Intrmdiat Macroconomic Thory / Macroconomic Analysis (ECON 3560/5040) Final Exam (Answrs) Part A (5 points) Stat whthr you think ach of th following qustions is tru (T), fals (F), or uncrtain (U) and brifly xplain your answr. No crdit will b givn for an answr without any xplanation () [5 points] Staggring maks th ovrall lvl of wags and prics adjust quickly, bcaus individual wags and prics chang frquntly Fals. Staggrd pric adjustmnt significantly slows th adjustmnt of th pric lvl. Whn any on firm adjusts its pric, that firm will b rluctant to chang its pric vry much, sinc a larg chang would altr its ral pric (its pric rlativ to othr firms). Th rsult of ths incrmntal changs is that vn aftr vry firm in th conomy has gon through on round of pric adjustmnt, th aggrgat pric lvl will not hav fully adjustd to its nw quilibrium lvl () [5 points] If Congrss raiss taxs, th rspons of th conomy to th tax incras dpnds on how th cntral bank rsponds Tru. Th impact of a chang in fiscal policy dpnds on th policy th cntral bank pursus that is, on whthr it holds mony supply, intrst rat, or incom constant. Mor gnrally, whnvr analyzing a chang in on policy, w must mak an assumption about its ffct on th othr policy (3) [5 points] Th Mundll-Flming modl shows that a fiscal policy is mor ffctiv than a montary policy Uncrtain. According to th Mundll-Flming modl, undr floating xchang rats, a montary xpansion raiss incom whras a fiscal xpansion dos not, but undr fixd xchang rats, a fiscal xpansion raiss incom whras a montary xpansion dos not. Thrfor, th modl shows that th ffct of almost any conomic policy on a small opn conomy dpnds on whthr th xchang rat is floating or fixd
Part B (5 points) Brifly answr th following qustions in words. () [5 points] Can an IS curv b vrtical? Giv an xampl Th slop od an IS curv dpnds on incom and intrst rat lasticitis of aggrgat xpnditur. For xampl, if invstmnt dos not dpnd on th intrst rat, thn th IS curv is vrtical () [5 points] What is an advantag to fixd xchang rats? Fixd xchang rats rduc som of th uncrtainty in intrnational businss transactions and mak irrational and dstabilizing spculation difficult (3) [5 points] Why do firms hav motivs for holding invntoris of goods? Giv an xampl Firms hav motivs for holding invntoris of goods: smoothing production, using thm as a factor of production, avoiding stock-outs, and storing work in procss Part C (70 points) () [4 points] IS-LM Modl Assum th following modl of th closd conomy in th short run, with th pric lvl (P ) fixd at.0: M d C = 0.5(Y T ) T =, 000 I =, 500 50r G =, 500 = 0.5Y 500r P M s =, 000 (a) [ points] Writ a numrical formula for th IS curv, showing Y as a function of r alon [Hint: Substitut out C, I, G, and T ] IS : Y = 500r + 5000 (b) [ points] Writ a numrical formula for th LM curv, showing Y as a function of r alon [Hint: Substitut out M/P ] LM : Y = 000r + 000 (c) [ points] What ar th short-run quilibrium valus of Y, r, and national saving (S)? Y = 4000, r =, S = 000
(d) [ points] Assum that G incrass by,500 (i.., G = 3, 000). By how much will Y incras in short-run quilibrium? Y incrass by 000 () [3 points] You ar th chif conomic advisr in this hypothtical conomy. Do you bliv that fiscal policy is mor potnt than montary policy? Brifly discuss [Hint: Us th slop of IS and LM curv in (a) and (b)] Sinc th IS curv is stpr than th LM curv, fiscal policy is rlativly mor ffctiv than montary policy (f) [3 points] Writ th numrical aggrgat dmand (AD) curv for this conomy, xprssing Y as a function of P Y = (0, 000/3) + (000/3P ) or Y = 3333 + 667/P () [0 points] Classical modls in th Long Run During arly 980s, Prsidnt Ragan proposd to incras dfns spnding and dcras taxs. Tabl shows how th policis affctd th U.S. conomy. Us th Classical Modl to answr th following qustions (a) [3 points] Us th closd conomy modl and illustrat graphically how th modl prdicts national saving (S), invstmnt (I), ral intrst rat (r), nt xport(n X), and ral xchang rat (ε) in th long run S Figur (b) [ points] Ar th data in th tabl consistnt with modl prdictions that you found in part (a)? Brifly discuss Th closd conomy modl corrctly prdictd that national saving would fall and th intrst rat would ris. But, th closd conomy modl prdictd that invstmnt would fall as much as saving; actually, invstmnt fll by much lss than saving. Also, th closd conomy modl by dfinition could not hav prdictd th ffcts on th trad balanc or xchang rat (c) [3 points] Now us th small opn conomy modl and illustrat graphically how th modl prdicts national saving (S), invstmnt (I), ral intrst rat (r), nt xport (NX), and ral xchang rat (ε) in th long run S Figur (d) [ points] Ar th data in th tabl consistnt with modl prdictions that you found in part (c)? Brifly discuss Th small opn conomy modl corrctly prdictd what would happn to NX and th ral xchang rat, but incorrctly prdictd that th intrst rat and invstmnt would not chang. In ordr to xplain th U.S. xprinc, w nd to combin th insights of th closd and small opn conomy modls 3
