ECON 304 Final Exam | Complete Solution

Name ________________________________ Last 4 PSU ID____________

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.... next flip, you will do question #7 OR question #8., 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 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 rA 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.

 
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 rA with the associated output at YA. Note that YA, our initial equilibrium output, is below full employment output = YB (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!
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 MPKf 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! 
 
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 policy-directed 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 (wclass).  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 during.

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).  Shade in the additional profit when this firm acts like a vending machine and increases 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? 

 
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%.'

a) (20 points) Explain what the Phillips curve is and why would we expect in theory, the relationship between these two vitally important macroeconomic statistics 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? Why did inflation and the unemployment rate behave the way they did. Refer to the behavior of the misery index during this period. 

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).  

DO THIS QUESTION IF A FIVE IS FLIPPED

5.  (50 points total):  We discussed in class how Federal Reserve Policy has changed dramatically in the last 10 years. 

a) (20 points total - 10 for discussion - 10 for graph) Let us go back 10 years to March, 2006. Below is the first line of the FOMC statement from March 28, 2006. 
Release Date: March 28, 2006 
For immediate release 
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-3/4 percent. 
i) (10 points) Explain exactly how monetary policy worked back in March of 2006. That is, who exactly decides on changing the target for the federal funds rate and what exactly is the federal funds rate? How does the federal funds market operate - what is it used for? What is the operational aspect of changing the target for the federal funds rate as above (this is in 2006!)? 

ii) (10 points) Now use a graph of the federal funds market and depict exactly how the Fed would successfully raise the target by 25 basis points to 4 3/4 %. Begin with conditions before the March 28, 2006 FOMC announcement and label as point A.  Then show the change in conditions as point B. Assume that reserve demand is constant. Explain how and why your graph changes. What type of open market operations does the Fed need to conduct?

b) (10 points) Now let's update to the present. As we know, the Fed 'got off the zero bound' in December 2015. How did they do this?  How did the FOMC statement change relative to the 2006 statement. Be specific! What did the statement say exactly and how does this new monetary regime work exactly?.  

c) (10 points) The FOMC is contemplating another move at their April meeting and the decision whether to raise rates again depends critically on the labor market report released on Friday, April 1 (no fooling!) . Suppose that this report is extremely positive and thus, the Fed raises rates by another 25 basis points at their April 2016 FOMC meeting. How would they do this exactly and how and why would the federal funds rate change? How would the statement change? (more room on next page)

d) (10 points)  Now draw a graph with time on the horizontal axis and interest rates on the vertical axis - you need to have 3 different interest rates on the vertical axis (we did this in class). On the graph, clearly label the period of the 'zero bound', the period associated with the move in December of 2015, and the period after the hike at the April 2016 meeting (as assumed above). Make sure you label your graph completely including the horizontal axis representing time and the vertical axis representing interest rates. 

 
DO THIS QUESTION IF A SIX IS FLIPPED

6) (50 points total) The two tables below show the response of various interest rates to previous FOMC statements. The first Table shows the response to the Dec 16, 2016 FOMC statement where the Fed got off the zero bound by raising rates. The second Table shows the response of various interest rates to the most recent meeting when the FOMC decided not to change interest rates. please answer the questions below.  

Table 1
 

Table 2

a)(10 points) We are focusing on the reaction of the 1-year, 2-year, and 3-year Treasury constant maturities to the FOMC statement of Dec 16, 2015. What was the reaction, in basis points, of the 1-year, 2-year, and 3-year interest rates to the Dec. 16 announcement (compare to Dec 15, the day before the announcement) and how do these changes relate to the change in the federal funds rate (top row) between Dec. 16 and Dec. 17?  Explain why there was such a large difference in the movement of the Federal Funds rate relative to the other 3 interest rates.    

b)(10 points) We now focus on the reaction of the 1-year, 2-year, and 3-year Treasury constant maturities to the most recent FOMC statement of March 16, 2016. What was the reaction, in basis points, of the 1-year, 2-year, and 3-year interest rates to the March 16 announcement (compare to March 15, the day before the announcement) and how do these changes relate to the change in the federal funds rate (top row) between March 16 and March 17?  Explain why there was such a large difference in the movement of the Federal Funds rate relative to the other 3 interest rates.    

c)(10 points) The first line of a WSJ article we discussed in class that was written the night of  Wednesday, March 16, 2016 is below:

The Federal Reserve eased monetary policy on Wednesday, and the global economy is safer for it.

