final_2013_ans

Erik’s FinalMacro

Winter 2013

Name (print): _______ANSWERS___________________________

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Exam Assumptions

These assumptions hold throughout the ENTIRE exam (unless told otherwise)

1) we always start at Y*,

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

3) Capital (K) is fixed in both the short and long run, but is allowed to change in the really long run.

4) NX is fixed (at zero), unless otherwise instructed,

5) no policy response takes place, unless otherwise instructed,

6) consumers are non-liquidity constrained, non-Ricardian PIH (who have long lives such that LL is large), unless otherwise instructed,

7) all shocks to the economy are permanent and unexpected, unless otherwise stated,

8) Expected inflation has no effect on money demand,

9) Changes in N have no effect on investment demand,

10) TFP, oil prices, consumer confidence, business confidence, changes in the stock market, changes in population, and changes in value of leisure (i.e., all exogenous variables) only change when I tell you they change.

**When discussing long run changes, compare the initial condition of the economy to where it will end up in the long run (unless told otherwise).

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Part I: Circle the True Answers (27 points total, 3 points each)

Parts A-E (Questions A – E all have the following background information)

Suppose the economy starts at Y* and all consumers are Keynesian who make their consumption decisions out of current income (not wages). Suppose that government spending (G) permanently decreases? (This is similar to the current sequester situation). For each of the questions below, you are to assess what effect a permanent decrease in G has on the economy. When answering the questions, make the following additional assumptions:

Assume there are no other policy changes (i.e., M is held fixed). For Keynesians, assume C = YD (where YD = disposable income). Assume there is no income effect on labor supply for Keynesians.

A. What happens to both investment and consumption in the short run?

i. Both investment and consumption increase.

ii. Investment falls and consumption remains the same.

iii. Consumption falls and investment increases.

iv. Both consumption and investment fall.

v. Consumption increases and investment can either increase or decrease.

In the short run, the IS curve will shift left (as G and C decrease in the short run). This will cause the LM curve to shift out (as P decreases resulting from AD shifting left). The leftward shift of the IS curve and the rightward shift of the LM curve implies unambiguously that r falls. That means I will definitely increase in the short run.

C falls in the short run because C = b (Y-T). As Y falls, C will definitely decrease for Keynesian consumers.

B. What happens to both nominal wages (W) and N between the short run and the long run?

i. Both N and W increase between the short run and the long run.

ii. N increases and W remains constant between the short run and the long run.

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iii. N remains constant and W falls between the short run and the long run.

iv. N remains constant and W increases between the short run and the long run.

v. N increases and W falls between the short run and the long run.

W decreases because of the self-correcting mechanism. In the short run, N < N* (and, consequently Y < Y*). Workers will be off their labor supply curve. Once the self-correcting mechanism kicks in (per the problems instructions), W will decrease making it less expensive for firms to hire labor. The decrease in W will cause N to increase (and Y to return to Y*). So, between the short run and the long run, W will decrease and N will increase.

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Part I (continued): Circle the True Answers (27 points total, 3 points each)

C. Given the Keynesian consumers described above, how would the magnitude of the change in investment (I) between the initial condition and the long run compare to the magnitude of the change in government spending (G) over the same period?

i. The absolute value of the change in investment between the initial condition and the long run will be less than the absolute value of the change in government spending.

ii. The absolute value of the change in investment between the initial condition and the long run will be greater than the absolute value of the change in government spending.

iii. The absolute value of the change in investment between the initial condition and the long run will be the same as the absolute value of the change in government spending.

iv. It is uncertain whether the absolute value of the change in investment between the initial condition and the long run will be bigger or smaller than the absolute value of the change in government spending.

Investment will increase in the long run. If G falls by X, I will increase by X. The reason is that Y will not change in the long run (as A, K and N* do not change) and C will not change in the long run (because C is a function of Y that does not change). So, like our standard examples, there will be perfect crowding in of investment in the long run from a permanent decrease in government spending.

