Final Exam. You may not use calculators, notes, or aids of any kind.

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1 Professor Christiano Economics 311, Winter 2005 Final Exam IMPORTANT: read the following notes You may not use calculators, notes, or aids of any kind. A total of 100 points is possible, with the distribution by question indicated in parentheses. Explain your answers carefully in clear English. Write neatly and label all diagrams. cannot read your answer. We cannot give you credit if we Write your name here: CIRCLE your TA Helge - 9:00 Fri (101 Annenberg) Helge - 3:00 Fri (32 Annenberg) Jon - 9:00 Fri (32G Annenberg) Jon - 3:00 Fri (203 Harris) Nenad - 9:00 Fri (203 Harris) Nenad - 3:00 Fri (308 Harris) Scores: Q1: Q2: Q3: Q4: Q5: Q6: Total: 1

2 Here are some basic economic relationships and notation that are useful for working this exam. The supply-side of the economy in the short and medium run is summarized by the following equations: Price setting : P = (1 + )W=a Wage setting : W = ap e F (u; z) Unemployment-Output Link : u = 1 N=L Production Function: Y = an; where N denotes total employment and a is the productivity of labor. Aggregate demand is Z: Z = C d + I d + G d + NX d ; where the superscript d means desired or planned. Also, Household Consumption: C d = c 0 + c 1 (Y T ) ; Business Investment: I d = I bi + qy; Net Exports : NX d = NX("; Y; Y ); G d = G; T = T ; Real Exchange Rate : " = EP P : The asset markets are summarized by: UIP: i = i + Ee E + ; E Money Demand: M d = P L(i; Y ); Money Market Clearing: M s = M; where c 0 ; c 1 ; b > 0; c 1 < 1; and could be positive, negative, or zero. Also, F is a decreasing function of u; and z captures other in uences on the bargaining power of workers. A superscript d means desired. No superscript on a variable means actual. A * superscript means foreign, and all such variables are exogenous. Finally, P e and E e are the expected future values of the price level, P; and the exchange rate, E, respectively. The open economy IS-LM model is composed of the real exchange rate condition, UIP, Money Demand, the Money Market Clearing condition, and goods market clearing (Y = Z). In the open economy IS-LM model, E e and P are exogenous variables. The AD AS model is composed of the goods market clearing condition, Y = Z; the money market clearing condition, the price setting equation, the wage setting equation, the unemployment-output link and the production function. In the standard AD AS model, q = 0: 2

3 1. (20) Shorter questions. (a) (3) A crucial reason why changes in the money supply have an e ect on the economy is that price expectations are slow to adjust. Explain by discussing what happens with a change in M when price expectations are slow to adjust and when they are quick to adjust. (b) (3) Explain why NX is an increasing function of "; a decreasing function of Y and an increasing function of Y : (c) (2) Explain why F is a decreasing function of u: (d) (3) What is it about the business investment decision that q > 0 is designed to capture? 3

4 (e) (3) Why is it that a enters negatively in the price setting equation? (f) (2) Explain why it is that when Y goes up by $1, Z goes up by less than $c 1 : (g) (4) What happens to output in the open economy IS-LM model, if E e suddenly jumps? 4

5 2. (15) Consider a rise in a: (a) (10) What are the short and medium run e ects on the interest rate, output, employment, investment, consumption, unemployment, the real wage, W=P; and the price level of the rise in a in the standard AD AS model when the money supply, M; is held xed. Provide necessary graphical and mathematical analysis to the right of the table. Short-run i Y N I C u W=P (b) (5) Describe how the analysis part (a) of this question is modi ed if M is increased when a rises. In particular, what happens to the short run unemployment response to the rise in a? Provide necessary graphical and mathematical analysis to the right of the table. Short-run i Y N I C u W=P 5

6 3. (10) When the central bank depreciates the currency, a force comes into play that increases net exports, and a force comes into play that decreases net exports. Explain what these forces are and explain why policymakers in foreign countries refer to one of these forces with the phrase, beggar they neighbor, and to the other one as the locomotive. 6

7 4. (20) Suppose there are civil and other disturbances in the rest of the world, and that people view the US economy as a safe haven for their assets. (a) (5) Explain why this idea is nicely captured by a drop in in the UIP equation. (b) (5) Explain in detail what the drop in does to the location of the IS curve. 7

8 (c) (5) Explain the impact of the drop in on equilibrium consumption, output, and the interest rate in the open economy IS-LM model. (d) (5) Suppose the monetary authority wants to completely insulate US economic output from the e ects of the shock to : What does it need to do to the money supply? Explain, using graphs. 8

9 5. (10) Why is it that a monetary authority which applies a little stimulus to the economy to get unemployment below the natural rate, risks ultimately ending up in a situation where it needs to add stimulus just to stop the economy from dropping below the natural rate? 9

10 6. (25) Fiscal Policy (a) (3) Consider the standard AD-AS model described at the beginning of the exam. With prices on the vertical axis and output on the horizontal axis, show what happens when exogenous government spending increases by G. Note the original medium-run equilibrium, the short-run equilibrium, and the new medium-run equilibrium by 1, 2, and 3 respectively. (b) (3) With prices on the vertical axis and output on the horizontal axis, show what happens when taxes are increase by T. Note the original medium-run equilibrium, the short-run equilibrium, and the new medium-run equilibria by 1, 2, and 3 respectively. 10

11 (c) Instead of examining those two shocks separately, we will consider the case in which they are implemented simultaneously. Assume that Congress passes a budget that calls for both an increase in government spending, G, and an increase in the taxes, T. Furthermore, assume that the increase in spending is completely nanced by taxes such that T = G. i. (5) Assume that q > 0. With interest rates on the vertical axis and output on the horizontal axis (the IS-LM graph), show which curve(s) shift in the short-run, if any, and precisely by what amount. Denote any short-run shifts with a single (for example, IS or LM ). Use algebra to support your assertion. On the same graph show the movement, if any, of any other curves in the medium-run. Denote any medium-run movements with a double (for example, IS or LM ). ii. (5) Use these results to motivate an AD-AS graph describing the same situation. Show the initial, short-run, and medium-run e ects on these simultaneous shocks, and denote the equilibria by 1, 2, and 3 respectively. 11

12 iii. (9) Compare the new medium-run equilibrium after G increases by G and T increases by G to the old medium-run equilibrium. What happens to Y; I; C; i; W; P; M=P. Explain. Variable New MR vs. old MR Reason Y I C i W P M=P 12

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