Tabl : Th Ragan Dficits variabl 970s 980s actual chang S 9.6 7.4 I 9.9 9.4 no chang r. 6.3 N X -0.3 -.0 ε 5. 9.4 Data: dcad avrags; all xcpt r and ε ar xprssd as a prcnt of GDP (3) [6 points] Opn Economy in th Short Run Economic xpansion throughout th rst of th world raiss th world intrst rat. Us th Mundll-Flming (IS LM ) modl to illustrat graphically th impact of an incras in th world intrst rat (r ) on th nominal xchang rat () and lvl of output (Y ) in a small opn conomy with a floating-xchang-rat systm Th fiscal xpansion in th rst of th world would rais th world intrst rat and lowr domstic invstmnt. As a rsult, an incras in world intrst rat will rais national incom and lowr nominal xchang rat (4) [0 points] Th Modl of AD and AS Assum that an conomy is initially oprating at th natural rat of output (Y ). A short-run aggrgat supply quation is givn by Y t = Y + α(p t P t ), whr Y is output, P is th pric lvl, P is th xpctd pric lvl, and α > 0 (a) [ points] What is th slop of th aggrgat supply curv? Th slop of AS curv is α (b) [3 points] According to th sticky-pric modl, th valu of α dpnds on th fraction of firms with sticky prics. Othr things bing qual, if a gratr proportion of firms follows th sticky-pric rul, what happns to th slop of th AS curv? Th slop of AS curv ( α ) incrass (dcrass) as th fraction of firms with flxibl prics incrass (dcrass) in th sticky-pric modl. Thrfor, if a gratr proportion of firms follows th sticky-pric rul, th AS curv will b flattr (c) [5 points] Us th modl of aggrgat dmand and aggrgat supply to illustrat graphically th short-run and long-run ffcts on pric and output of an unxpctd xpansionary montary policy chang This positiv AD shock movs output abov its natural rat and P abov th lvl popl had xpctd. Ovr tim, P riss, SRAS shifts up, and output rturns to its natural rat. S Figur 3 4
(5) [0 points] Th Phillips Curv Suppos that an conomy has th Phillips curv π t = π t 0.5(u t 0.06) (a) [ points] What is th natural rat of unmploymnt (u n )? u n = 0.06 or u n = 6% (b) [4 points] Us th Phillips curv diagram to illustrat graphically how th inflation rat (π) and unmploymnt rat (u) chang in th short run to an unxpctd xpansionary montary policy If th chang in montary policy is not xpctd, in th short run, th inflation rat incrass and th unmploymnt falls. It causs a movmnt along th Phillips curv. S Figur 4 (c) [4 points] Us th Phillips curv diagram to illustrat graphically how th inflation rat (π) and unmploymnt rat (u) chang in th short run to an xpctd xpansionary montary policy If th chang in montary policy is fully xpctd, th Phillips curv shifts upward to th right in th short run. Thrfor, unmploymnt rat stays th sam, but inflation rat will b highr than what it was initially. S Figur 5 (6) [0 points] Consumption Thoris (a) [3 points] What wr Kyns s thr conjcturs about th consumption function? i) MPC is btwn zro and on ii) APC falls as incom riss iii) Incom is th primary dtrminant of consumption and th intrst rat dos not hav an important ffct on consumption (b) [ points] What is th consumption puzzl? Studis of houshold data and short tim-sris found a rlationship btwn consumption and incom similar to th on Kyns conjcturd (short-run consumption function). But studis of long tim-sris found that th APC did not vary systmatically with incom (long-run consumption function) (c) [3 points] How dos th Prmannt Incom Hypothsis (PIH) rsolv th puzzl? Th PIH implis that popl try to smooth consumption by mphasizing that popl xprinc random and tmporary changs in thir incom from yar to yar. Th PIH xplains th consumption puzzl by suggsting th standard Kynsian consumption function uss th wrong variabl for incom. Th APC is a dcrasing function of incom if much of yar-to-yar variation in incom is transitory. In long tim-sris data, howvr, variations in incom ar largly prmannt; thrfor, consumrs do not sav any incrass in incom, but consum thm instad (d) [ points] Dmographrs prdict that th fraction of th population that is ldrly will incras ovr th nxt 0 yars. What dos th Lif-Cycl Hypothsis (LCH) prdicts 5