D. What happens to real wages (W/P) and the real money supply (M/P) between the initial condition and the long run?

i. Both real wages and the real money supply are constant in the long run.

ii. Both real wages and the real money supply fall in the long run.

iii. Both real wages and the real money supply increase in the long run.

iv. Real wages are constant in the long run while the real money supply increases.

iv. Real wages increase in the long run while the real money supply is constant.

vi. Real wages are constant in the long run while the real money supply falls.

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W/P does not change (no change in labor demand or labor supply – so we will return to the original W/P).

M/P will increase as P decreases and M is fixed.

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E. What happens to the AD and the IS curves between the short run and the long run?

i. Neither the AD curve nor the IS curve shifts between the short run and the long run.

ii. The AD curve shifts right between the short run and the long run while the IS curve does not shift between the short run and the long run.

iii. The IS curve shifts right between the short run and the long run while the AD curve does not shift between the short run and the long run.

iv. Both the AD curve and the IS curve shift right between the short run and the long run.

As C returns to its initial level (as Y returns to its initial level), both the AD and IS curves will shift right between the short run and the long run.

***This only happens with the Keynesian consumers***

C increases because the self-correcting mechanism will kick in and eventually return Y to its original level. The long run AD and IS will still be to the left of the original curves (as G is lower).

Note - per the problem instructions - C is a function of total income (Y) NOT wages (W/P).

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Parts F-I (Questions F – I all have the following background information)

Suppose that Y > Y* in the short run. For each of the following questions, circle the answer that makes the question true. Again, there is only one true answer to each of the question stems. (Note: It does not matter why Y is currently higher than the potential level (Y*) when answering the questions below).

For parts F-I, we will assume that:

Consumers are standard non-liquidity constrained (non-Ricardian) PIH consumers. No policy takes place to return the economy to Y* (i.e., the economy corrects itself).

When Y > Y* then it must be true that N must be greater than N*. We know that in the short run, workers are off of their labor supply curve. The self-correcting mechanism tells us that nominal wages must increase between the short and long run in order for us to walk back up the labor supply curve to N* at W/P*. (Like always, N falls and W/P increases)

As W increases, it becomes more expensive for firms to produce at each level of output so the SRAS will shift in until Y=Y*. As the SRAS curve shifts in, we know prices will increase.

As prices increase, M/P will fall which means in the IS-LM market the LM curve will shift in until Y=Y*. As a result, r will increase between the short and long run. As r increases, I must fall (the movement along the IS curve as the LM curve shifts in).

As Y falls between the short and long run, the money demand curve will shift in.

From many, many quiz questions, you should know that the magnitude of the change in nominal wages should be greater than the magnitude of the change in prices. This must be true in order for the self-correcting mechanism to return the economy to Y*.

F. Which of the following is true about real wages (W/P) in the short run relative to real wages in the long run (assuming Y > Y* in the short run)?

i. Real wages in the short run will be higher than real wages in the long run.

ii. Real wages in the short run will be lower than real wages in the long run.

iii. Real wages in the short run will be the same as the real wages in the long run.

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iv. It is uncertain whether real wages in the short run will be higher or lower than real wages in the long run.

It must be true that when N>N*, W/P in the short run is below the initial W/P*. Recall, workers are off their labor supply curve. It is also true that W/P in the short run is lower than W/P in the long run- remember W increases between the short and long run to get us back to W/P* which is also equal to the long run real wage.

G. Which of the following is true about investment (I) in the short run relative to investment (I) in the long run (assuming Y > Y* in the short run)?

i. Investment in the short run will be higher than investment in the long run.

ii. Investment in the short run will be lower than investment in the long run.

iii. Investment in the short run will be the same as the investment in the long run.

iv. It is uncertain whether investment in the short run will be higher or lower than investment in the long run.

