Exam 2 Econ 304 Chuderewicz Fall 2014

Exam 2 – Econ 304 – Chuderewicz – Fall 2014

Name ______Last 4 (PSU ID) ______

PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET – THANKS AND GOOD LUCK!!!

Total Points for exam = 224

Test time = 120 minutes

Approximately one minute for every two points

To help with time management if spreading time evenly

Question #1 with LM shock = 92 points..... 46 minutes

Question #1 with IS shock = 72 points ...... 36 minutes

Question #2 = 30 points.... 15 minutes

Question #3. = 30 points ....15 minutes

Exam 2 – Econ 304 – Chuderewicz – Fall 2014

1. THIS IS THE GENERAL EQUILIBRIUM PROBLEM THAT I PROMISED. YOU FIRST SOLVE FOR THE INITIAL EQUILIBRIUM AS POINT A. WE CONSIDER TWO DIFFERENT AND SEPARATE SHOCKS (I CALL THEM SCENARIOS). THE FIRST SHOCK IS TO THE LM CURVE, THE SECOND SHOCK IS AN ‘IS’ SHOCK. AGAIN, WE CONSIDER THESE SHOCKS SEPARATELY SO THAT AFTER YOU COMPLETE SCENARIO 1 (THE LM SHOCK), WE GO BACK TO THE ORIGINAL CONDITIONS AND CONSIDER THE SECOND SCENARIO WHICH IS THE ‘IS’ SHOCK.

Consider the following model of the economy

Production function: Y = AKN – N2/2

Marginal product of labor: MPN = AK – N.

where the initial values of A = 8 and K = 10.

The initial labor supply curve is given as: NS = 20 + 9w.

Cd = 401 + .50(Y-T) – 500r

Id = 800 – 500r

G = 500

T= 100

We assume that expected inflation is zero (πe= 0) so that money demand depends directly on the real interest rate (since i = r).

Md/P = 469 + 0.5Y- 1000r

Nominal Money supply M = 4000

1 a) (6 points)Solve for the labor market clearing real wage (w*), the profit maximizing level of labor input (N*), and the full employment level of output (Y*). Please show work.

b) (4 points) Derive an expression for the IS curve (r in terms of Y). Please show all work

c) (3 points) Find the real interest rate that clears the goods market. Please show all work

d) (3 points) Find the price level needed to clear the money market.Please show all work

e) (4 points) Find the expression for the LM curve (r in terms of Y). Please show all work

Now draw four separate diagrams: (40 points total) Top left: a desired savings equals desired investment (Sd = Id ), Top right: a FE - IS – LM diagram, Bottom left: a money market diagram, Bottom right: An AD - AS diagram, locating this initial equilibrium point as point A. BESURE to LABEL all diagrams completely (10 points for each correctly drawn and labeled diagram…each diagram will have three different equilibriums points A, B, and C)

SCENARIO #1 – AN LM SHOCK!

Now suppose that there is non-policy shock to nominal money supply so that the new nominal money supply is: M = 4120.

S1 a) (5 points) Name and explain two reasons why money supply would change the way it did. Note that this was a non-policy shock to the money supply - it was not caused by open market operations. Finish your answer commenting on whether a money shock like this is currently a concern in the United States.

S1 b)(5 points) What is the new, short run (fixed price level) expression for the LM curve? Please show all work.

S1 c) (4 points) What is the short run, Keynesian (fixed price) level of equilibrium output and real interest rate? Please show all work.

Please label these new short run conditionsto your four diagrams as point B. Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class.

S1 d) (4 points) Find the new price level associated with the long run general equilibrium.

Please label these long run conditionsto your four diagrams as point C. Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class.

S1 e) (4 points)Let us focus on the movement from point A to B (the short -run) in your money market diagram. Explain why (and in what direction) the real interest rate had to change to 'clear' the money market. Be as specific as possible as we talked about this a great deal in class!

S1 f) (5 points) Now explain why output has changed in the short-run. Be as specific as possible.

S1 g) (5 points) What would the Fed have to do, exactly in order to hit their inflation target of 2% (hint: the target price level is 2% higher than the original price level). Please state the type and amount of open market operations. Assume the money multiplier is equal to 0.8, just like it is in the real world.

SCENARIO #2 – AN IS SHOCK! (75 points total)

We spoke of the surprise move of the Bank of Japan announcing quantitative easing in response of renewed deflationary fears partly caused by the increase in taxes. Below is an excerpt from the article we looked at.

"The BOJ’s move, scarcely expected by central-bank watchers, came after fresh data added to evidence that the April increase in the national sales tax threw the world’s third-largest economy off track."

In this part of the problem, we are going to model this tax hike and the proposed response by the BOJ.

Let’s return to our original conditions: Please write down the expressions for your ORIGINAL IS curve and LM curves in the space below (so the grader can follow your starting points).

