FINAL EXAM: Macro 302 Winter 2013

Transcription

1 FINAL EXAM: Macro 302 Winter 2013 Surname: Name: Student Number: State clearly your assumptions when you derive a result. You must always show your thinking to get full credit. You have 3 hours to answer all questions. Good luck! 1

2 Please leave this page blank for your grade. 2

3 Today is your first day on the job at Macromagic, a firm specialized in macroeconomics and management consulting. Your boss, Mr. X, asks you to work on this set of issues in preparation of next week meetings. Question 1 Let s discuss the Bush-Greenspan policy mix versus the Clinton-Greenspan policy mix in the short run. Starting from 2001 the Federal Reserve (at the time still run by Alan Greenspan) pursued a very loose monetary policy (increasing money supply, M s ), while at the same time President Bush increased government spending (G) substantially, to finance the war in Afghanistan (the first part of an even deeper war effort in the following years). a) Please illustrate within the IS-LM setup this situation, specifically indicating what happens in the short run to desired output and real interest rates when this policy mix is implemented. (4 pts.) An increase in money supply will cause a shift to the right of the LM, decreasing the interest rate and increasing output. An increase in government expenditure will shift inward the S schedule (for any given level of interest rate there will be less savings and investments). This will cause an outward shift of the IS curve which will increase output and interest rate as well, everything else constant. The overall effect on output is positive, the combined decisions of the Fed and the federal government will increase output, while the overall effect on the interest rate is ambiguous. b) Your boss asks: Is the effect of this mix on the real interest rate r unambiguously determined? Why? (3 pts.) No. As explained above, the Fed decision will decrease the interest rate, while the federal government policy will push the real interest rate up. The overall effect is ambiguous and depends on the relative size of the LM and IS shifts. c) Your boss then asks: Well, real GDP growth was very low in between and the country actually experienced a recession. Why? Because of this mix? (2 pts.) No. The recession was caused by a drop in consumption and investments following the burst of the Internet bubble and 9/11 terrorist attack. Both the Federal Reserve and the Bush Administration tried to ease the recession and bring the economy back to full employment Y* through the expansionary policies described above. 3

4 d) During the Clinton administration however the policy mix had changed towards a tighter fiscal policy (lower G) and more expansionary monetary policy (higher M S ). Please illustrate within the IS-LM set up this situation, specifically indicating what happens in the short run to desired output and real interest rates at the moment this policy mix is implemented. (4 pts.) The LM moves as described in point a). An expansionary monetary policy decreases interest rates and increase output (the LM shifts out). The Clinton Administration however contracted government expenditure, G. The IS moved inward when G was decreased. The result of this policy mix is different from the previous one in terms of output: the level of desired output goes up or down depending on the relative size of the IS and LM shifts. In this case we are however able to say what happens to the interest rate. If G decreases and M S increases, then the real interest rate will go down because of both a larger availability of resources for firms to invest (desired savings increase, all else given) and real money balances increase (decreasing the price of money, r). e) Your boss asks: What happens to investment when the Clinton-Greenspan mix is implemented? (3 pts.) The reduction in the interest rate (and the reduction in government expenditure) both causes a shift in the S schedule. The S schedule will shift down to the right at a new equilibrium point where private investment is higher. 4