As stated in the explanation above, r must increase between the short and long run as the LM curve shifts in as a result of P increasing in the AS-AD market (from the shift in of the SRAS curve). As r increases, Investment will fall (the LM curve moves along the IS curve until Y returns to Y*).

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H. Which of the following is true about the money demand curve in the short run relative to the money demand curve in the long run (assuming Y > Y* in the short run)?

i. The money demand curve in the short run will be to the right of the money demand curve in the long run.

ii. The money demand curve in the short run will be to the left of the money demand curve in the long run.

iii. There will be no change in the money demand curve between the short run and the long run.

iv. It is uncertain whether the money demand curve in the short run will be to the right or the left of the money demand curve in the long run.

As Y falls between the short and long run to return the economy to Y*, money demand must fall. Recall, we say money demand is a function of expected inflation and Y. In the assumptions, we said to assume expected inflation has no effect on money demand, so we focus attention to the change in Y.

I. Which of the following are true about the aggregate demand (AD) curve in the short run relative to the aggregate demand curve in the long run (assuming Y > Y* in the short run)?

i. The aggregate demand curve in the short run will be to the right of the aggregate demand curve in the long run.

ii. The aggregate demand curve in the short run will be to the left of the aggregate demand curve in the long run.

iii. There will be no change in the aggregate demand curve between the short run and the long run.

iv. It is uncertain whether the aggregate demand curve in the short run will be to the right or the left of the aggregate demand curve in the long run.

How the self-correcting mechanism works in each of the markets in our model given our assumptions:

In the Labor market: nominal wages change to return N=N*. In this example, W increases and N falls

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In the AS-AD market: the SRAS changes and P changes as a result. The direction of the shift depends on what happens to nominal wages in the labor market. In this example, it shifts in and prices increase.

In the IS-LM market: the LM curve changes as a result of the change in prices in the AS-AD market and r changes as a result of the shift in the LM curve. In this example, the LM curve shifts in and r will increase.

Note that the AD and IS curve do not move here. Why? Consumption should not change because consumers are Non-Ricardian, PIH. The change in Investment here is a movement along the IS curve.

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Part II: TFP changes and Economic Mechanisms (12 points total – 4 points each)

Consider the models developed in class so far. In this question, we are going to analyze what happens when there is an unexpected permanent increase in TFP. In this example, we will assume the following (in addition to the standard exam assumptions on page 3):

Income effects are the same order of magnitude as the substitution effects on labor supply (i.e., the two effects cancel).

Prices DO NOT fall in the short run (they could either rise or stay the same).

All other exogenous variables (tax rates, government spending, confidence, wealth, etc.) are held fixed.

NX = 0.

Given the above, circle the true answers. There is only one correct answer to each of the following three question stems (i.e. you should only be circling three things in this part of the exam - one for part A, one for part B, and one for part C.).

A) With respect to the marginal utility of leisure (MUL) and the marginal product of labor (MPN), which one of the following is definitely true?

i. In the long run, both the marginal product of labor and the marginal utility of leisure will remain unchanged.

ii. In the long run, both the marginal product of labor and the marginal utility of leisure will increase.

iii. In the long run, both the marginal product of labor and the marginal utility of leisure will fall.

iv. In the long run, the marginal product of labor will fall and the marginal utility of leisure will remain unchanged.

v. In the long run, the marginal product of labor will rise and the marginal utility of leisure will remain unchanged.

vi. In the long run, the marginal product of labor will fall and the marginal utility of leisure will remain unchanged.

vii. In the long run, the marginal product of labor will remain unchanged and the marginal utility of leisure will rise.

viii. In the long run, the marginal product of labor will remain unchanged and the marginal utility of leisure will fall.

