#ic# means in t#e &S0;M market t#e ;M c!r3e 'ill s#i*t in !ntil 989(, As a res!lt) r 'ill increase 4et'een t#e s#ort an$ lon% r!n, As r increases) & m!st *all (t#e mo3ement alon% t#e &S c!r3e as t#e ;M c!r3e s#i*ts in), As 9 *alls 4et'een t#e s#ort an$ lon% r!n) t#e mone+ $eman$ c!r3e 'ill s#i*t in, From man+) man+ =!iD =!estions) +o! s#o!l$ kno' t#at t#e ma%nit!$e o* t#e c#an%e in nominal 'a%es s#o!l$ 4e %reater t#an t#e ma%nit!$e o* t#e c#an%e in prices, "#is m!st 4e tr!e in or$er *or t#e sel*0correctin% mec#anism to ret!rn t#e econom+ to 9(,

7.

9hich o the ollowin" is true about real wa"es (9A-) in the short run relative to real wa"es in the lon" run (assumin" Y B Y* in the short run)= i. ,eal wa"es in the short run will be hi"her than real wa"es in the lon" run.

ii, Real 'a%es in t#e s#ort r!n 'ill 4e lo'er t#an real 'a%es in t#e lon% r!n, iii. ,eal wa"es in the short run will be the same as the real wa"es in the lon" run.

iv. .t is uncertain whether real wa"es in the short run will be hi"her or lower than real wa"es in the lon" run. &t m!st 4e tr!e t#at '#en NCN() W@- in t#e s#ort r!n is 4elo' t#e initial W@-(, Recall) 'orkers are o** t#eir la4or s!ppl+ c!r3e, &t is also tr!e t#at W@- in t#e s#ort r!n is lo'er t#an W@- in t#e lon% r!n0 remem4er W increases 4et'een t#e s#ort an$ lon% r!n to %et !s 4ack to W@-( '#ic# is also e=!al to t#e lon% r!n real 'a%e,

?.

9hich o the ollowin" is true about investment (.) in the short run relative to investment (.) in the lon" run (assumin" Y B Y* in the short run)= i, &n3estment in t#e s#ort r!n 'ill 4e #i%#er t#an in3estment in t#e lon% r!n,

ii. .nvestment in the short run will be lower than investment in the lon" run. iii. .nvestment in the short run will be the same as the investment in the lon" run. iv. .t is uncertain whether investment in the short run will be hi"her or lower than investment in the lon" run. As state$ in t#e e planation a4o3e) r m!st increase 4et'een t#e s#ort an$ lon% r!n as t#e ;M c!r3e s#i*ts in as a res!lt o* - increasin% in t#e AS0A: market (*rom t#e s#i*t in o* t#e SRAS c!r3e), As r increases) &n3estment 'ill *all (t#e ;M c!r3e mo3es alon% t#e &S c!r3e !ntil 9 ret!rns to 9(),

15

-art & (contin!e$): .ircle t#e "r!e Ans'ers (2E points total) 3 points eac#)

/.

9hich o the ollowin" is true about the money demand curve in the short run relative to the money demand curve in the lon" run (assumin" Y B Y* in the short run)= i, "#e mone+ $eman$ c!r3e in t#e s#ort r!n 'ill 4e to t#e ri%#t o* t#e mone+ $eman$ c!r3e in t#e lon% r!n,

ii. 6he money demand curve in the short run will be to the le t o the money demand curve in the lon" run. iii. 6here will be no chan"e in the money demand curve between the short run and the lon" run. iv. .t is uncertain whether the money demand curve in the short run will be to the ri"ht or the le t o the money demand curve in the lon" run. As 9 *alls 4et'een t#e s#ort an$ lon% r!n to ret!rn t#e econom+ to 9() mone+ $eman$ m!st *all, Recall) 'e sa+ mone+ $eman$ is a *!nction o* e pecte$ in*lation an$ 9, &n t#e ass!mptions) 'e sai$ to ass!me e pecte$ in*lation #as no e**ect on mone+ $eman$) so 'e *oc!s attention to t#e c#an%e in 9, .. 9hich o the ollowin" are true about the a""re"ate demand (;@) curve in the short run relative to the a""re"ate demand curve in the lon" run (assumin" Y B Y* in the short run)= i. 6he a""re"ate demand curve in the short run will be to the ri"ht o the a""re"ate demand curve in the lon" run.

ii. 6he a""re"ate demand curve in the short run will be to the le t o the a""re"ate demand curve in the lon" run. iii, "#ere 'ill 4e no c#an%e in t#e a%%re%ate $eman$ c!r3e 4et'een t#e s#ort r!n an$ t#e lon% r!n, iv. .t is uncertain whether the a""re"ate demand curve in the short run will be to the ri"ht or the le t o the a""re"ate demand curve in the lon" run. Bo' t#e sel*0correctin% mec#anism 'orks in eac# o* t#e markets in o!r mo$el %i3en o!r ass!mptions: &n t#e ;a4or market: nominal 'a%es c#an%e to ret!rn N8N(, &n t#is e ample) W increases an$ N *alls