IS: r = ______

LM: r = ______

IS shock - the Government (we can pretend it is Japan) raises taxes (T) from 100 to 180.

S2 a) (4 points) Derive a ‘new’ expression for the IS curve (r in terms of Y). Please show all work

S2 b) (4 points) Now solve for the short-run equilibrium output (Keynesian) and the corresponding real rate of interest. Please show all work. Please label this short run (fixed price) equilibrium as point B on all four of your diagrams.

S2 c) (4 points) Now find the long run real interest rate consistent with general equilibrium. Please show all work.

S2 d) (4 points) Find the new price level associated with the long run equilibrium. Please show all work

Label this long run equilibrium as point C in all four of your diagrams.

S2 e) (5 points) Is this result desirable? That is, with perfect information, would the BOJ let this long-run adjustment take place? Why or why not? Please be as specific as possible.

S2 f) (5 points) What would the BOJ have to do, in terms of the type and quantity of open market operations, to keep the price level at its original level, consistent with their price stability objective? Assume the money multiplier is equal to 1.00 in Japan.

S2 g) (6 points) Explain how the AS - AD, IS-LM-FE, and money market diagrams would be effected if the BOJ conducted the policy as in S2 f) above (i.e., to keep the price level its original level).

2. (30 points total) We talked a lot about the Fed's balance sheet, quantitative easing, and the fact that since October 2008, they (the Fed) now pay interest on reserves.

2.a) (15 points) In 2008, the Fed pleaded and pleaded with Congress trying to convince them that the economic situation was deteriorating fast and that they needed to grant the authority to the Fed to pay interest on reserves sooner rather than later. So in October, 2008, the Fed was officially granted the authority to pay interest on reserves (please locate October 2008 on Balance Sheet diagram below). Explain exactly why the Fed so badly wanted this authority and explain exactly what they did (in terms of monetary policy) as soon as they were granted this authority (refer to the Balance Sheet below). Be sure to include in your answer what would have happened and why if the Fed behaved the exact same waywithout (being granted) the authority to pay interest on excess reserves.

2.b) (15 points) Many are worried that if the banks starting lending out their excess reserves all at once, inflationary pressures will build given that the money supply could 'blow up.' Under what conditions (i.e., why) would the banks start getting rid of their excess reserves and what exactly could the Fed do about. I am looking for 3 specific policy responses from the Federal Reserve. Be sure to explain how each policy response would put a lid on money growth (i.e., the so-called exit strategy).

3. (30 points total)

3. a) (10 points) Explain what happened to the money multiplier and why during the Great Depression - be sure to write out expression for money multiplier and discuss what happened to its components and why. Then discuss what happened to the money multiplier as soon as the Fed got the authority to pay interest on reserves in October 2008.

3. b) (10 points) Many criticize the Fed for not reacting appropriately during the Great Depression. Explain these criticisms and if the Fed would have it to do over again, what would they do exactly? Be sure to support your answer by using the definition (expression) of the money supply.

3.c) (10 points) According to a WSJ article that we looked at in class, forward guidance was much more powerful and effective than quantitative easing during this past financial crisis / recession. What do the authors mean when they say more powerful and how exactly is forward guidance supposed to work? Be sure to include the equation we used in class. Is the Fed still using forward guidance? Explain.

Exam 2 –Econ 304 – Chuderewicz – Spring 2015

Name ______Last 4 (PSU ID) ______

Section: Please Check:

Sparks ______

Keller ______

PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET – ONLY NON-PROGRAMMABLE CALCULATORS ALLOWED. THANKS AND GOOD LUCK!!!

Total Points for exam = 240

Test time = 120 minutes

One minute for every two points

To help with time management if spreading time evenly

Question #1 with LM shock = 88 points..... 44 minutes

Question #1 with IS shock = 82 points ...... 40 minutes

Question #2 = 35 points.... 17 minutes

Question #3. = 35 points ....17 minutes

1. THIS IS THE GENERAL EQUILIBRIUM PROBLEM THAT I PROMISED. YOU FIRST SOLVE FOR THE INITIAL EQUILIBRIUM AS POINT A. WE CONSIDER TWO DIFFERENT AND SEPARATE SHOCKS (I CALL THEM SCENARIOS). THE FIRST SHOCK IS TO THE LM CURVE, THE SECOND SHOCK IS AN ‘IS’ SHOCK. AGAIN, WE CONSIDER THESE SHOCKS SEPARATELY SO THAT AFTER YOU COMPLETE SCENARIO 1 (THE LM SHOCK), WE GO BACK TO THE ORIGINAL CONDITIONS AND CONSIDER THE SECOND SCENARIO WHICH IS THE ‘IS’ SHOCK.

Consider the following model of the economy

Production function: Y = AKN – N2/2

Marginal product of labor: MPN = AK – N.

where the initial values of A = 9 and K = 10.

The initial labor supply curve is given as: NS = 30 + 9w.