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Given our Cobb-Douglas production function, we know that there is complementarity between TFP and labor. We can see this from taking a partial derivative with respect to N of the production function:

Y= AK0.3N0.7 to yield: MPN= dY/dN = 0.7A(K/N)0.3

If A increases, MPN increases (holding N fixed). We say the labor demand curve = MPN = W/P. So, the labor demand curve must shift out (at every level of W/P). All else equal, this will result in increasing N and W/P. As W/P increases permanently, we know there will be a substitution effect (movement along the labor supply curve) and an income effect (shift in of the labor supply curve). Because we stated by assumption that the income and substitution effects will cancel, we know that N will be the same as the initial N. If N does not change, MUL will not change. MUL is a function of leisure (as leisure falls, MUL increases because of diminishing marginal utility of leisure. If leisure does not change, than the marginal utility of leisure will not change.

However, W/P must increase:

W/P

W/P** ND0

W/P ND1

NS1 NS0

N**=N* N

Also, given MPN = W/P, we know that MPN will unambiguously increase because W/P increases.

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Part II: TFP Question (12 points total – 4 points each)

B) With respect to the marginal utility of capital (MPK) and total investment (I), which one of the following is definitely true?

i. In the long run, both MPK and I will remain unchanged.

ii. In the long run, both MPK and I will increase.

iii. In the long run, both MPK and I will fall.

iv. In the long run, the change in both MPK and I will be ambiguous.

v. In the long run, MPK will be unchanged and I will rise.

vi. In the long run, MPK will rise and I will remain unchanged.

vii. In the long run, MPK will rise and I will remain ambiguous.

viii. In the long run, MPK will be ambiguous and I will rise.

ix. In the long run, MPK will fall and I will rise.

There is complementarity between A and K. Similar to what we did in the last problem, we get this from taking the partial derivative of the output function- this time with respect to K: MPK = 0.3A(N/K)0.7

Thus as A increases, MPK will increase (holding K fixed). As MPK increases (holding K fixed), firms will want to invest more so I(.) will increase. We also know that Consumption will increase. Why? Because W/P permanently increases so PVLR increases. So, we get a shift out of the IS and AD curves from the increase in C and I(.). As the AD curve shifts out, P will increase which will cause M/P to fall and the LM curve will shift in causing r to increase further. As r increases, the interest sensitive part of investment must fall. Therefore, the effect on investment is ambiguous. However, given MPK = r, an increase in r will mean that MPK will unambiguously increase.

C)Given the above information, discuss whether the following statement is true, false or uncertain.

Your explanation will determine your entire grade. Your answer should not be longer than 3-4 well constructed sentences. Use what you have learned in class to answer this question. This question will graded on the 0/4 scale (no partial credit).

Between the short run and the long run, the change in household savings (SHH) will be exactly the same as the change in investment (I)?

FALSE. Between short run and long run, investment will fall, government savings will fall between short run and long run because government revenues should fall between the short run and the long run as the tax base is falling.

We know that SHH + SGOV = I 15

Therefore, if government savings are falling and investment is falling between the short and long run, the change in household savings must be more positive (higher) than the change in investment.

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Part III: True/False/Uncertain (45 points – 5 points each)

Each of the parts below sets up a scenario (in italics) and ends with a statement. In this section, you are to discuss whether that final statement is True, False or Uncertain.

As on the practice exams - explanation determines your entire grade! We will give no credit for writing true when the answer is true but your logic is wrong. Each of your answers should be at most 3-4 clearly written sentences. Lastly, to receive full credit, you need to be explicit about the mechanism that is driving your results. Each question is worth 5 points each.

Some questions have multiple parts within the question stem such as: "Suppose the economy is hit with an increase in "z". If "z" increases, then both "x" and "y" will increase." For those questions, you will need to discuss both parts to get full credit. In other words, you will have to discuss whether the increase in "z" will cause "x" to increase and then separately discuss whether it will cause "y" to increase.

Lastly, you should consider your analysis in terms of the models developed in class. Note: all assumptions on page 3 of the exam hold unless I tell you otherwise.

A. Suppose that there is both a permanent increase in G and a permanent increase in business confidence. Assume no other policy intervention takes place. Lastly, assume that the increase in business confidence has no effect on labor demand.