5 Question 2 Your mild-mannered boss asks you: Hey you, rookie, I forgot how to derive an aggregate demand curve. Remind me how we get that, because I feel it may be important for macro. Do not get upset at the man. Please explain your boss what an aggregate demand curve is and how to derive it from equilibria in the goods and asset markets. (8 pts.) The aggregate demand curve represents the negative relationship between real (demanded) output, Y, and the price index, P. AD is derived from the equilibrium in the goods and asset markets as follows (slides in Topic 6). For a given level of Prices (P0) there is equilibrium in the goods-asset markets at the point where the LM crosses the IS. This equilibrium defines an equilibrium level of desired output (Y0). We can represent the point (P0, Y0) in the (P, Y) space (the space where the AD curve is defined). What happens if we increase the price level from P0 to P1 and we keep everything else constant? An increase in price level will cause a decrease in real money balances (M/P). This implies a decrease in money supply, hence a shift up and to the left of the LM curve. This identifies a new equilibrium on the IS-LM space with a lower level of output (Y1 < Y0). We can represent this new point (P1, Y1) in the (P, Y) space. Since the price level has increased and the output level is lower, it will be to the left and above the (P0, Y0) point. This describes a negative relationship between prices and output. We can repeat the same exercise for many levels of P and reconstruct the whole AD negative relationship between price and output levels. The intuition for why the AD slopes down is that when prices are higher and real money balances are lower interest rates will be higher and this will contract the amount individuals wish to consume and invest (notice than when P increases the LM shifts left, tracing and crossing the IS at points of lower and lower Y, i.e. equilibria in the goods market where investment and consumption are going to be lower). This intuition is different from that for higher relative prices people want to consume fewer goods, as for any standard demand curve you have seen in Micro. Here we are not dealing with the price of one good relative to all the other goods, but with the price index of the whole economy (price of all goods). 5

6 Question 3 Your senior colleague wants to test you with some true/false/uncertain questions on AD/AS over coffee break. After pausing for a second regarding what a workplace you ended up at, you patiently start answering. Complete True/ False/Uncertain. Why? (2 pts. each) 1) The natural level of output can be determined by looking at the aggregate supply relation alone. True. The natural level of output is the amount of resources that can be produced by the economy, given its endowment of inputs (labor, capital, technological development, TFP, etc). It depends hence on the inputs and the production function only. 2) The aggregate demand relation slopes down because at a higher price level, consumers wish to purchase fewer goods. False. As explained in question 2 the aggregate demand slopes down because, all else constant, higher prices levels imply lower real money balances, shift the LM to the left and decrease output. 3) Expansionary monetary policy has no effect on the level of output in the long run. True. Expansionary monetary policies will have no effect on real variables in the long run (money is neutral in the long run). In particular monetary expansion will cause higher price levels in the long run (more money chasing the same amount of goods). 4) In the absence of changes in fiscal or monetary policy, the economy will always remain at the potential level of output. False. The economy is constantly hit by exogenous shocks to demand (for example changes in consumers propensity to consume) and supply (oil prices or technological shocks). 5) In the long run output and the price level always return to the same value. False. Even absent economic growth, which will constantly push outward the long run output Y*, fiscal policies or exogenous shocks can have effects on the long-run output. They can for example change the amount of inputs in the production function, thereby changing the long-run output. 6) Fiscal policy cannot affect investment in the long run because output returns to its potential level. False. Fiscal policy can increase/decrease investments. Consider, for example, an increase in government expenditure. This will cause a decrease in investment in the long run, because of an increase in the interest rate, in the long run. This phenomenon is called crowding 6

7 out of private investment. Another example is a decrease in tax rates on investments. This will stimulate labor demand, potentially increasing the number of workers (it also depends on the income effect on workers) and in the very long run it will also increase the capital stock increasing the potential output and investment level. 7) Everything else constant, an increase in the marginal product of labor will increase the level of full employment in the economy. Uncertain. It depends on the income effect on labor supply (and on whether the MPN shock is permanent or not). An increase in MPN will increase labor demand, increasing both employment and wages for sure. A (permanent) increase in wages however will increase the PVLR, which will decrease labor supply at every level of wage rate (income effect). Depending on the relative size of the increase in labor demand and the decrease in labor supply we can have an increase, decrease or no effect of the full employment level in the economy. 7