Explain exactly how the Fed eased monetary policy on Wednesday, March 16, 2016. Are your  results from part b) consistent with easier monetary policy? To support your answer, what happened to the one year interest rate expected one year from now - our notation is i12e. 

d)(10 points)  Regarding the lessons learned from the research on forward guidance, did the Fed employ  the lesson learned from the research following their March 15 - 16, 2016 FOMC meeting? Why or why not - explain. What was the lesson learned and how exactly did we learn the lesson on forward guidance? 

e) (10 points)  Now draw a graph with time on the horizontal axis and interest rates on the vertical axis - you need to have 3 different interest rates on the vertical axis (we did this in class). On the graph, clearly label the period of the 'zero bound', the period associated with the move in December of 2015, and the period after the hike at the April 2016 meeting (we assume another 25 basis point at their April meeting). Make sure you label your graph completely including the horizontal axis representing time and the vertical axis representing interest rates. Explain why the federal funds rate will change when the Fed changes interest rates.

 
DO THIS QUESTION IF A SEVEN IS FLIPPED
#7 (40 points total) We discussed the business cycle fact that government purchases is a pro-cyclical economic statistic. 

a) (20 points) First, explain how the real business cycle theorists explain the pro-cyclical behavior of government purchases. In the space below, draw three diagrams - a labor market diagram, a production function diagram, and an IS - LM - FE diagram. Start at point A and let G rise. Show and explain how each of your three diagrams are effected by the increase in G and label as  point B. Be sure to explain how each of your diagrams are effected - the intuition of moving from points A to B. Do the real business cycle theorists believe that it is a good idea to fight recessions with expansionary fiscal policy as defined by increases in G? Why or why not? Explain.

b) (20 points) Now explain how the New Keynesians explain the pro-cyclical behavior of government purchases. In the space below, draw a savings - investment diagram, an IS, LM, FE diagram, and an aggregate demand - aggregate supply diagram. Start at point A and allow the increase in G to move us to point B. Be sure to label all your diagrams completely. What does the power of this fiscal policy critically depend on.  Be sure to mention the state of the economy in your discussion.  Does investment get crowded out in this model and if so, what determines the degree of crowding out? Why do critics dislike the idea of crowding out so much, especially with regard to investment getting crowded out?

DO THIS QUESTION IF AN EIGHT IS FLIPPED
#8 (40 points total) We discussed the business cycle fact that money is a pro-cyclical economic statistic.

a) (20 points) First, explain how the real business cycle theorists explain the pro-cyclical behavior of money. In the space below, draw three diagrams, a money market diagram, an IS - LM - FE diagram, and an aggregate demand - aggregate supply diagram. Start at point A and describe how the business cycle theorists explain the fact that money is leading and pro-cyclical as we move from point A to point B. Be sure to explain the move from point A to B in all three diagrams. Now show what would happen if the Fed did nothing and label as points C. Is this result desirable, why or why not? Do the real business cycle theorists believe that it is a good idea to fight recessions with expansionary monetary policy as defined by increases in M? Why or why not? Explain.

b) (20 points) Now explain how the New Keynesians explain the pro-cyclical behavior of money. In the space below, draw a money market diagram, an IS - LM - FE diagram, and  savings - investment diagram, an IS, LM, FE diagram, and an aggregate demand - aggregate supply diagram. Start at point A and allow the increase in M to move us to point B. Be sure to label all your diagrams completely.  What does the power of expansionary monetary policy depend on? Be sure to mention the state of the economy in your discussion.