Name ________________________________ Last 4 PSU ID____________
Final Exam: Econ 304 – Fall 2015
Depending on the card flips you will do question #1 OR question #2.....next flip, you will do
question #3 OR question #4.....next flip, you will do question #5 OR question #6.....QUESTION
#7 IS MANDATED, for a total of four different questions - the cards will be flipped at the very
beginning of exam.....if you accidently do the wrong question, or if you purposely do the wrong
question, you will score a zero for that question.
DO THIS QUESTION IF AN ACE (A ONE) IS FLIPPED
#1 (ACE) (70 points total)Christina Romer and Jared Bernstein in "The Job Impact of the
American Recovery and Reinvestment Plan" calibrated the impact of the proposed expansionary
fiscal policy (we know it as an increase in G and/or a lower T) on jobs and GDP growth (Click
Here for paper). In order to do so, they make assumptions about the size of Government spending
and tax multipliers. One important assumption is contained in the paragraph below about the
level of the federal funds rate:
" For the output effects of the recovery package, we started by
averaging the multipliers for increases in government spending and
tax cuts from a leading private forecasting firm and the Federal
Reserve’s FRB/US model. The two sets of multipliers are similar and
are broadly in line with other estimates. We considered multipliers
for the case where the federal funds rate remains constant,
rather than the usual case where the Federal Reserve raises the
funds rate in response to fiscal expansion, on the grounds that
the funds rate is likely to be at or near its lower bound of zero
for the foreseeable future." So in this question, we are going to employ some of the tools that we have acquired throughout
the semester to understand how this assumption, "that the funds rate is likely to be at or near its
lower bound of zero for the foreseeable future," effects the government spending and tax
multipliers.
a) (30 POINTS) In this question, we are going to compare the size of the Government spending
multiplier under two different assumptions: i) the Fed sits on their hands so that when G rises, r
rises with it (the standard case), and ii) the Fed accommodates the (real) shock to money demand
so that real interest rates remain constant.
In the space below, draw 4 diagrams (label them 1 through 4) with 1) a closed economy desired
saving; desired investment diagram, followed by 2) an IS – LM diagram followed by 3) a money
market diagram followed by 4) an aggregate supply ; aggregate demand diagram.
We begin at our initial point A which is at an output well below potential GDP (i.e., there is a
significant 'output' gap). We let G rise and with the assumption that the Fed sits on their hands
(assumption i) above) we move to point B, which corresponds to an output closer to potential
GDP, but still not quite there. We then assume assumption ii) above so that the Fed 1 accommodates the real shock to money demand to keep real interest rates constant. This
assumption takes us to point C, which is at potential GDP (i.e., the output gap is gone!).
Start at an initial equilibrium and label as point A in all diagrams, with all the associated market
clearing variables denoted by subscript A. For example, in your IS – LM diagram, the interest
rate that clears the goods and money market is labeled as r A with the associated output at YA. Note
importantly that we are assuming fixed prices throughout this exercise. Now let G rise to G' and
show how all your graphs are affected. In particular, locate point B in all graphs making sure
you refer to each graph separately explaining the intuition of the movement from point A to
point B. Note, we are assuming assumption i), the Fed sits on their hands and does not
accommodate the shock to real money demand.
b) (20 points for explanation) We now apply assumption ii), the one Romer and Bernstein use
"that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future." In
terms of our analysis, the Fed is going to make sure that real rates remain at their initial level (i.e.,
they totally accommodate the real shock to money demand). Show this accommodation as point
C on all of your diagrams. Recall that we are at full employment/potential GDP at point(s) C.
Again, make sure you refer to each graph separately explaining the intuition of the
movement from point B to point C.
c) (20 points) Now compare the government spending multiplier under assumption i) no Fed
accommodation and ii) the Fed accommodates the real shock to money demand. Be specific with
regard to the multiplier as well as the intuition. To support your intuition, draw two diagrams: the
user cost = MPKf and the two period consumption model clearly locating points A, B, and C.