8 Question 4 Your boss has very peculiar views on the role of the Fed: The Federal Reserve has the easiest job in the world. All it has to do is to conduct expansionary monetary policy when the unemployment rate increases and contractionary monetary policy when the unemployment rate falls. Comment on his statement. On the basis of which sound economic reasoning would you agree/disagree? Please provide him with some examples. (8 pts.) We should disagree. The job of the Federal Reserve is really quite complicated. Whenever Bernanke makes a decision he has to keep in mind not only the level of unemployment, but also the inflation level. By taking into consideration the Fed s dual objectives, it is not correct to say that the Fed should increase money supply when unemployment rate goes up and vice-versa. The unemployment rate might be changing for many different reasons. When unemployment rate increases because of demand shocks prices and unemployment move in opposite directions: if unemployment increases, prices decrease. In this case the Fed might consider increasing money supply, as your boss suggests, in order to fight the recession without having to worry too much about inflation. This was the case, for example, in 1991 when the recession was caused by a contraction in aggregate demand and the Fed decided to ease money supply to help firms and consumers. If unemployment changes are caused by shocks to aggregate supply, then the situation is quite different. In case of an adverse aggregate supply shock, unemployment and prices move in the same direction (and notice employment and prices move in opposite direction). In this case the Fed has to decide whether the main concern is to stabilize output around Y* or fight inflation. During the seventies, when the oil shocks hit the world economy, industrialized nations faced high unemployment, sluggish economic growth and high inflation (a phenomenon called stagflation). In this instance the Fed job was not as easy. Had it decided to ease recessionary pressures, as your boss suggests, it would have contributed to the increase in price levels; had it decided to curb inflation it would have contributed to further contraction in output. The Fed has to balance different possibilities and then decide. 8

9 Increase in the labor force Question 5 We are currently consulting for a large labor union, your boss tells you, We have to understand how massive immigration of workers from Mexico is going to affect our economy. Describe him graphically how the short run, the labor market and the long run equilibrium will change in response to this increase in the labor force. Assume zero income effects on the labor supply function, but that C responds to changes in PVLR. You may use the graphs below. [Hint: recall that an increase in the population shifts the N S ] The main effect of an increase in the working-age population like the one described in the exercise is an increase in the long-run full-employment level of output in the economy determined by an expansion of the labor supply due to an increase in the sheer number of people workin (Ns moves to the right). This will induce lower real wages in the long run and lower PVLR for workers/consumers. Lower PVLR will induce lower C. Once we exclude further effects on the labor supply of workers due to income effects, the main effects concerning consumers will go through a reduction of desired aggregate consumption C due to the drop in PVLR. Hence in the short-run IS and AD will contract. Since we are changing equilibrium price levels, the LM will readjust slightly for whatever change in the equilibrium price level (in particular when prices go down real money balances increase and the LM moves to the right). The excess labor supply in the labor market will progressively push real wages down, through a self-correcting mechanism, towards the equilibrium point where the new labor supply meets the old labor demand Nd. Lower nominal wages will also push progressively outward the SRAS. At the lower market-clearing real wages will be lower and potential output Y* will be higher (remember that the LRAS is affected by the full employment level in the labor market through the production function). 9

10 Short run here (4 pts.) LRAS SRAS N s P 0 W 0 /P 0 AD N D * Y 0 * N 0 LRAS LM NOTES C drops &AD moves r 0 IS * Y 0 10

11 Labor market here. (4 pts.) LRAS SRAS N s N s P 0 W 0 /P 0 AD N D * Y 0 * N 0 LRAS LM NOTES Note the increase in the labor supply r 0 IS * Y 0 11

12 Long run here (4 pts.) LRAS SRAS N s P 0 W 0 /P 0 AD N D * Y 0 * N 0 LRAS LM NOTES Higher output and lower prices in the LR r 0 IS * Y 0 12