Given the above assumptions, we know unambiguously that investment (I) will fall in the long run.

TRUE

An increase in business confidence will cause I(.) to increase. The combined increase in G and I(.) will cause the IS and AD curves to shift out in the short run and Y>Y*. As AD increases, P will increase. Thus, W/P decreases so N >N*. As P increases, M/P will fall so the LM curve will shift in. Thus, r will unambiguously increase in the short run. The self-correcting mechanism tells us that nominal wages must increase (and increase by more than the increase in prices) to get N back to N*. As W/P increases, the SRAS shifts in, so P increases between the short and long run. Thus, the LM curve must shift in between the short and long run bringing the IS-LM curve back to long run equilibrium at Y= Y*. We know as the LM curve shifts in, r increases unambiguously between the short and long run. As r increases, the interest rate sensitive part of investment must fall between the short and long run. So, we have I(.) increasing in the short run from the increase in business confidence; the interest rate sensitive part of I falling in the short run as r increases and the interest rate sensitive part of I decreasing between the short and long run as r increases.

**It is important to note that the increase in G and business confidence will not affect Y*.

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A naïve answer may be that the effect on I is ambiguous but we know that this is not true because for the economy to get back to Y*, I must fall by the amount of the increase in I(*) and the amount of the increase in G. So, I must fall in the long run.

B. Suppose that within a country, the following information was given:

Real wages always grew at 6% per year.The velocity of money always grew at 1% per year.Real GDP always increased by 3% per year.The nominal money supply always grew at 6% per year.Real interest rates in the economy were always 2% per year.The unemployment rate is always 5% per year.

Given the information above, the inflation rate in this economy would always be 4% per year.

True – this was very straight forward given the definition of velocity. V = PY/M. Given some algebra (as in class), we know:

% change in P = % change in V + % change in M - % change in Y

Given above information, %change in P = 1% + 6% - 3% = 4%

You needed to say the answer was 4% (or imply the above formula) to get full credit.

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C. Suppose that there is an unexpected permanent increase to the nominal money supply (M).

In the short run, both the real money supply (M/P) curve and the money demand curve would shift to the right. Furthermore, in the long run, there would be no shift in either the money demand curve or the real money supply curve (relative to their initial position).

Note: In make sure you discuss all parts of this question to get full credit.

TRUE. We know that changing M will not expand (or contract) the production frontier of our economy (i.e., Y*). In other words, changing M will not result in changes to Y*. Thus, the increase in Y that we get from increasing M in the short run must be undone between the short and long run for Y to return to Y*. As Y falls between the short and long run, the money demand curve will shift in by exactly the same amount as it shifted out between the initial condition and the short run. We know the self-correcting mechanism will work through the AS-AD market to shift in the SRAS curve as W increases so P must increase. As P increases, M/P will fall (so the LM curve and real money supply curves shift in). We know that between the short and long run, the LM curve must shift in by exactly the same amount as it shifted out between the initial condition and short run for Y= Y*. So r does not change in the long run. Thus, the real money supply curve must also shift in between the short and long run by the same magnitude that it shifted out between the initial condition and the long run.

D. Consider the equilibrium labor market developed in class. Suppose that both TFP permanently increases and the marginal tax rate on labor income (tn) permanently declines. Lastly, assume that income effects on labor supply exactly offset substitution effects on labor supply.

Theoretically, our model of the labor market predicts that a permanent increase in TFP (A) coupled with a sharp decline in labor income taxes (tn) would unambiguously shift the labor supply curve to the left (on net) in the long run.

TRUE.

From the increase in TFP: The labor demand curve will shift out (because increasing A increases MPN) which will result in W/P and N increasing. As W/P increases, the substitution effect will cause N to increase (a shift along the labor supply curve) and the income effect will cause the labor supply curve to shift in (as PVLR increases, we want to work less).

** It is important to note here that the substitution effect with respect to the increase in A is NOT a shift.

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Because the income and substitution effects perfectly cancel, N will not change but we know that W/P must increase from the shift back of the labor supply curve from the income effect.