for th influnc of this dmographic chang on th national saving rat? That is, will th national saving rat incras or dcras? Why? Th lif-cycl modl prdicts that an important sourc of saving is that popl sav whil thy work to financ consumption aftr thy rtir. If th fraction of th population that is ldrly will incras ovr th nxt 0 yars, th lif-cycl modl prdicts that as ths ldrly rtir, thy will bgin to dissav thir accumulatd walth in ordr to financ thir rtirmnt consumption: thus, th national saving rat should fall ovr th nxt 0 yars (7) [0 points] Mony Supply and Inflation To incras tax rvnu, th US govrnmnt in 93 imposd a two-cnt tax on chcks writtn on dposits in bank accounts (In today s dollars, this tax was about 5 cnts pr chcks) (a) [ points] How do you think th chck tax affctd th currncy-dposit ratio? Brifly xplain Th introduction of a tax on chcks maks popl mor rluctant to us chcking accounts as a mans of xchang. Thrfor, thy hold mor cash for transactions purposs, raising th currncy-dposit ratio (b) [ points] Brifly discuss how this tax affctd th mony supply using th modl of th mony supply undr a fractional-rsrv banking systm Th highr th currncy-dposit ratio, th lowr th proportion of th montary bas that is hld by banks in th form of rsrvs and, hnc, th lss mony banks can crat (c) [3 points] Now us th IS LM modl to discuss th impact of this tax on th conomy in th short run. Was th chck tax a good policy to implmnt in th middl of th Grat Dprssion? Th contraction of th mony supply shifts th LM curv upward, raising intrst rats and lowring output. This was not a snsibl action to tak during th Grat Dprssion (d) [3 points] Explain how this tax influncd nominal intrst rats and inflation rats in th long run using th Quantity Thory of Mony (QTM) and th Fishr ffct In th long run, th Quantity Thory of Mony says that th montary tightning should rduc inflation. Th Fishr Effct says that th fall in inflation rat should caus an qual fall in nominal intrst rat Part D (0 points) If you ar a Graduat studnt, you should answr th following qustions. This is a bonus qustion for Undrgraduat Studnts (8) [0 points] Suppos that th cntral bank strictly followd a rul of kping th ral intrst rat at 3% pr yar. That rat happns to b th ral intrst rat consistnt with th conomy s initial quilibrium 6
(a) [5 points] Assum that th conomy is hit by a mony dmand shock only. Undr th cntral bank s rul, how will th mony supply rspond to a mony dmand shock? Will th rul mak aggrgat dmand mor stabl or lss stabl than it would b if th mony supply wr constant? If th Fd targts th ral intrst rat, thn mony dmand shocks ar offst by changs in th mony supply, so th LM curv dos not mov. Sinc th shock causs th mony supply to chang, but dos not affct output, th mony supply is acyclical. By following th intrst-rat-targting rul, th AD curv is unaffctd by mony-dmand shocks (sinc thy ar offst by mony-supply changs), so it is mor stabl than if th Fd did not rspond at all (b) [5 points] Assum that th conomy is hit by IS shocks only. Undr th cntral bank s rul, how will th mony supply bhav? Will th intrst-rat rul mak aggrgat dmand mor stabl or lss stabl than it would b if th mony supply wr constant? Whn thr ar IS shocks, th rul dos not work vry wll. Suppos a shock shifts th IS up and to th right. Targting th ral intrst rat rquirs th Fd to incras th mony supply to shift th LM curv down and th right. Whil this maintains th ral intrst rat at its initial lvl, output is abov full-mploymnt output. Th mony supply is procyclical, sinc th shift in th IS curv causd output to ris, and th incras in th mony supply causd output to ris furthr. This rspons to IS shocks maks th aggrgat dmand curv lss stabl, as it shifts th AD curv farthr to th right in rspons to an IS shock than it would hav if th LM curv did not rspond 7
r S S r r I I I(r) S, I Figur : Th Ragan dficits: Closd Economy Modl ( *) ( *) ( ) Figur : Th Ragan dficits: Opn Economy Modl 8
P LRAS SRAS SRAS P = P = P 3 3 P P = P AD AD Y Y = Y = Y 3 Y Figur 3: Effcts on Pric and Output of an Unxpctd Expansionary Montary Policy Chang π π + ν β n u u Figur 4: Effcts on Unmploymnt and Inflation of an Unxpctd Expansionary Montary Policy Chang 9
π π π + ν + ν n u u Figur 5: Effcts on Unmploymnt and Inflation of an Expctd Expansionary Montary Policy Chang 0