Solutions. Question 1. Given what we have learned in class, which of the following statements are true and which false? (1 point each 6 points total)

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1 QUIZ 7: Macro Winter 2008 Solutions Question 1 Given what we have learned in class, which of the following statements are true and which false? (1 point each 6 points total) a) In a short run equilibrium both the money market and the goods market are in equilibrium. TRUE. By definition, a short run equilibrium is the intersection between the IS and the LM curve! b) If the IS curve is steeper, a monetary policy is less effective TRUE. That is something is going on now! The IS is steeper if I and C do not react much to the nominal interest rate on government bonds. This is what happens now that the banking sector is in crisis and firms and households know that whatever is i, they will be cut out from credit! Hence, a monetary policy, which affects i, won t be very effective. c) In the long run, money is neutral. TRUE. In the long run the aggregate supply is vertical at Y*, so a change in M does not affect Y*, but will be reflected only in prices! d) If the economy is at its potential Y* and there is a contractionary monetary policy (the Fed decreases money supply), in the long run prices will be higher. FALSE. If M decreases, in order to have an equilibrium in the money market, the interest rate needs to be higher and this reduces I and C, pushing down output. In the short run, firms will reduce prices but the nominal wage will be fixed so that the real wage is higher than before and firms reduce employment and Y. In the long run firms will start cutting nominal wages and the SRAS will shift to the right, reducing prices even further. In the long run Y will go back to Y*, but prices will be lower! e) If we are in a recession, Y<Y*, and Y* does not change, according to our model of the short run based on sticky wages (version 2), nominal wages will tend to increase in the long run.

2 FALSE. If we are in a recession, according to our sticky wage model, we are on the labor demand curve but not on the labor supply and in particular there is underemployment, that is, N<N*, and workers work less than they would like for the current real wage. This means that in the long run firms will tend to cut the nominal wages to go back to an equilibrium in the labor market. f) Imagine the economy starts at potential Y*. In response to a negative shock to demand, e.g. Investment declines, output will drop more in the short run if we believe that prices are sticky (version 1) rather than if we believe that only nominal wages are sticky (version 2). TRUE. If we believe that all prices, both goods prices and wages, are sticky there are more rigidities in the economy and output will drop more in response to a negative demand shock. Question 2 What does it mean that the United States is now in a liquidity trap? (Be short 4 points) This means that the nominal interest rate has hit the 0 lower bound, so that the standard monetary policy is now powerless. If the Fed conducts more open market purchases, she will inject money in the economy, but people will be willing to hold their wealth in money because they will never accept a negative nominal interest rate on bonds. Hence a standard monetary policy will not change the nominal interest rate on non-monetary assets and hence won t have an expansionary effect on the real economy.

3 Question 3 Suppose that the economy is at the potential level of output Y* and the government conducts a one-time permanent increase in G (from G 0 to G 1 >G 0 ). Answer the following questions. If no curve shifts, answer NO to the direction question. (2 point each letter 16 points total) Assume that: 1) consumers are non-ricardian, that is, that they do not think about a future increase in taxes (their PVLR does not change); 2) wages are sticky, that is, we are in Version 2 of the short run and the SRAS is upward sloping. THINK ABOUT THE SHORT RUN FOR QUESTIONS (a)-(d) a) What happens to the AD-SRAS? 1. Which curve is going to move? AD 2. In which direction? To the right The AD shifts to the right because as G increases, there is more aggregate demand for goods! Hence in the short run equilibrium both output and prices are going to be higher. b) What happens to the IS-LM? 1. Which curve is going to move? IS and LM 2. In which direction? IS to the right and LM to the left The IS shifts to the right because of the increase in demand coming from the government! If we believe that the consumers are not perfectly PIH, but react to current output, then the Keynesian multiplier is actually bigger than 1 and an increase in G will increase C as well, given that C reacts to Y and an increase in G increases Y in the short run! Also, as prices are increasing (see previous demand) the real money supply decreases and the LM shifts to the left. c) What happens in the labor market? 1. Which curve is going to move? None. 2. In which direction? No.

4 The demand and supply of labor do not shift because of the increase in G. What happens is that as the demand for goods increases, then firms will increase prices and, given that in the short run by definition nominal wages are fixed, this decreases real wages. This generates a movement ALONG the labor demand curve only, not a shift!!! THINK ABOUT THE LONG RUN FOR QUESTIONS (e)-(h). LIST ONLY THE MOVEMENTS THAT HAPPEN IN THE LONG RUN AND DO NOT IN THE SHORT RUN. d) What happens to the AD-SRAS? 1. Which curve is going to move? SRAS 2. In which direction? To the left In the short run the labor market is not in equilibrium because workers work more than they would like for the given real wage. In the long run the nominal wages need to increase, and hence the short run aggregate supply curve will shift to the left because the cost for the firms are going to be higher and hence they are willing to supply less goods for the same price level! Hence, the long run equilibrium will be characterized by the original level of potential output, but by higher prices! e) What happens to the IS-LM? 3. Which curve is going to move? LM 4. In which direction? To the left As nominal wages increase in the long run and, so that prices increase further, the supply of real money balances decreases. This shifts the LM to the left until Y=Y*! So in the long run output will be the same but interest rate will be higher, which means that private investment and consumption have been crowded out by Government spending.

5 f) What happens in the labor market? 1. Which curve is going to move? None 2. In which direction? No In the long run, still there is no shift in the demand or supply for labor! What happens is that by definition the labor market must be in equilibrium! Given that in the short run real wages are lower than in equilibrium and workers are working more than they would like, there is pressure in the labor market to increase the real wage, and in the long run the nominal wage will increase so that the real wage goes back to its equilibrium level! Once again, there is going to be a movement along the labor demand. Question 4 In the Economist article Lessons from a lost decade, the journalist compare the economic condition of the United States the past September with the economic condition of Japan in the 90s. What is one of the main advantage of the United States in comparison to Japan? (4 points) You could have answered this questions in many ways (you get full credit for any of these): 1. America has relatively high inflation, while Japan had deflation 2. When the article was written, American banks have been quicker to disclose and write off losses and raise new capital 3. America is spreading the costs of its housing bust across other countries. Foreigners hold a large slice of American mortgage-backed securities.