Now let’s think about the tax change:

As labor income taxes fall, we know the substitution effect will shift the labor supply curve out (remember, tax rates are a shifter of the labor supply curve with respect to the substitution effect) and the income effect will shift the labor supply curve in. So, the labor supply curve movements from the change in taxes perfectly cancel.

That simplifies our analysis because we can just focus on what happened to the labor supply curve with respect to the TFP change and that was a shift in.

W/P

W/P** ND0

W/P ND1

NS1 NS0

N**=N* N

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E. Consider the model of the banking sector developed in class.

According to the model developed in class, the only difference between the money supply and the monetary base is value of total loans (TL) in the economy.

TRUE. This problem is mostly about knowing the necessary identities (or having them on your cheat sheet) and algebra:

Let’s start by defining the Monetary Base and the Money Supply:

Monetary Base = Total Reserves (TR) + Total Currency held outside the banking system (TC) call this equation (1)

Money supply (MS) = Total deposits in banking system (TD) + Total currency held outside the banking system (TC) call this equation (2)

Now , we can rearrange (1) in terms of TC:

TC = Base - TR call this equation (3)

But, we know that

Total Reserves (TR) = TD – TL call this equation (4)

So we can plug (4) into (3) for TR and get: TC = Base – TD + TL call this equation (5)

Now, plug equation (5) into equation (2) for TC and we will get the money supply defined in terms of the monetary base:

MS = TD + Base – TD + TL = Base + TL

F. Suppose the economy is a recession such that Y is below Y*. Suppose the Fed gets the economy back to Y* via expansionary monetary policy.

The main difference between the expansionary monetary policy getting the economy back to Y* and the self-correcting mechanism taking the economy back to Y* is that the Fed policy will result in lower interest rates (r) and higher investment (I) in the long run.

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FALSE – the self-correcting mechanism AND the Fed policy will have the same demand side effects on r and I. The Fed policy influences the demand side of the economy by changing M (which changes M/P which changes r and which changes I). The self-correcting mechanism influences the demand side of the economy by changing W which changes P (as SRAS shifts out). The declining P causes M/P to increase, r to fall and I to increase. In both cases I will increase by enough to get us back to Y*. So, in both cases, Y will return us to Y* by I increasing. This implies that – with respect to I – it doesn’t matter if the self-correcting mechanism takes back or the Fed takes us back. The difference will be the Fed can do it without creating deflationary pressures (the self-correcting mechanism will create deflationary pressures).

Some of you may say that the answers will differ because the Fed does not know where Y* is and that they may do the wrong policy. As long as you show us that absent the Fed’s mistakes it would be the same, you will receive full credit

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G. Consider our model developed in class with a Cobb-Douglas production technology. Assume further that income effects on labor supply are small relative to substitution effects on labor supply. Lastly, assume that the parameters of the production function (the exponents) are constant over time.

Given the above assumptions, over long periods of time, permanent and unexpected increases in TFP will result in the share of total income flowing to workers (in the form of wages) to increase over time.

FALSE. We know that the exponents on the Cobb-Douglas production function tell us the shares of labor

going to both capital and labor. The easy answer (which we would accept) is that the exponents do not change so the income shares will not change.

But, let’s use a little math to prove it to ourselves:The share of income going to workers can be defined as:

W NPY

Call this equation (1). This is the average wages in the economy per worker (W/P) times the number of workers. We have an equilibrium definition of real wages (W/P = MPN) and we have a definition for Y (Y= AK0.3N0.7).

Now, we will substitute these identities into those definitions into equation (1):

Notice, equation (1) - with a Cobb-Douglas production function - just reduces to 0.7. Changes in A do not affect the share of earnings going to workers out of total GDP. The Cobb-Douglas production function assumes this ratio is constant regardless of the level of A.