Referring to your 2 graphs, explain the intuition as to why we move from point A to point B as
well as why we move from points B to C. Be sure to label your graphs completely or points will
be taken off. Make sure you relate your discussion of your two graphs to the difference in the
multiplier depending on what the Fed does or doesn't do. 2 DO THIS QUESTION IF A TWO IS FLIPPED
#2 (70 points total) We recently discussed that investment in the US economy is weak and we
also discussed how important investment is for living standards in the future (for both workers
and firms!). An excerpt from a WSJ article dated 12/1/2015 is below:
11:59 am ET
Dec 1, 2015 Business Cycles CEOs’ Economic Outlook Dims as More
Plan to Pull Back Investment
“Companies are putting capital budgets together right now and don’t have a clear line of
sight on what their tax bill will be on those investments,” he said on a call with reporters
Tuesday. “When the tax code is uncompetitive, like ours is, it has the effect of
incentivizing investment elsewhere” in the world.
In this problem, we are going to assume that a 'supply sider' wins the election and
immediately lowers the effective tax on capital to make our tax code MORE competitive
(recall that the US has the second highest effective tax rate (on capital) in the world
according to our textbook).
a) (30 POINTS) In this part you are to explain exactly how lowering the effective tax rate on
capital (τ) will work (in theory) its way through the economy. In this discussion, you need to
differentiate between the short- run and long-run. In the space below, explain, with graphical
analysis, how lowering the effective tax rate on capital will influence real economic variables in
the short run (hint, it’s a demand side story). Draw 4 diagrams (label them 1 through 4), with 1)
a user cost ; desired capital (K*) diagram, followed by 2) a closed economy desired saving;
desired investment diagram, followed by 3) an IS – LM diagram followed by 4) an aggregate
supply ; aggregate demand diagram.
Start at an initial equilibrium and label as point A in all diagrams, with all the associated market
clearing variables denoted by subscript A. For example, in your IS – LM diagram, the interest
rate that clears the goods and money market is labeled as r A with the associated output at YA. Note
that YA, our initial equilibrium output, is below full employment output = Y B (we still have
slack in the economy, in fact the GDP gap is currently, as of Dec 2015, -3%). Now let the
effective tax rate on capital fall (same as a fall in τ) and show how all your graphs are affected. In
particular, locate point B as the new short-run equilibrium in all graphs (assume the standard;
that is, let output rise to YB = full employment Y) while holding the general price level fixed at
PA = PB. Make sure you refer to each diagram individually explaining how and why we get to
point B (i.e., provide intuitive economic reasoning starting with how a lower τ effects K* and
why)!). Be sure to include a discussion of why the real interest rate has to change the way it
does - hint, the money market! 3 b) (20 POINTS) Now we are going to focus on the idea that in the longer run, the influence of
the decrease in the effective tax rate on capital will have ‘supply-side’ effects. In particular, we
argue that this new investment, spurred on by the lower effective tax rate on capital, will result in
a positive productivity shock resulting in a higher “A and K" which will result in a shift upward
in the production function (via increasing the MPK f and MPN….these are the supply side
effects) In the space below draw a production function with the labor market diagram directly
below it and show what is going on in this longer run. That is, locate the corresponding point B
(from above), and then show the longer run influence as point C in these two (supply – side)
diagrams. What happens to N* and w*=W/P? Explain in detail. Are these results in the labor
market consistent an increase in the welfare of workers? Why or why not? Are these results
consistent with the business cycle facts? Now explain why output has changed, give two specific
reasons. Note, in this part of the problem, do not worry about identifying point A in the labor
market diagram and production function diagram since point A does not exist given the
assumption that labor markets always clear at full employment (i.e., a weakness of the classical
model). Be sure to label your graphs completely (relevant shift variables) or points will be taken
off.
c) (20 POINTS) Now show how graphs 1) through 4) are influenced by this longer-run
development. Note again that we assume that before these longer run developments take hold,
the FE line in graph 3) and the LRAS in graph 4) is set at YB. Now let these longer run
developments take hold, i.e., these supply side effects, and label this final equilibrium as point C.
Again, please make sure you refer to each diagram individually explaining how and why we
get to point C (i.e., provide intuitive economic reasoning!). Be sure to include a discussion of
why the real interest rate has to change the way it does - hint, the money market! 4 DO THIS QUESTION IF A THREE IS FLIPPED
#3. (40 POINTS TOTAL) The Fed's FRB/US is a New Keynesian model (Click Here for article).
