Exam 2 – Econ 304 – Spring 2010
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 = 2A·K – N.
where the initial values of A = 5 and K = 6.
The initial labor supply curve is given as: NS = 20 + 3w.
Cd = 85 + .50(Y-T) – 500r
Id = 50 – 500r
G = 50
T= 100
Md/P = 85 + 0.5Y- 1000r
Nominal Money supply M = 400
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.
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) (3 points) Find the expression for the LM curve (r in terms of Y). Please show all work
Now draw three separate diagrams: (30 points total) a FE - IS – LM diagram, a desired savings equals desired investment (Sd = Id ), and a money market 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 the real demand for money has changed and is now:
Md/P = 105 + 0.5Y- 1000r
S1 a) (6 points) What would cause such a development?? Explain using the three main characteristics of asset demand.
S1 b) (4 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 on your FE, IS, LM diagrams as point B. Be sure to label diagram completely with the inclusion of all the relevant shift variables like we did numerous times in class.
S1 d) 3 points) If the Fed did nothing, explain how exactly the economy will return to full employment.
S1 e) (4 points) Assuming that the Fed did nothing, find the new price level associated with the long run general equilibrium.
Please label this long run equilibrium on your FE, IS, LM diagrams as point C. Be sure to label diagram completely with the inclusion of all the relevant shift variables like we did numerous times in class.
S1 f) (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!).
S1 g) (5 points) Suppose otherwise and that the Fed wanted to keep prices constant at their original level at points A and B. What would the Fed have to do exactly, as in open market operations? Assume that the money multiplier is 1. Be specific and show work.
Finally, draw an aggregate demand and aggregate supply curve locating points A, B, and C. Please label everything completely. Be sure to add the SRAS curves and the LRAS curve to your two AD curves. A completely drawn and labeled diagram is worth 10 points.
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 = ______
Now draw another set of diagrams, i.e., three separate diagrams, identical to the first part of this problem (i.e., we are starting at the same equilibrium point = point A): a FE - IS – LM diagram, a desired savings equals desired investment (Sd = Id ), and a money market 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. (30 points total)
In this scenario #2, we let those wonderful elected officials of ours increase G to 80 (from 50)
S2 a)(4 points) (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.
S2 c) )(4 points) In the short run, what is the “Keynesian” Government spending multiplier? Please show all work
S2 d) (4 points) Solve for the real rate of interest in this long run equilibrium.
S2 e) (4 points)We now consider the long run when prices adjust. 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.
S2 g) (4 points) In the long run, how much investment has been crowded out? Please show all work.
Label this long run equilibrium as point C in all three of your diagrams.
2. (35 points total)
Suppose the real money demand function is:
Md/P1500 0.2 Y – 10,000 (re).
Assume M 4000, P 2.0, e 0.01, and Y 5000. Note: we are holding P and Y constant in this problem.
a) (4 points) What is the market clearing real interest rate?
Show your results on a real money supply, real money demand diagram and label this initial equilibrium point as point A. Be sure to label your graph completely!
Correctly drawn and completely labeled diagram is worth 10 points total.
b) (6 points)Suppose Bernanke and the Fed were successful in their campaign to raise inflationary expectations to 4% (.04). Why would they want to do this and how would they do this??
c) (4 points) Solve for the real interest rate that clears the money market given the change in inflationary expectations. Please show work and Label this new point as point B
d) (10 points) Explain how this strategy of raising inflationary expectations is supposed to stimulate output. Recall that output is equal to C + I + G! Be very specific as this question is worth 10 points.
e) (6 points) Now its your turn to be critical of this Fed strategy – that is, provide arguments as to why this strategy won’t work and may actually result in lower output rather than raise output. Again, be as specific as possible.
3. (30 points total) We discussed the money supply process in some detail along with the concept of quantitative easing. In particular, we argued that the Fed, with the most astute student of the Great Depression (GD) at the helm (Ben Bernanke), appears to have learned their lesson from the Great Depression(GD). Please answer the following questions.
a) (10 points) What lesson did the Fed learn from the GD exactly? That is, if you wanted to blame the Fed for the GD, where would we start. In the space below, write an essay criticizing the Fed for their behavior during the GD making sure to address the behavior of the money multiplier (and its components), the monetary base, and the nominal money supply during the GD.
b) (5 points) If we could go back in time and you could be the Fed Chair during the GD, what would you do different?? Make sure you refer to percent changes in your answer. As a hint, what would you make sure of when it comes to the percent change in the monetary base?
c) (10 points) Let’s fast forward to the recent financial crisis and quantitative easing. The graph below depicts the money multiplier during the ‘great recession.’ Explain exactly why the money multiplier has plummeted and what the appropriate response is, given that the Fed learned their lesson from the Great Depression. How can we tell if the Fed truly learned their lesson from the GD and how can we be sure that their behavior is consistent with quantitative easing? Be as specific as possible.
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