H. For Japan, 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

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world market. Finally, suppose that the Bank of Japan has a dual policy goal of price stability and full employment. Lastly, assume net exports (and exchange rates) are permanently fixed (no need to think about NX at all in this problem).

Given the above assumptions, when there is a large unexpected increase in aluminum and nickel prices on the world market, the Bank of Japan can achieve both policy goals by buying bonds on the open market.

FALSE.Note that the price change on an input of production here is unexpected but not permanent. What do we expect to happen in the short run? The SRAS curve should shift in (it is more expensive for Japanese producers to produce at each level of output) causing prices to increase and output to fall.

Remember that all central banks have one hammer in our model: the nominal money supply. If the Japanese Central Bank wants to stabilize (lower) price, it will have to contract the AD curve by reducing the nominal money supply. This would be achieved in open market operations by selling bonds.

If the Central Bank wants to stabilize output (increase Y from Y<Y* to Y = Y*), it will have to shift out the AD curve. This would be achieved in open market operations by buying bonds.

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I. Consider the labor markets developed in class (where both income and substitution effects exist). Suppose that the government unexpectedly announced today (year 1) that it was going to decrease labor income tax rates (tn) permanently starting tomorrow (year 2). Suppose further that individuals are sufficiently long lived (i.e., individuals are expected to live T more years, where T is really big).

Given the above policy, the amount of hours that individuals work (N) should unambiguously fall today (in year 1).

TRUE. This is a problem that tests your knowledge of income effects and substitution effects. The taxes changes tomorrow (in period 2). In period 1, there is only an income effect for the PIH consumers (who were non-liquidity constrained per the exam assumptions). So, in this example, today they will definitely work less (because households realize that their PVLR has increased). Tomorrow (when taxes actually change), there will be both income and substitution effects making the effect on N (tomorrow) ambiguous. However today, with forward looking PIH consumers, there is only an income effect today (because taxes didn’t change today – so there is no substitution effect today).

If you assumed different types of consumers (which went against the exam assumptions), we would give credit if your answer is correct and you clearly showed that there was only an income effect in the year 1.

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Part IV: Understanding Current Macroeconomic Conditions (16 points – 4 points each)

In this question, I want us to use the models we have developed in class to assess a variety of macro issues discussed in the popular press (or by economic pundits) during the last three months. Hopefully, using the models we have developed will allow us to provide clarity to these discussions.

When answering these questions, frame your answers within the models and discussions we had in class! If you are answering the question and you are NOT using the framework/discussions we had in class, your answer will not be correct. I am trying to test if you can apply what we have learned.

A. In the last month, there has been a large amount of discussion surrounding the implementation of the sequester when nominal interest rates (i) are currently close to zero. For example, on the Economist blog on February 7th, 2013, there was an entry entitled “How Scary is the Sequester?” The thesis in many of these discussions is that big declines in government spending (G) when interest rates are close to zero will lead to a larger decline in outputs.

Using the models we have developed in class, discuss why this conjecture is either True or False. Be specific in your explanation. In particular, you should frame your answer discussing – in words – the models we have built in class. Note: Your answer should be 2-4 sentences and refer specifically to the curves built in class.

This question was straightforward. We wanted you to think about the IS-LM market. Recall that in a normal setting if G falls, the IS curve will shift in and r will fall. As r falls, I will increase. If the r is near 0, the IS curve shifting in does not result in any further fall in interest rates. Thus, we can’t get any "crowding in" of investment to help mitigate the fall in G.

-------------------------------------------------------------------------------------------------------------------(No need to write below this line – exam continues on next page)

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Part IV: Understanding Current Macroeconomic Conditions (16 points – 4 points each)

B. As we discussed in class last week (and in the article I sent via email last week), there is a large discussion in Washington about whether or not the Fed will be able to successfully unwind their balance sheets. Bernanke believes that he will definitely be able to unwind the balance sheets without inflationary pressures building. The key to his argument is that he will only start to unwind the Fed’s balance sheet when the economy starts to recover. Critics respond that the unwinding could prevent the recovery from happening. Bernanke disagrees with this latter assessment.