13 Question 6 Indian Banks to Increase Reserves By Jackie Range Wall Street Journal April 18, 2008; Page A8 NEW DELHI -- The Reserve Bank of India again raised the amount of capital banks must keep in the central bank's coffers in an attempt to ward off inflation. But it remains an open question whether the move will be enough to tamp down rising prices across the economy, especially those of food and commodities, which have been climbing world-wide. "Inflation today is due to a supply shock, and monetary-policy actions can do very little to bring it down," said Dharmakirti Joshi, principal economist at Mumbai ratings service Crisil. Mr. Joshi pointed out that there is also a time lag between the Reserve Bank's actions and any impact on India's economy. The central bank said it would increase the cash-reserve ratio, or the proportion of deposits that banks must leave with it as cash, by half a percentage point to 8% in two stages.[ ] Please discuss the channels and effects of this policy action. Do you agree with Mr. Joshi? What are the implicit assumptions he is making? (8 pts.) The policy action of the Reserve Bank of India is equivalent to a contraction of money supply, a reduction in the real money balances and an increase in the interest rates. Private, commercial banks will decrease the amount of loans they concede because now they have to set aside larger amounts of their deposits as reserves. Liquidity in the country will decrease. Why is the bank of India doing this? A tightening of money supply helps fighting inflationary pressures. To understand the effects of this policy decision we should consider the source of inflation. The rise in food and commodities prices is driven (mainly) by the increase in oil prices, which increase energy prices and also the price of many products used in agriculture to produce food. This amounts to a supply shock, as correctly pointed out by Mr. Joshi. However, when inflation is caused by a supply shock the central bank faces a difficult decision between curbing inflation and helping economic growth. Reducing money supply will contribute to the reduction of inflation, by lowering AD and so pressures on prices, but will raise real interest rates, pushing down both consumption and investment. This negative pressure on aggregate demand further reduces economic growth. Hence, Mr. Joshi seems to be confused between what the Bank of India can do (contracting the AD to counteract the increase in prices due to a contraction of the SRAS) and what it would be willing to do (curbing inflation at the cost of slowing down the economy further than what already implied by the AS shock). In the very long run (beyond the scope of our business cycle analysis, that is) the increase in food prices will stimulate more research and development and will eventually encourage entry in the industry by new firms and efficiency gains by those already producing. These new entries and technological improvement will probably decrease food prices over very long horizons, despite a permanent increase in oil prices. 13

14 Fiscal policy and investment. Question 7 Do you agree with the following statements by your boss? Explain. (4 pts. each): a) Private saving goes either towards financing the budget deficit or financing investment. It does not take a genius to conclude that reducing the budget deficit leaves more saving available for investment, so investment increases. This statement correctly points at the fact that, for given output and consumption levels, government expenditure crowds out private investment. The result is derived directly from the identity between Savings and Investments, S = I, and from the definition of Savings as S = S HH + S GOV (recall that we are working in a closed economy, i.e. NX = 0). If the government is dissaving, i.e. is running a budget deficit, it decreases the resources available to finance Investments. A decrease in the government deficit will then increase the amount of resources available for Investments. b) During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. This statement is correct. It suggests that during expansions, especially those driven by increases in Aggregate Demand (positive AD shocks), inflation can be curbed by a stabilization policy including either higher taxes or lower government spending (hence, a higher government surplus). Contractionary fiscal policy lowers AD. A lower AD will, ceteris paribus, decrease the price level (or inflation). Some of you have pointed out that controlling the inflation rate is not the government job. This is partially correct in the sense that the Fed is the government agency usually associated with fighting inflation; moreover the government is usually interested in achieving other goals rather than fighting inflation. However the question asks whether the government can curb the inflation running a budget surplus and not whether this is optimal or desirable (which might be under certain circumstances). c) Whether for good or for ill, fiscal policy's ability to affect the level of output via aggregate demand wears off over time. Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not increase output at all. This statement suggests that economic expansions driven by increases in AD (positive AD shocks) due to either lower taxes or higher government spending are temporary and eventually the economy reverts to Y*, whenever the production function in the economy is unchanged (which is always true for aggregate demand shocks). This statement is correct in the sense that positive AD shocks have only effects on prices in the long run. 14