11

&n t#e AS0A: market: t#e SRAS c#an%es an$ - c#an%es as a res!lt, "#e $irection o* t#e s#i*t $epen$s on '#at #appens to nominal 'a%es in t#e la4or market, &n t#is e ample) it s#i*ts in an$ prices increase, &n t#e &S0;M market: t#e ;M c!r3e c#an%es as a res!lt o* t#e c#an%e in prices in t#e AS0A: market an$ r c#an%es as a res!lt o* t#e s#i*t in t#e ;M c!r3e, &n t#is e ample) t#e ;M c!r3e s#i*ts in an$ r 'ill increase, Note t#at t#e A: an$ &S c!r3e $o not mo3e #ere, W#+6 .ons!mption s#o!l$ not c#an%e 4eca!se cons!mers are Non0Ricar$ian) -&B, "#e c#an%e in &n3estment #ere is a mo3ement alon% t#e &S c!r3e,

12

-art &&: "F- c#an%es an$ Economic Mec#anisms (12 points total 2 E points eac#) Consider the models developed in class so ar. .n this +uestion, we are "oin" to analy&e what happens when there is an !ne pecte$ permanent increase in "F- . .n this e!ample, we will assume the ollowin" (in addition to the standard e!am assumptions on pa"e 3): .ncome e ects are the same order o ma"nitude as the substitution e ects on labor supply (i.e., the two e ects cancel). -rices @C $C6 all in the short run (they could either rise or stay the same). ;ll other e!o"enous variables (ta! rates, "overnment spendin", con idence, wealth, etc.) are held i!ed. $% D 5.

?iven the above, circle the true answers. "#ere is onl+ one correct ans'er to eac# o* t#e *ollo'in% t#ree =!estion stems (i.e. you should only be circlin" three thin"s in this part o the e!am * one or part ;, one or part >, and one or part C.). A) i. ii. iii. all. iv. 3, vi. vii. viii. .n the lon" run, the mar"inal product o labor will all and the mar"inal utility o leisure will remain unchan"ed. &n t#e lon% r!n) t#e mar%inal pro$!ct o* la4or 'ill rise an$ t#e mar%inal !tilit+ o* leis!re 'ill remain !nc#an%e$, .n the lon" run, the mar"inal product o labor will all and the mar"inal utility o leisure will remain unchan"ed. .n the lon" run, the mar"inal product o labor will remain unchan"ed and the mar"inal utility o leisure will rise. .n the lon" run, the mar"inal product o labor will remain unchan"ed and the mar"inal utility o leisure will all. Wit# respect to t#e mar%inal !tilit+ o* leis!re (MF;) an$ t#e mar%inal pro$!ct o* la4or (M-N)) '#ic# one o* t#e *ollo'in% is $e*initel+ tr!e6 .n the lon" run, both the mar"inal product o labor and the mar"inal utility o leisure will remain unchan"ed. .n the lon" run, both the mar"inal product o labor and the mar"inal utility o leisure will increase. .n the lon" run, both the mar"inal product o labor and the mar"inal utility o leisure will

13

5i3en o!r .o440:o!%las pro$!ction *!nction) 'e kno' t#at t#ere is complementarit+ 4et'een "Fan$ la4or, We can see t#is *rom takin% a partial $eri3ati3e 'it# respect to N o* t#e pro$!ction *!nction: 98 A70,3N0,/ to +iel$: M-N8 $9@$N 8 0,/A(7@N)0,3 &* A increases) M-N increases (#ol$in% N *i e$), We sa+ t#e la4or $eman$ c!r3e 8 M-N 8 W@-, So) t#e la4or $eman$ c!r3e m!st s#i*t o!t (at e3er+ le3el o* W@-), All else e=!al) t#is 'ill res!lt in increasin% N an$ W@-, As W@- increases permanentl+) 'e kno' t#ere 'ill 4e a s!4stit!tion e**ect (mo3ement alon% t#e la4or s!ppl+ c!r3e) an$ an income e**ect (s#i*t in o* t#e la4or s!ppl+ c!r3e), Aeca!se 'e state$ 4+ ass!mption t#at t#e income an$ s!4stit!tion e**ects 'ill cancel) 'e kno' t#at N 'ill 4e t#e same as t#e initial N, &* N $oes not c#an%e) MF ; 'ill not c#an%e, MF; is a *!nction o* leis!re (as leis!re *alls) MF; increases 4eca!se o* $iminis#in% mar%inal !tilit+ o* leis!re, &* leis!re $oes not c#an%e) t#an t#e mar%inal !tilit+ o* leis!re 'ill not c#an%e, Bo'e3er) W@- m!st increase: W@-

W@-(( W@NS1

N:0 N:1 NS0

N((8N(

Also) %i3en M-N 8 W@-) 'e kno' t#at M-N 'ill !nam4i%!o!sl+ increase 4eca!se W@- increases,

1#

-art &&: "F- 1!estion (12 points total 2 E points eac#) A) i. ii. iii. iv. v. vi. 3ii, viii. i!. Wit# respect to t#e mar%inal !tilit+ o* capital (M-7) an$ total in3estment (&)) '#ic# one o* t#e *ollo'in% is $e*initel+ tr!e6 .n the lon" run, both <-K and . will remain unchan"ed. .n the lon" run, both <-K and . will increase. .n the lon" run, both <-K and . will all. .n the lon" run, the chan"e in both <-K and . will be ambi"uous. .n the lon" run, <-K will be unchan"ed and . will rise. .n the lon" run, <-K will rise and . will remain unchan"ed. &n t#e lon% r!n) M-7 'ill rise an$ & 'ill remain am4i%!o!s, .n the lon" run, <-K will be ambi"uous and . will rise. .n the lon" run, <-K will all and . will rise.