Using the model we developed in class, under what assumptions will Bernanke’s conjecture be correct. In other words, how is it theoretically possible for the Fed to (1) keep inflation in check, (2) unwind its balance sheet, (3) have positive economic growth, and (4) have economic growth be slower than it would be absent the unwinding. Note: Your answer should be 2-4 sentences and refer specifically to the curves built in class.

Recall that in class we discussed that this recession was demand driven—C and I(.) fell so the IS and AD curves shifted in. Through expansionary monetary policy, the Federal Reserve shifted out the AD and LM curves increasing Prices, Output and decreasing interest rates.

As consumer and business confidence recover, we anticipate that C and I(.) will increase and push out the IS and AD curves which will result in higher r, higher P and higher Y. Once this happens, the Fed will unwind by contracting M (remember they have one hammer- the nominal money supply) and the AD and LM curves will shift in, lowering P and Y and increasing r.

C. There is a growing amount of research discussing the role that “policy uncertainty” plays in deterring economic growth. My colleague Steve Davis (with co-authors from Stanford) has a recent paper showing that policy uncertainty has increased substantially in the last few years. Policy uncertainty refers to the fact that consumers and businesses are uncertain about future levels of taxes and spending. Steve and his co-authors argue that such policy uncertainty is at an all-time high.

Using the models we developed in class, how can policy uncertainty deter economic recovery? Again, your answers should respond to specific components of the model we built in class and discuss how those components of the model deter GDP growth. Note: Your answer should be 2-4 sentences and refer specifically to the curves built in class.

Much of the discussion about policy uncertainty among economic researchers and in the popular press as well has been centered around effects of uncertainty on consumers, workers, and firms.

A straightforward story is that policy uncertainty could negatively affect consumer confidence and further decreasing output.

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In thinking about the labor market, policy uncertainty could affect decisions such as investment in human capital (which could distort the allocation of and returns to labor in our economy), decisions about personal pension contributions (which could affect readiness of certain workers to retire and thus change both the composition and size of our labor supply) or could affect people’s choices about when to move from employment to nonemployment.

Maybe the most interesting case (and what Professor Davis’ work focuses on) is the effect of policy uncertainty on firm investment. We would like it if your answer incorporated any of these ideas, but we would love it if it included this line of thought:

As we discussed toward the beginning of the course, uncertainty will steepen the IS curve. If the IS curve is steeper, we know that it will take larger shifts in the LM curve to bring the economy back to Y*. For monetary policy, that means the Fed would need to expand the nominal money supply by a lot. For the economy to self-correct that means we would need big changes in nominal wages in order to get the big changes in the SRAS that we would need to result in large enough decreases in P to get the IS-LM market back to Y*.

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Part IV: Understand Current Macroeconomic Conditions (16 points – 4 points each)

D. During the last year, there have been frequent discussions surrounding the long run survival of the European Union. The European Union is a currency union that – in spirit – is similar to the United States. The United States has a common currency among its member “nations” (Texas and California as opposed to Germany and Greece). One question that often comes up is why the currency union within the United States is so much more successful than the currency zone that is the European Union?

In class, we discussed a few reasons as to why the U.S. currency zone is so much more successful than the European Union. List and discuss two of the reasons that we discussed in class below. After you list the reason (which could be a sentence or a phrase), provide 2-3 sentences discussing why this reason promotes a successful currency union.

i. In the U.S. due to our common language and culture, workers are better able to migrate when employment opportunities change. If there are no jobs in Mississippi, a worker can relocate with relative ease to Texas. Whereas, if there are no jobs in Spain, it might be quite difficult for a worker who only speaks Spanish to relocate to Germany for a job.

ii. Inter-regional transfers- In the U.S., I showed you that there are large, relatively frictionless transfers from rich states to poor states

This chart should look familiar from lecture:

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