Below is an excerpt from the article:
"An aspect of FRB/US that is closely related to slow market adjustment is the behavior of
inflation. In the model, firms seek to pay workers the value of their marginal
product and to price their output as a markup over trend unit labor and energy costs. However,
labor contracts and other factors create frictions that slow the speed at which wages
and prices adjust to shifts in demand and supply. (Commodity prices are an exception to this
behavior because they adjust quickly on world spot markets). Such ‘‘sticky-price’’ behavior is
incorporated into the equations of FRB/US that govern the response of inflation to changes in
economic conditions. An important implication of this view of the inflation process is that policydirected changes in short-term nominal interest rates have a temporary influence on the real rate
of interest."
a) (20 points) Begin with discussing why the New Keynesians believe that prices are sticky in as
much detail as possible. Then use the efficiency wage theory/model to buttress (support) your
argument (i.e., why does the efficiency wage theory play a critical role in explaining why
firms are willing to produce more output at the same price?) Draw two graphs, one showing
the effort curve and the efficiency wage (be sure to explain how firms pick the efficiency wage)
and the other being a labor supply- labor demand diagram with the assumption that the efficiency
wage (w*) is above the market clearing (classical) wage (w class). Why is this model so attractive
in dealing with the empirical reality in labor markets that the classical school has such a hard time
with and what is the empirical reality we are referring to? Please apply your answer to the recent
experience in US labor markets.
b) (20 points) Now draw two more diagrams depicting what is happening in the product markets
(demand, marginal revenue, marginal cost and profits) and why firms are willing to change
output at the given price level (short run), given a positive shock to (aggregate) demand? Begin
at point A with the initial conditions and then let the positive demand shock occur. Label the new
profit maximizing price, quantity, and profits as point B on both diagrams. Now locate points C
on both diagrams assuming that the firm did not immediately change prices and thus, kept prices
fixed, consistent with the ‘‘sticky-price’’ behavior alluded to in the excerpt above. Please be very
clear as to why exactly firms are willing to act like a 'vending machine' in the short run (be
willing to increase output at the same price). Is this firm behavior, being willing to increase
output at the same price, consistent with the firm’s profit maximizing objective? Why or why
not? 5 DO THIS QUESTION IF A FOUR IS FLIPPED #4 (40 points total) We are going to use the table below along with the graphic that
follows to analyze two different periods in history - the first, being the 'Hey Day' of
Keynesian economics during the 1960s and 1970s and the second, the Great Recession.
Recall the Time Magazine article from December 31, 1965..."We are all Keynesians
Now" and this excerpt: 'Secretary Willard Wirtz argues that the Government should
continue pushing and stimulating the economy, even at the risk of some inflation, in
order to bring unemployment down to 3%.' 6 7 a) (20 points) Explain what the Phillips curve is and why would we expect in theory, the
relationship between these two vitally important macroeconomic statisitics to exist. That
is, give the intuition as to why we would expect this relationship to hold in the real world.
Now draw two diagrams: an AS - AD diagram and a Phillips curve diagram locating
points A, B, and C on both diagrams.
Writing about this period and Keynesian economics, Kydland and Prescott argued that it
would better for policy makers and the economy if policymakers would establish a rule
and stick to it. Please apply this principle to your diagrams above referring to the misery
index. Why didn't Keynesian economics during this time work, that is, why was trying to
get unemployment down to 3% a bad idea?
b) (20 points) Now let's update to the great recession: Draw two diagrams: an AS - AD
diagram and a Phillips curve diagram locating points D, E, and F on both diagrams.
Please be sure to completely label your diagrams.
Why do your results differ so much between the 'Keynesian period above' vs. the Great
Recession? - note that monetary policy and fiscal policy were expansionary in both
periods. Please explain using the intuition we discussed in class. To support your
arguments, draw the cyclically shaped aggregate supply curve that we drew in class
locating points A and C from part a) and points E and F from this part b).
8 DO THIS QUESTION IF A FIVE IS FLIPPED #5 (30 points total) We have been discussing all semester about when and if the Fed is
going to get off the zero bound and start raising interest rates (aka, the exit strategy). In
fact, it appears quite likely that the Fed will get off the zero bound at after their 2 day
meeting Dec. 15 and Dec 16.
a) (10 points) In class we watched a WSJ clip explaining how the new tools of the Fed
will work when the Fed decides to get off the zero bound. Pretend that you are the Chair
of the FOMC and you were in charge of writing the statement that is highly anticipated.
