Exam 2 Econ 304 Chuderewicz Spring 2012

Exam 2 – Econ 304 – Chuderewicz – Spring 2014

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Exam 2 – Econ 304 – Chuderewicz – Fall 2013

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 = A·K·N – N2/2

Marginal product of labor: MPN = A·K – N.

where the initial values of A = 6 and K = 10.

The initial labor supply curve is given as: NS = 20 + 4w

Initial conditions in the goods market

Cd = 130 + .50(Y-T) – 500r

Id = 704 – 500r

G = 150

T= 100

Md/P = 166 + 0.5Y- 1000r

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

Nominal Money supply: M = 2000

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.

In the space below, draw two diagrams vertically with the labor market on the bottom graph and the production function on the top graph. Be sure to label everything including this initial equilibrium point as point A. (10 points for completely labeled and correct diagrams)

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. BE SURE 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 shock to real money demand so that the new real money demand function is:

Md/P = 146 + 0.5Y- 1000r

S1 a) (4 points) Name and explain two reasons why money demand could change like this - if you simply list two reasons, you get half credit - so please support your answers with a sentence or two and relate to the real world.

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.

Please label these new short run conditions to 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 conditions to 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 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! (75 points total)

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 - suppose the consumption function has changed and is now:

Cd = 110 + .50(Y-T) – 500r

S2 a) (5 points) Name and support 3 reasons why the consumption function would change like this. Please refer to real world events that could/did cause this to happen to the consumption function.

S2 b) (4 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.

S2 g) (5 points) Is this result desirable? That is, with perfect information, would the Fed allow this long run adjustment to take place? Why or why not? Explain in as much detail as possible using a real world event (hint, it’s a central banking nightmare!).

S2 h) (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.

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 way without (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) We discussed the three policy alternatives at the zero bound. Recently, Janet Yellen, the new Chair of the Fed, delivered a talk. An excerpt from a WSJ article is below:

Ms. Yellen's comments, coming less than two weeks after a Fed policy meeting where officials discussed the path to rate increases, were a notable affirmation of her commitment to low rates until the economy is much stronger...... "She doesn't want to get the market overly concerned that she's going to tighten anytime soon, because she's not," said Doug Cote, chief market strategist at ING Investment Management. "She said she has an extraordinary commitment to boost the economy in a still-struggling labor market. I think it put the market at ease."

a) (20 points) Which of the three alternatives apply here and how exactly is this alternative supposed to work in terms of influencing economic activity. In your answer, provide a two period consumption model diagram assuming consumers in the economy are on net, borrowers. Provide a discussion of how the income and substitution effects play a role here. Then, provide a user cost / MPKf diagram explaining how this policy alternative is supposed to work exactly in terms of influencing investment. Be sure to explain in detail. For both diagrams start at point A and assuming that her words above worked like they are supposed to, move to point B with and explanation as to why we move to point B.

b) (10 points) Now play a devil's advocate as in arguing why this policy alternative won't work in the real world. In particular, focus on why this policy won't work in terms of influencing consumption or investment. Again, be as specific as possible as to why this policy alternative won't work.