"#ere is complementarit+ 4et'een A an$ 7, Similar to '#at 'e $i$ in t#e last pro4lem) 'e %et t#is *rom takin% t#e partial $eri3ati3e o* t#e o!tp!t *!nction0 t#is time 'it# respect to 7: M-7 8 0,3A(N@7)0,/ "#!s as A increases) M-7 'ill increase (#ol$in% 7 *i e$), As M-7 increases (#ol$in% 7 *i e$)) *irms 'ill 'ant to in3est more so &(,) 'ill increase, We also kno' t#at .ons!mption 'ill increase, W#+6 Aeca!se W@- permanentl+ increases so -G;R increases, So) 'e %et a s#i*t o!t o* t#e &S an$ A: c!r3es *rom t#e increase in . an$ &(,), As t#e A: c!r3e s#i*ts o!t) - 'ill increase '#ic# 'ill ca!se M@- to *all an$ t#e ;M c!r3e 'ill s#i*t in ca!sin% r to increase *!rt#er, As r increases) t#e interest sensiti3e part o* in3estment m!st *all, "#ere*ore) t#e e**ect on in3estment is am4i%!o!s, Bo'e3er) %i3en M-7 8 r) an increase in r 'ill mean t#at M-7 'ill !nam4i%!o!sl+ increase, .) 5i3en t#e a4o3e in*ormation) $isc!ss '#et#er t#e *ollo'in% statement is tr!e) *alse or !ncertain, 9o!r e planation 'ill $etermine +o!r entire %ra$e, 9o!r ans'er s#o!l$ not 4e lon%er t#an 30E 'ell constr!cte$ sentences, Fse '#at +o! #a3e learne$ in class to ans'er t#is =!estion, "#is =!estion 'ill %ra$e$ on t#e 0@E scale (no partial cre$it), Between the short run and the long run, the change in household savings (S HH) will be exactly the same as the change in investment ( )! FA;SE, Aet'een s#ort r!n an$ lon% r!n) in3estment 'ill *all) %o3ernment sa3in%s 'ill *all 4et'een s#ort r!n an$ lon% r!n 4eca!se %o3ernment re3en!es s#o!l$ *all 4et'een t#e s#ort r!n an$ t#e lon% r!n as t#e ta 4ase is *allin%, We kno' t#at SBB H S5>G 8 & 1'

"#ere*ore) i* %o3ernment sa3in%s are *allin% an$ in3estment is *allin% 4et'een t#e s#ort an$ lon% r!n) t#e c#an%e in #o!se#ol$ sa3in%s m!st 4e more positi3e (#i%#er) t#an t#e c#an%e in in3estment,

1)

-art &&&: "r!e@False@Fncertain (EI points 2 I points eac#) 3ach o the parts below sets up a scenario (in italics) and ends with a statement. .n this section, you are to discuss whether that inal statement is 6rue, 7alse or Encertain. ;s on the practice e!ams * e!planation determines your entire "radeF 9e will "ive no credit or writin" true when the answer is true but your lo"ic is wron". Each of your answers should be at most 3-4 clearly written sentences. 0astly, to receive ull credit, you need to be e!plicit about the mechanism that is drivin" your results. 3ach +uestion is worth ' points each. 8ome +uestions have multiple parts within the +uestion stem such as: G8uppose the economy is hit with an increase in G&G. . G&G increases, then both G!G and GyG will increase.G 7or those +uestions, you will need to discuss both parts to "et ull credit. .n other words, you will have to discuss whether the increase in G&G will cause G!G to increase and then separately discuss whether it will cause GyG to increase. 0astly, you should consider your analysis in terms o the models developed in class. ass!mptions on pa%e 3 o* t#e e am #ol$ !nless & tell +o! ot#er'ise, ;. Note: all

Suppose that there is both a permanent increase in " and a permanent increase in business confidence# $ssume no other policy intervention takes place# %astly, assume that the increase in business confidence has no effect on labor demand# ?iven the above assumptions, we (now unambi"uously that investment (.) will all in the lon" run.

"RFE An increase in 4!siness con*i$ence 'ill ca!se &(,) to increase, "#e com4ine$ increase in 5 an$ &(,) 'ill ca!se t#e &S an$ A: c!r3es to s#i*t o!t in t#e s#ort r!n an$ 9C9(, As A: increases) 'ill increase, "#!s) W@- $ecreases so N CN(, As - increases) M@- 'ill *all so t#e ;M c!r3e 'ill s#i*t in, "#!s) r 'ill !nam4i%!o!sl+ increase in t#e s#ort r!n, "#e sel*0correctin% mec#anism tells !s t#at nominal 'a%es m!st increase (an$ increase 4+ more t#an t#e increase in prices) to %et N 4ack to N(, As W@- increases) t#e SRAS s#i*ts in) so - increases 4et'een t#e s#ort an$ lon% r!n, "#!s) t#e ;M c!r3e m!st s#i*t in 4et'een t#e s#ort an$ lon% r!n 4rin%in% t#e &S0;M c!r3e 4ack to lon% r!n e=!ili4ri!m at 98 9(, We kno' as t#e ;M c!r3e s#i*ts in) r increases !nam4i%!o!sl+ 4et'een t#e s#ort an$ lon% r!n, As r increases) t#e interest rate sensiti3e part o* in3estment m!st *all 4et'een t#e s#ort an$ lon% r!n, So) 'e #a3e &(,) increasin% in t#e s#ort r!n *rom t#e increase in 4!siness con*i$enceJ t#e interest rate sensiti3e part o* & *allin% in t#e s#ort r!n as r increases an$ t#e interest rate sensiti3e part o* & $ecreasin% 4et'een t#e s#ort an$ lon% r!n as r increases, ((&t is important to note t#at t#e increase in 5 an$ 4!siness con*i$ence 'ill not a**ect 9(,

11

A naK3e ans'er ma+ 4e t#at t#e e**ect on & is am4i%!o!s 4!t 'e kno' t#at t#is is not tr!e 4eca!se *or t#e econom+ to %et 4ack to 9() & m!st *all 4+ t#e amo!nt o* t#e increase in &(() an$ t#e amo!nt o* t#e increase in 5, So) & m!st *all in t#e lon% r!n, >. Suppose that within a country, the following information was given& 'eal wages always grew at () per year# *he velocity of money always grew at +) per year# 'eal ",- always increased by .) per year# *he nominal money supply always grew at () per year# 'eal interest rates in the economy were always /) per year# *he unemployment rate is always 0) per year# ?iven the in ormation above, the in lation rate in this economy would always be #H per year. "r!e 2 t#is 'as 3er+ strai%#t *or'ar$ %i3en t#e $e*inition o* 3elocit+, G 8 -9@M, 5i3en some al%e4ra (as in class)) 'e kno': L c#an%e in - 8 L c#an%e in G H L c#an%e in M 0 L c#an%e in 9 5i3en a4o3e in*ormation) Lc#an%e in - 8 1L H ML 0 3L 8 EL 9o! nee$e$ to sa+ t#e ans'er 'as EL (or impl+ t#e a4o3e *orm!la) to %et *!ll cre$it,

12

-art &&&: "r!e@False@Fncertain (EI points 2 I points eac#) C. Suppose that there is an unexpected permanent increase to the nominal money supply (1)# .n the short run, both the real money supply (<A-) curve and the money demand curve would shi t to the ri"ht. 7urthermore, in the lon" run, there would be no shi t in either the money demand curve or the real money supply curve (relative to their initial position). $ote: .n ma(e sure you discuss all parts o this +uestion to "et ull credit. "RFE, We kno' t#at c#an%in% M 'ill not e pan$ (or contract) t#e pro$!ction *rontier o* o!r econom+ (i,e,) 9(), &n ot#er 'or$s) c#an%in% M 'ill not res!lt in c#an%es to 9(, "#!s) t#e increase in 9 t#at 'e %et *rom increasin% M in t#e s#ort r!n m!st 4e !n$one 4et'een t#e s#ort an$ lon% r!n *or 9 to ret!rn to 9(, As 9 *alls 4et'een t#e s#ort an$ lon% r!n) t#e mone+ $eman$ c!r3e 'ill s#i*t in 4+ e actl+ t#e same amo!nt as it s#i*te$ o!t 4et'een t#e initial con$ition an$ t#e s#ort r!n, We kno' t#e sel*0correctin% mec#anism 'ill 'ork t#ro!%# t#e AS0A: market to s#i*t in t#e SRAS c!r3e as W increases so - m!st increase, As - increases) M@- 'ill *all (so t#e ;M c!r3e an$ real mone+ s!ppl+ c!r3es s#i*t in), We kno' t#at 4et'een t#e s#ort an$ lon% r!n) t#e ;M c!r3e m!st s#i*t in 4+ e actl+ t#e same amo!nt as it s#i*te$ o!t 4et'een t#e initial con$ition an$ s#ort r!n *or 98 9(, So r $oes not c#an%e in t#e lon% r!n, "#!s) t#e real mone+ s!ppl+ c!r3e m!st also s#i*t in 4et'een t#e s#ort an$ lon% r!n 4+ t#e same ma%nit!$e t#at it s#i*te$ o!t 4et'een t#e initial con$ition an$ t#e lon% r!n,

@.

2onsider the e3uilibrium labor market developed in class# Suppose that both *4- permanently increases and the marginal tax rate on labor income (t n) permanently declines# %astly, assume that income effects on labor supply exactly offset substitution effects on labor supply# 6heoretically, our model o the labor mar(et predicts that a permanent increase in 67- (;) coupled with a sharp decline in labor income ta!es (t n) would unambi"uously shi t the labor supply curve to the le t (on net) in the lon" run.

"RFE, From t#e increase in "F-: "#e la4or $eman$ c!r3e 'ill s#i*t o!t (4eca!se increasin% A increases M-N) '#ic# 'ill res!lt in W@- an$ N increasin%, As W@- increases) t#e s!4stit!tion e**ect 'ill ca!se N to increase (a s#i*t along t#e la4or s!ppl+ c!r3e) an$ t#e income e**ect 'ill ca!se t#e la4or s!ppl+ c!r3e to s#i*t in (as -G;R increases) 'e 'ant to 'ork less), (( &t is important to note #ere t#at t#e s!4stit!tion e**ect 'it# respect to t#e increase in A is N>" a s#i*t,

14

Aeca!se t#e income an$ s!4stit!tion e**ects per*ectl+ cancel) N 'ill not c#an%e 4!t 'e kno' t#at W@- m!st increase *rom t#e s#i*t 4ack o* t#e la4or s!ppl+ c!r3e *rom t#e income e**ect, No' lets t#ink a4o!t t#e ta c#an%e: As la4or income ta es *all) 'e kno' t#e s!4stit!tion e**ect 'ill s#i*t t#e la4or s!ppl+ c!r3e o!t (remem4er) ta rates are a s#i*ter o* t#e la4or s!ppl+ c!r3e 'it# respect to t#e s!4stit!tion e**ect) an$ t#e income e**ect 'ill s#i*t t#e la4or s!ppl+ c!r3e in, So) t#e la4or s!ppl+ c!r3e mo3ements *rom t#e c#an%e in ta es per*ectl+ cancel, "#at simpli*ies o!r anal+sis 4eca!se 'e can N!st *oc!s on '#at #appene$ to t#e la4or s!ppl+ c!r3e 'it# respect to t#e "F- c#an%e an$ t#at 'as a s#i*t in,

W@-

W@-(( W@NS1

N:0 N:1 NS0

N((8N(

25

-art &&&: "r!e@False@Fncertain (E0 points 2 I points eac#) 3. 2onsider the model of the banking sector developed in class# ;ccordin" to the model developed in class, the only di erence between the money supply and the monetary base is value o total loans (60) in the economy. "RFE, "#is pro4lem is mostl+ a4o!t kno'in% t#e necessar+ i$entities (or #a3in% t#em on +o!r c#eat s#eet) an$ al%e4ra:

;ets start 4+ $e*inin% t#e Monetar+ Aase an$ t#e Mone+ S!ppl+: Monetar+ Aase 8 "otal Reser3es ("R) H "otal .!rrenc+ #el$ o!tsi$e t#e 4ankin% s+stem (".) call t#is e=!ation (1) Mone+ s!ppl+ (MS) 8 "otal $eposits in 4ankin% s+stem (":) H "otal c!rrenc+ #el$ o!tsi$e t#e 4ankin% s+stem (".) call t#is e=!ation (2) No' ) 'e can rearran%e (1) in terms o* ".: ". 8 Aase 0 "R call t#is e=!ation (3) A!t) 'e kno' t#at "otal Reser3es ("R) 8 ": 2 "; call t#is e=!ation (E) So 'e can pl!% (E) into (3) *or "R an$ %et: ". 8 Aase 2 ": H "; call t#is e=!ation (I) No') pl!% e=!ation (I) into e=!ation (2) *or ". an$ 'e 'ill %et t#e mone+ s!ppl+ $e*ine$ in terms o* t#e monetar+ 4ase: MS 8 ": H Aase 2 ": H "; 8 Aase H ";

7.

Suppose the economy is a recession such that 5 is below 56# Suppose the 4ed gets the economy back to 56 via expansionary monetary policy# 6he main di erence between the e!pansionary monetary policy "ettin" the economy bac( to Y* and the sel *correctin" mechanism ta(in" the economy bac( to Y* is that the 7ed policy will result in lower interest rates (r) and hi"her investment (.) in the lon" run.

21

FA;SE 2 t#e sel*0correctin% mec#anism AN: t#e Fe$ polic+ 'ill #a3e t#e same $eman$ si$e e**ects on r an$ &, "#e Fe$ polic+ in*l!ences t#e $eman$ si$e o* t#e econom+ 4+ c#an%in% M ('#ic# c#an%es M@- '#ic# c#an%es r an$ '#ic# c#an%es &), "#e sel*0correctin% mec#anism in*l!ences t#e $eman$ si$e o* t#e econom+ 4+ c#an%in% W '#ic# c#an%es - (as SRAS s#i*ts o!t), "#e $eclinin% ca!ses M@- to increase) r to *all an$ & to increase, &n 4ot# cases & 'ill increase 4+ eno!%# to %et !s 4ack to 9(, So) in 4ot# cases) 9 'ill ret!rn !s to 9( 4+ & increasin%, "#is implies t#at 2 'it# respect to & 2 it $oesnt matter i* t#e sel*0correctin% mec#anism takes 4ack or t#e Fe$ takes !s 4ack, "#e $i**erence 'ill 4e t#e Fe$ can $o it 'it#o!t creatin% $e*lationar+ press!res (t#e sel*0correctin% mec#anism 'ill create $e*lationar+ press!res), Some o* +o! ma+ sa+ t#at t#e ans'ers 'ill $i**er 4eca!se t#e Fe$ $oes not kno' '#ere 9( is an$ t#at t#e+ ma+ $o t#e 'ron% polic+, As lon% as +o! s#o' !s t#at a4sent t#e Fe$s mistakes it 'o!l$ 4e t#e same) +o! 'ill recei3e *!ll cre$it

22

-art &&&: "r!e@False@Fncertain (EI points 2 I points eac#)

?.

2onsider our model developed in class with a 2obb7,ouglas production technology# $ssume further that income effects on labor supply are small relative to substitution effects on labor supply# %astly, assume that the parameters of the production function (the exponents) are constant over time# ?iven the above assumptions, over lon" periods o time, permanent and une!pected increases in 67- will result in the share o total income lowin" to wor(ers (in the orm o wa"es) to increase over time.

FA;SE, We kno' t#at t#e e ponents on t#e .o440:o!%las pro$!ction *!nction tell !s t#e s#ares o* la4or %oin% to 4ot# capital an$ la4or, "#e eas+ ans'er ('#ic# 'e 'o!l$ accept) is t#at t#e e ponents $o not c#an%e so t#e income s#ares 'ill not c#an%e, A!t) lets !se a little mat# to pro3e it to o!rsel3es: "#e s#are o* income %oin% to 'orkers can 4e $e*ine$ as:

8 9 5
.all t#is e=!ation (1), "#is is t#e a3era%e 'a%es in t#e econom+ per 'orker (W@-) times t#e n!m4er o* 'orkers, We #a3e an e=!ili4ri!m $e*inition o* real 'a%es (W@- 8 M-N) an$ 'e #a3e a $e*inition *or 9 (98 A70,3N0,/), No') 'e 'ill s!4stit!te t#ese i$entities into t#ose $e*initions into e=!ation (1):
5.3

K 8 9 5.1 $ 9 5.1 $K 5.3 9 5.1 5 9 - = = = 5.1 5 5 5 5

= 5.1

Notice) e=!ation (1) 0 'it# a .o440:o!%las pro$!ction *!nction 0 N!st re$!ces to 0,/, .#an%es in A $o not a**ect t#e s#are o* earnin%s %oin% to 'orkers o!t o* total 5:-, "#e .o440:o!%las pro$!ction *!nction ass!mes t#is ratio is constant re%ar$less o* t#e le3el o* A,

/.

4or :apan, raw materials such as aluminum and nickel are an important input into production# Suppose that there is a very large unexpected increase in the price of aluminum and nickel on the 23

world market# 4inally, suppose that the Bank of :apan has a dual policy goal of price stability and full employment# %astly, assume net exports (and exchange rates) are permanently fixed (no need to think about 9; at all in this problem)# ?iven the above assumptions, when there is a lar"e une!pected increase in aluminum and nic(el prices on the world mar(et, the >an( o Iapan can achieve both policy "oals by buyin" bonds on the open mar(et. FA;SE, Note t#at t#e price c#an%e on an inp!t o* pro$!ction #ere is !ne pecte$ 4!t not permanent, W#at $o 'e e pect to #appen in t#e s#ort r!n6 "#e SRAS c!r3e s#o!l$ s#i*t in (it is more e pensi3e *or Oapanese pro$!cers to pro$!ce at eac# le3el o* o!tp!t) ca!sin% prices to increase an$ o!tp!t to *all, Remem4er t#at all central 4anks #a3e one #ammer in o!r mo$el: t#e nominal mone+ s!ppl+, &* t#e Oapanese .entral Aank 'ants to sta4iliDe (lo'er) price) it 'ill #a3e to contract t#e A: c!r3e 4+ re$!cin% t#e nominal mone+ s!ppl+, "#is 'o!l$ 4e ac#ie3e$ in open market operations 4+ sellin% 4on$s, &* t#e .entral Aank 'ants to sta4iliDe o!tp!t (increase 9 *rom 9<9( to 9 8 9()) it 'ill #a3e to s#i*t o!t t#e A: c!r3e, "#is 'o!l$ 4e ac#ie3e$ in open market operations 4+ 4!+in% 4on$s,

2#

-art &&&: "r!e@False@Fncertain (EI points 2 I points eac#) .. 2onsider the labor markets developed in class (where both income and substitution effects exist)# Suppose that the government unexpectedly announced today (year +) that it was going to decrease labor income tax rates (t n) permanently starting tomorrow (year /)# Suppose further that individuals are sufficiently long lived (i#e#, individuals are expected to live * more years, where * is really big)# ?iven the above policy, the amount o hours that individuals wor( ($) should unambi"uously all today (in year 1).