Cd = 1166 + .50(Y-T) – 500r

Id = 670 – 500r

G = 500

T= 500

Md/P = 154 + 0.5Y- 1000r

Nominal Money supply M = 4200

We assume that expected inflation is zero (πe= 0) so that money demand depends directly on the real interest rate (since i = r).

1 a) (6 points)Solve for the labor market clearing real wage (w*), the profit maximizing level of labor input (N*), and the full employment level of output (Y*). Please show work.

b) (4 points) Derive an expression for the IS curve (r in terms of Y). Please show all work

c) (3 points) Find the real interest rate that clears the goods market. Please show all work

d) (3 points) Find the price level needed to clear the money market.Please show all work

e) (4 points) Find the expression for the LM curve (r in terms of Y). Please show all work

SCENARIO #1 – AN LM SHOCK!

S1 a) (5 points) Now suppose that there is a shock to the real money demand so that the new money function is:

Md/P = 114 + 0.5Y- 1000r

What has happened to money demand at any given output and real interest rate and name two real world reasons why a shock to money demand like this may occur - please support your reasons.

S1 b)(6 points) What is the new, short run (fixed price level) expression for the LM curve? Please show all work.

S1 c) (4 points) What is the short run, Keynesian (fixed price) level of equilibrium output and real interest rate? Please show all work.

S1 d) (4 points) Find the new price level associated with the long run general equilibrium.

Please label these long run conditionsto your four diagrams as point C. Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class.

S1 f) (5 points) What would the Fed have to do exactly in order to keep prices at their original level, consistent with their price stability objective? Assume the money multiplier is equal to 0.8, just like it is in the real world.

SCENARIO #2 – AN IS SHOCK! (A new Grader)

Let’s return to our original conditions: Please write down the expressions for your ORIGINAL IS curve and LM curves in the space below (so the grader can follow your starting points).

IS: r = ______

LM: r = ______

In this scenario #2, the investment function changes and is now: Id = 630 – 500r

S2 a) (6 points) Name and support three reasons why the investment function would change like this. A list without support is worth half of the credit so support your answers!

S2 b) (5 points) Derive a ‘new’ expression for the IS curve (r in terms of Y). Please show all work

S2 c)(4 points) Now solve for the short-run equilibrium output (Keynesian) and the corresponding real rate of interest. Please show all work. Please label this short run (fixed price) equilibrium as point B on all four of your diagrams.

S2 d) (4 points) Now find the long run real interest rate consistent with general equilibrium. Please show all work.

S2 e) (4 points) Find the new price level associated with the long run equilibrium. Please show all work

S2 f) (4 points) Derive a new expression for the LM curve. Please show all work.

Label this long run equilibrium as point C in all four of your diagrams.

S1 g) (5 points) From the central bank's perspective, is this long run adjustment in the general price level desirable? Why or why not, explain.

S2 h) (5 points) Assume that this example is from Japan and we know that anytime we mention Japan we think of deflation. As such, the Bank of Japan is targeting the inflation rate at 2.5% from their original level. What type and how many open market operations would the Bank of Japan have to conduct to achieve the 2.5% target (i.e., the price level being 2.5% higher than their original level)? Please show all work.

S2 i) (5 points)Explain, do not show on your diagrams, how the policy conducted by the Bank of Japan would influence your IS-LM-FE and AS/AD diagrams. Be as specific as possible.

2) (35 points) We discussed in detail how the Fed has managed its balance sheet in recent years in conjunction with why the Fed wanted to pay interest on reserves. Using the balance sheet below, answer the following questions:

a) (10 points) We discussed the concepts of sterilization and unlimited balance sheet capacity. On the graphic above, locate (mark on the graphic) the period of sterilization and explain exactly what sterilization is and why and under what conditions, central banks practice sterilization. Why was the Fed practicing sterilization during this period and what exactly was the concern about this sterilized intervention? (more room next page)

b) (10 points) The Fed pleaded with Congress to push up the date in which the Fed would be granted the authority to pay interest on reserves. Why was the Fed pleading for this authority, when did they get the authority, and what did they do as soon as they got the authority? Please mark on your diagram the date that the Fed received this authority. Finish your essay by answering the following questions: What exactly does 'unlimited balance sheet capacity' mean? What happened to excess reserves and the money multiplier as soon as the Fed was granted the authority to pay interest on reserves? Please use an expression for the money multiplier to support your answer.

c) (5 points) Using the table below, calculated the percent change in money supply (MS) between June 2008 (2008-06-01) and June 2010 (2010-06-01) and compare it to the percent change in the money supply if the Fed acted the same way but did not get the authority to pay interest on reserves. That is, the monetary base changed as it did but the money multiplier remained constant as it is in June 2008.

d) (10 points) We used the graphic below in class in conjunction with why the Fed wanted to pay interest on reserves. Please answer the following questions: