Exam 2 Econ 304 Chuderewicz Spring 2012

Exam 2 – Econ 304 – Chuderewicz – Spring 2012

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Exam 2 – Econ 304 – Chuderewicz – Spring 2012

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

Md/P = 469 + 0.5Y- 1000r

Nominal Money supply M = 4000

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) (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!

S1 a) (4 points) Now suppose that here is a shock to real money demand so that the new money demand function is:

Md/P = 449 + 0.5Y- 1000r

Name and support two reasons why real money demand would change like this - please do your best to relate your answer to recent real world events.

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) From the Fed's perspective, is this long run adjustment in the general price level desirable, noting that the Fed's target for inflation = %ΔP = 2%. If it is not desirable, then what can the Fed do to hit their inflation target? Would they conduct open market purchases or open market sales? Hint: feel free to use the quantity theory of money and Milton Friedman's famous quote as part of your answer.

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, there is a shock to the consumption function so that the new consumption function is:

Cd = 381 + .50(Y-T) – 500r

S2 a) (6 points) Name three reasons why the desired consumption function would change like this.

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 you diagrams.

S2 d) (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 e) (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.

2. (40 points total) When talking about money demand, we talked of the importance in terms of policy of identifying the shock to money demand. We characterized shocks to money demand as either real or portfolio.

2.a) (10 points) Please explain the differences between these shocks to money demand (real vs portfolio) using real world examples to support your answer. Please list as many portfolio shocks as possible and make sure you sign each shock with a brief explanation as to why you signed it (+ or - ) the way you did.

We now consider a specific case, call it case #1, where the real money demand curve shifts to the left (a decrease) due to a portfolio shock to money demand. In the space below, draw a money market diagram complete with real money supply and real money demand with the initial equilibrium at ra with output at Ya. Label this initial equilibrium point as point A.

10 points for correct and completely labeled diagram

2b) (5 points) We now encounter a portfolio shock that shifts the money demand curve to the left. Please give two specific reasons as to why the money demand curve shifted the way it did. Note, we assume that Y = Ya.

2.c) (5 points) Now discuss the appropriate response, if any, of the Federal Reserve. That is, write a short essay explaining the issues that the FOMC would discuss around that fancy mahogany table in Washington DC.

2.d) (5 points) Suppose that the Fed decided that the response, most consistent with meeting their dual mandate, was to keep real rates of interest the same (i.e.,, they want to perfectly smooth the real rate of interest). What would the FOMC tell the New York Fed to do (be specific) exactly? Be specific. Show this new equilibrium point as point B on your diagram being sure to label your diagram completely.

2.d) (5 points) Now discuss how your answer would change (in 2.c)) if instead the source of the shock to money demand was real, as in a change in real output. Include in your answer how the Fed's response would likely be different given that the shock to money demand was real rather than nominal (portfolio). You just need to discuss this and not show on your diagram. In other words, when they called the New York Fed, how would their instructions change? Explain.

3. (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 paid interest on reserves. The graphic below clearly shows this development. Please answer the following questions:

3.a) (10 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. 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. 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.

3.b) (5 points) According to graphic above, banks are currently holding almost $1.6 trillion in excess reserves. Explain exactly why banks are (currently) holding so many excess reserves and where did these excess reserves come from?

3.c) (10 points) Many are worried that if the banks starting lending out their excess reserves all at once, inflationary pressures will build. Using the expression for the money multiplier along with the quantity theory of money, show why this concern is very real. Start your essay explaining under what conditions (i.e., why) would the banks start getting rid of their excess reserves.

3.d) (5 points) Suppose that the banks did start getting rid of their excess reserves faster than the Fed was comfortable with. What could the Fed do exactly to slow down the amount of excess reserve entering the system? Please be as specific as possible. I am looking for two possible policy actions.