15 Question 8 PIMCO is one of the largest specialty fixed income fund managers in the world. Your boss asks you to check with them what are the yields (returns) of Treasury Inflation-Protected Securities (TIPS). TIPS are securities that are automatically protected for inflation and guaranteed by the Treasury. Here s the snapshot (TIPS are in the lower block, the upper block are the interest rates that the Treasury pays on the main non-indexed securities): a) How can we interpret the yield of an Inflation Indexed Treasury? Can you employ the Fisher equation to obtain expected inflation for the 30yr and 10yr bonds? (4 pts.) The yield of an Inflation Indexed Treasury can be interpreted as the real interest rate. The Fisher equation states that i = r + π e where π e is the expected rate of inflation. The difference between the Treasury Bonds (whose return is the nominal interest rate) and the Inflation Indexed Treasury bonds (whose return is the real interest rate) will give us the expected rate of inflation. Expected inflation for 30yr = 4.44% 1.64% = 2.8% Expected inflation for 10yr = 3.54% 1.06% = 2.48% b) Which percentage of the spread (i.e. the difference) between the 30yr and the 10yr yield is due to expected inflation? (3 pts.) The spread between 30yr and 10yr is 4.44% 3.54% = 0.9%. The difference in expected inflation is 2.8% 2.48% = 0.32%. The percentage of difference explained by inflation is 0.32%/0.9% = 35%. c) Do you notice anything surprising concerning the 5yr Treasury? What is its real return? (3 pts.) The surprising thing is that the real return on 5yr Treasury bonds is 0%. 15

16 d) What is the average inflation rate expected over the next five years? Do the data exclude deflationary pressure over any time horizon? (3 pts.) The average inflation rate expected in the next five years is 2.53%, i.e. the return on 5yr Treasuries not indexed for inflation. Deflation is defined as negative price growth. The data seem to suggest that expected inflation will always be positive, for the next five, ten and thirty years. The expected rates of inflation are all above 2%. The data suggest that inflation might be slightly lower between five years from now and ten years from now (because the average decreases a little). 16

17 Seignorage. Question 9 The real revenue generated from money creation is called seignorage. The term derives from the consideration that ancient seigneurs could buy the goods they wanted by just issuing their own money and use it to pay for the goods. Consider M being the nominal money stock, M the change in the amount of money (i.e. the new money issued), P the price level. Seignorage = M/P which is the real value of the new money supplied. Assume that money (liquidity) demand takes the form: M/P = Y[1 (r + e )] Where Y =1000 and r = 0.1. a) Assume that in the short run e = 25%. Calculate the rate of seignorage for each rate of money growth M/M. i. 25% ii. 50% iii. 75% [Hint: the formula for seignorage can be expressed in terms of money growth.] (5 pts.) Consider the equilibrium in the asset market where money (liquidity) demand equals money supply. This takes the form: M S /P =M/P = Y[1 (r + e )] And for our given values: M/P = 1000*[1 (.10 + )] = 650 By dividing and multiplying by M, seignorage can be written as: So the seignorage levels are: i. *650 = ii. *650 = 325 iii. *650 = Seignorage = ( M/M)*(M/P) or Seignorage = ( M/M)*650 17

18 b) In the long run e = = M/M. Consider the levels of seignorage with the previous three rates of money growth (25%, 50%, and 75%). Give your intuition for why your answers differ from a). (5 pts.) Applying the same mechanism as in the previous point, the seignorage levels are now: i. *(1000*( )) = ii. *(1000*( )) = 200 iii. *(1000*( )) = Market expectations concerning monetary policy are directly reflected into prices when e = = M/M. Clearly, the amount of resources the central bank is able to extract is higher if it can surprise the agents in the economy (what happened at point a. for cases ii. and iii.). Notice that the money growth level that maximizes seignorage is not achieved by maximizing M/M. Ok, your boss says after you have finished discussing the issues he presented, now you deserve a beer and relax. 18