Following the WSJ clip and the Fed's model of the exit strategy, please write the
statement below. Make sure you refer to the new tools and make sure you include the all
important forward guidance......I will get you started........ Today, the FOMC agreed to
change ...............
b) (10 points) Now suppose you were Gagnon and Sack and you were in charge of
writing the statement that follows the Dec. 15 and Dec. 16 meeting. Again, make sure
you refer to the new tools and the all important forward guidance. ......I will get you
started........ Today, the FOMC agreed to change ...............
c) (10 points) Now write an essay discussing the pros and cons on how the Fed plans on
conducting the 'exit strategy' and compare it to the pros and cons of the exit strategy
proposed by Gagnon and Sack. 9 DO THIS QUESTION IF A SIX IS FLIPPED #6 (30 points total) The following excerpt is from the article that we reviewed with the
graphics depicting the power of putting a date on forward guidance. How severe has the zero lower bound
constraint been?
Eric T Swanson 08 November 2014 (click Here for the article)
In December 2008, the Fed lowered the federal funds rate to essentially zero and has kept
it there since then. This column argues that, contrary to traditional macroeconomic
thinking, monetary policy has not been severely constrained by the zero bound until mid2011. The results imply that the Fed could have done more to ease monetary policy
between 2009 and 2011. These findings could also help explain why the fiscal stimulus
package adopted in 2009 did not bring the expected success.
a) (10 points) Explain how forward guidance, especially after we hit the zero bound, is
supposed to work in terms of influencing real economic activity. Use and explain the pure
expectations theory and how exactly the fed can influence longer term interest rates via
forward guidance (be sure to use a few equations). How do the authors of the paper
prove that forward guidance did not have maximum bite until mid 2011?
b) (20 points) The authors argue that the Fed could have done more to ease policy
between 2009 and 2011. Draw two diagrams, one being the user cost - desired capital
stock and the other the two period consumption model. Locate as point A, the desired
level of capital say in 2010, given that the Fed acted as they did with regard to forward
guidance and label as K*A. Similarly, in your two period consumption diagram, label as
points C*A and Cf*A, the level of current and future consumption given the Fed acted as
they did with regard to forward guidance. Now suppose the Fed did put a date on their
forward guidance as soon as they hit the zero bound in Dec. 2008. Label this as points B
on both diagrams. Explain exactly why real economic activity, in terms of investment and
consumption has changed relative to point(s) A.
Are your results consistent with the following passage? Why or why not?
"These findings could also help explain why the fiscal stimulus package adopted in 2009
did not bring the expected success." 10 YOU MUST DO THIS QUESTION - THERE IS NO CHOICE
#7 (20 points) a) In Ben S, Bernanke's book: "The Courage to Act" he writes of when overnight
lending markets first began becoming tight. It was on August 9, 2007 when BNP Paribus ( a bank
in France) suspended withdrawals from its sub-prime funds. News from European markets arrives
in early morning and short term financial markets in the US were feeling the brunt. That morning,
Ben Bernanke emailed Brian Madigan (a Penn Stater) to instruct the New York Fed to purchase
large quantities of Treasury Securities on the open market. The New York Fed ended up
purchasing $24 Billion in Treasury securities that morning. The target for the Federal Funds rate
at this time was 5 1/4 %.
a) (10 points) Draw a Reserve Market Diagram depicting the state of affairs on August 8, the day
before the shock, assuming the Fed was hitting their target exactly. Now depict the shock and the
reaction of the New York Fed assuming that they purchased just enough securities to get the
federal funds rate back to target. What would determine how many securities that the New York
Fed would have to purchase to bring the federal funds rate back to target?
b) (10 points) Let's pretend that the exact same shock occurs but that we are in a world where
there is about $2.6 trillion in excess reserves (this is the current number as of Oct. 2015) and that
the Fed is paying 5 1/4% for holding these excess reserves. Redraw the reserve market diagram as
above locating point A. Now, given this new regime, show point B and explain exactly what is
going on here. Does Brian Madigan have to instruct the New York Fed to purchase large
quantities of Treasury Securities on the open market? Why or why not? Explain. 11