"RFE, "#is is a pro4lem t#at tests +o!r kno'le$%e o* income e**ects an$ s!4stit!tion e**ects, "#e ta es c#an%es tomorro' (in perio$ 2), &n perio$ 1) t#ere is onl+ an income e**ect *or t#e -&B cons!mers ('#o 'ere non0li=!i$it+ constraine$ per t#e e am ass!mptions), So) in t#is e ample) to$a+ t#e+ 'ill $e*initel+ 'ork less (4eca!se #o!se#ol$s realiDe t#at t#eir -G;R #as increase$), "omorro' ('#en ta es act!all+ c#an%e)) t#ere 'ill 4e 4ot# income an$ s!4stit!tion e**ects makin% t#e e**ect on N (tomorro') am4i%!o!s, Bo'e3er to$a+) 'it# *or'ar$ lookin% -&B cons!mers) t#ere is onl+ an income e**ect to$a+ (4eca!se ta es $i$nt c#an%e to$a+ 2 so t#ere is no s!4stit!tion e**ect to$a+), &* +o! ass!me$ $i**erent t+pes o* cons!mers ('#ic# 'ent a%ainst t#e e am ass!mptions)) 'e 'o!l$ %i3e cre$it i* +o!r ans'er is correct an$ +o! clearl+ s#o'e$ t#at t#ere 'as onl+ an income e**ect in t#e +ear 1,

2'

-art &G: Fn$erstan$in% .!rrent Macroeconomic .on$itions (1M points 2 E points eac#) .n this +uestion, . want us to use the models we have developed in class to assess a variety o macro issues discussed in the popular press (or by economic pundits) durin" the last three months. /ope ully, usin" the models we have developed will allow us to provide clarity to these discussions. 9hen answerin" these +uestions, rame your answers within the models and discussions we had in classF . you are answerin" the +uestion and you are $C6 usin" the ramewor(Adiscussions we had in class, your answer will not be correct. . am tryin" to test i you can apply what we have learned.

;.

.n the last month, there has been a lar"e amount o discussion surroundin" the implementation o the se+uester when nominal interest rates (i) are currently close to &ero. 7or e!ample, on the 3conomist blo" on 7ebruary 1th, 2513, there was an entry entitled J/ow 8cary is the 8e+uester=K 6he thesis in many o these discussions is that bi" declines in "overnment spendin" (?) when interest rates are close to &ero will lead to a lar"er decline in outputs. Esin" the models we have developed in class, discuss why this conLecture is either 6rue or 7alse. >e speci ic in your e!planation. .n particular, you should rame your answer discussin" M in words M the models we have built in class. $ote: Your answer should be 2*# sentences and re er speci ically to the curves built in class.

"#is =!estion 'as strai%#t*or'ar$, We 'ante$ +o! to t#ink a4o!t t#e &S0;M market, Recall t#at in a normal settin% i* 5 *alls) t#e &S c!r3e 'ill s#i*t in an$ r 'ill *all, As r *alls) & 'ill increase, &* t#e r is near 0) t#e &S c!r3e s#i*tin% in $oes not res!lt in an+ *!rt#er *all in interest rates, "#!s) 'e cant %et an+ Pcro'$in% inP o* in3estment to #elp miti%ate t#e *all in 5,

******************************************************************************************************************* ($o need to write below this line M e!am continues on ne!t pa"e)

2)

-art &G: Fn$erstan$in% .!rrent Macroeconomic .on$itions (1M points 2 E points eac#) >. ;s we discussed in class last wee( (and in the article . sent via email last wee(), there is a lar"e discussion in 9ashin"ton about whether or not the 7ed will be able to success ully unwind their balance sheets. >ernan(e believes that he will de initely be able to unwind the balance sheets without in lationary pressures buildin". 6he (ey to his ar"ument is that he will only start to unwind the 7edNs balance sheet when the economy starts to recover. Critics respond that the unwindin" could prevent the recovery rom happenin". >ernan(e disa"rees with this latter assessment. Esin" the model we developed in class, under what assumptions will >ernan(eNs conLecture be correct. .n other words, how is it theoretically possible or the 7ed to (1) (eep in lation in chec(, (2) unwind its balance sheet, (3) have positive economic "rowth, and (#) have economic "rowth be slower than it would be absent the unwindin". $ote: Your answer should be 2*# sentences and re er speci ically to the curves built in class.

Recall t#at in class 'e $isc!sse$ t#at t#is recession 'as $eman$ $ri3enQ. an$ &(,) *ell so t#e &S an$ A: c!r3es s#i*te$ in, "#ro!%# e pansionar+ monetar+ polic+) t#e Fe$eral Reser3e s#i*te$ o!t t#e A: an$ ;M c!r3es increasin% -rices) >!tp!t an$ $ecreasin% interest rates, As cons!mer an$ 4!siness con*i$ence reco3er) 'e anticipate t#at . an$ &(,) 'ill increase an$ p!s# o!t t#e &S an$ A: c!r3es '#ic# 'ill res!lt in #i%#er r) #i%#er - an$ #i%#er 9, >nce t#is #appens) t#e Fe$ 'ill !n'in$ 4+ contractin% M (remem4er t#e+ #a3e one #ammer0 t#e nominal mone+ s!ppl+) an$ t#e A: an$ ;M c!r3es 'ill s#i*t in) lo'erin% - an$ 9 an$ increasin% r,

C.

6here is a "rowin" amount o research discussin" the role that Jpolicy uncertaintyK plays in deterrin" economic "rowth. <y collea"ue 8teve @avis (with co*authors rom 8tan ord) has a recent paper showin" that policy uncertainty has increased substantially in the last ew years. -olicy uncertainty re ers to the act that consumers and businesses are uncertain about uture levels o ta!es and spendin". 8teve and his co*authors ar"ue that such policy uncertainty is at an all*time hi"h. Esin" the models we developed in class, how can policy uncertainty deter economic recovery= ;"ain, your answers should respond to speci ic components o the model we built in class and discuss how those components o the model deter ?@- "rowth. $ote: Your answer should be 2* # sentences and re er speci ically to the curves built in class.

M!c# o* t#e $isc!ssion a4o!t polic+ !ncertaint+ amon% economic researc#ers an$ in t#e pop!lar press as 'ell #as 4een centere$ aro!n$ e**ects o* !ncertaint+ on cons!mers) 'orkers) an$ *irms, A strai%#t*or'ar$ stor+ is t#at polic+ !ncertaint+ co!l$ ne%ati3el+ a**ect cons!mer con*i$ence an$ *!rt#er $ecreasin% o!tp!t, 21

&n t#inkin% a4o!t t#e la4or market) polic+ !ncertaint+ co!l$ a**ect $ecisions s!c# as in3estment in #!man capital ('#ic# co!l$ $istort t#e allocation o* an$ ret!rns to la4or in o!r econom+)) $ecisions a4o!t personal pension contri4!tions ('#ic# co!l$ a**ect rea$iness o* certain 'orkers to retire an$ t#!s c#an%e 4ot# t#e composition an$ siDe o* o!r la4or s!ppl+) or co!l$ a**ect peoples c#oices a4o!t '#en to mo3e *rom emplo+ment to nonemplo+ment, Ma+4e t#e most interestin% case (an$ '#at -ro*essor :a3is 'ork *oc!ses on) is t#e e**ect o* polic+ !ncertaint+ on *irm in3estment, We 'o!l$ like it i* +o!r ans'er incorporate$ an+ o* t#ese i$eas) 4!t 'e 'o!l$ lo3e it i* it incl!$e$ t#is line o* t#o!%#t: As 'e $isc!sse$ to'ar$ t#e 4e%innin% o* t#e co!rse) !ncertaint+ 'ill steepen t#e &S c!r3e, &* t#e &S c!r3e is steeper) 'e kno' t#at it 'ill take lar%er s#i*ts in t#e ;M c!r3e to 4rin% t#e econom+ 4ack to 9(, For monetar+ polic+) t#at means t#e Fe$ 'o!l$ nee$ to e pan$ t#e nominal mone+ s!ppl+ 4+ a lot, For t#e econom+ to sel*0correct t#at means 'e 'o!l$ nee$ 4i% c#an%es in nominal 'a%es in or$er to %et t#e 4i% c#an%es in t#e SRAS t#at 'e 'o!l$ nee$ to res!lt in lar%e eno!%# $ecreases in - to %et t#e &S0;M market 4ack to 9(,

22

-art &G: Fn$erstan$ .!rrent Macroeconomic .on$itions (1M points 2 E points eac#) @. @urin" the last year, there have been re+uent discussions surroundin" the lon" run survival o the 3uropean Enion. 6he 3uropean Enion is a currency union that M in spirit M is similar to the Enited 8tates. 6he Enited 8tates has a common currency amon" its member JnationsK (6e!as and Cali ornia as opposed to ?ermany and ?reece). Cne +uestion that o ten comes up is why the currency union within the Enited 8tates is so much more success ul than the currency &one that is the 3uropean Enion= .n class, we discussed a ew reasons as to why the E.8. currency &one is so much more success ul than the 3uropean Enion. 0ist and discuss two o the reasons that we discussed in class below. ; ter you list the reason (which could be a sentence or a phrase), provide 2*3 sentences discussin" why this reason promotes a success ul currency union. i. &n t#e F,S, $!e to o!r common lan%!a%e an$ c!lt!re) 'orkers are 4etter a4le to mi%rate '#en emplo+ment opport!nities c#an%e, &* t#ere are no No4s in Mississippi) a 'orker can relocate 'it# relati3e ease to "e as, W#ereas) i* t#ere are no No4s in Spain) it mi%#t 4e =!ite $i**ic!lt *or a 'orker '#o onl+ speaks Spanis# to relocate to 5erman+ *or a No4,

ii, &nter0re%ional trans*ers0 &n t#e F,S,) & s#o'e$ +o! t#at t#ere are lar%e) relati3el+ *rictionless trans*ers *rom ric# states to poor states "#is c#art s#o!l$ look *amiliar *rom lect!re:

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