Download Week 9 Practice Quiz f Answers

QUIZ 5: Macro – Fall 2015
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Quiz assumptions (READ!): Use the models developed in class with our standard assumptions.
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All consumers are non-liquidity constrained, non-Ricardian PIH (as developed in class)
Expected inflation has no effect on money demand; NX = 0 .
All changes are permanent and unexpected unless told otherwise
The economy is initially in long run equilibrium at Y* (i.e., we start at Y*)
TFP, taxes, consumer confidence, value of leisure, population, government spending, and the
nominal money supply do not change unless I tell you they change
Question 1 (circle all the true answers – 7 points total, 1 point each)
Which of the following are definitely true about an unexpected permanent decrease in government
spending? Assume the self-correcting mechanism returns the economy to Y*.
Mariel provided the following graphical answers to our question. You should be able to follow the
steps to the short run equilibrium (point 1) and the new long run equilibrium (point 2).
Summary: In the short run, the decrease in G causes the IS curve to shift to the left, the AD
curve to shift to the left, and the LM curve to shift to the right (because of lower prices). In the
long run, wages begin to fall, SRAS curve shifts right, lowering prices, causing LM to shift right
again.
a. Interest rates (r) will fall between the short run and the long run.
True – In the short run, N < N* and Y < Y*, P falls causing W/P to rise. In the long run, as W
falls via the self-correcting mechanism, the SRAS curve shifts right putting further downward
pressure on prices. This causes M/P to rise shifting LM to the right and putting downward
pressure on interest rates. (As an aside, the downward pressure on interest rates causes I to
increase, not because I(.) shifts but because the endogenous response of investment to changing
interest rates – sliding down the IS curve).
b. The IS curve will shift out between the short run and the long run as investment falls.
False – the IS curve shifted left in the short run, and remained there in the long run.
c.
Consumption (C) will fall between the short run and the long run.
False – there is no change in PVLR (in short run or long run – so, no change in consumption).
d.
The labor supply curve will shift right between the short run and the long run.
False – there is no shift in the labor supply curve. In the short run, we are off our labor supply
curve. We are on the labor demand curve in the short run. We move up the labor demand
curve in the short run and back down the labor demand curve between the short run and the
long run.
e.
The money demand curve will shift right between the short run and the long run.
True. Money demand shifts with changes in Y. Between short run and the long run, Y
increases, so Money Demand shifts right.
f.
The money supply curve will shift right between the short run and the long run.
True. Money supply shift with P and M. As P falls between short run and long run, M/P
increases (see above). This is a shift right in the money supply curve.
g.
Real wages will fall between the short run and the long run.
True. See above. As P falls between short run and long run, W/P falls between short run and
long run.
Question 2 (circle all the true answers – 5 points total, 1 point each)
Which of the following are definitely true about an unexpected permanent increase in the money
supply (M)? Assume the self-correcting mechanism returns the economy to Y*.
This all comes from supplemental notes 12. See Mariel’s graphs below.
Summary: In short run, LM shift right once and AD shifted right once, causing prices to rise.
This caused LM to shift left some. In the long run, the self-correcting mechanism increased
nominal wages, SRAS shifted up/left, raising prices, causing LM to shift back to its original
position.
a. The IS curve will be shifted right in the long run (relative to its initial position).
False – see above. No change in C(.), I(.) or G in either short run or long run – so, the IS curve
stays fixed through this example.
b. The LM curve will be shifted left in the long run (relative to its initial position).
False – see above (both M and P increase by same amount so M/P will not change). We know
this has to happen because no change in Y in the long run. This can only happen when there is
no change in I (given C(.) and G do not change). This can only happen when there is no change
in r. r is only fixed in long run when M/P stays fixed in long run.
c. The money demand curve will be shifted right in the long run (relative to its initial position).
False – see above (no change in Y in long run).
d. The AD curve will be shifted right in the long run (relative to its initial position).
True – M increases (and stays at the new level). That shifts the AD curve right in short run and
stays shifted right in the long run.
e. The SRAS curve will be shifted left in the long run (relative to its initial position).
True – as W/P is low in the short run, W will rise. This will shift in the SRAS putting upward
pressure on prices.
Question 3 (4 points total—no partial credit: 0 or 4 points)
Consider a permanent decrease in labor income taxes where income effects on labor supply are equal
to substitution effects on labor supply. Assume the economy returns to Y* via Federal Reserve
policy. Which of the following statements is unambiguously true? For this problem, circle only
one of the following answers.
a. Consumption will increase in the long run (relative to its initial position).
True – taxes fall and PVLR (in after tax terms) increases. There will be no shift in the labor
supply curve on net. So, before tax wages will not change. Given that taxes fell, after tax wages
will increase permanently (increasing PVLR).
b. Investment will decrease in the long run (relative to its initial position).
True – this is the crowding out of investment due to increased consumption. As interest rates
rise, I will fall. This is a movement along the AD and IS curves. Y = C(.) + I(.) – dI r + G.
There is no change in I(.) and G. The increase in C(.) is offset by a decline in I (from the
endogenous interest rate response).
c. The labor supply curve will be shifted right in the long run (relative to its initial position).
False. You know this. This was a midterm question. If the income and substitution effects
cancel, the labor supply curve will not shift.
d. (a) and (b) are true.
e. (a) and (c) are true.
f.
(a), (b) and (c) are all true.
g. None of the above answers are true.
Question 4 (4 points total—no partial credit: 0 or 4 points)
Consider a permanent increase in government spending (G). This question compares two scenarios.
In scenario 1, the economy returns to Y* via the self-correcting mechanism. In scenario 2, the
economy returns to Y* through Federal Reserve policy. Assume the Federal Reserve policy takes
place after the economy gets to its short run equilibrium. Which of the following statements is
unambiguously true? For this problem, circle only one of the following answers.
This comes directly from last week’s lecture. Both via self correcting mechanism and Fed
stabilization policy, there is perfect crowding out of investment. In both cases, the absolute
value of the change in investment will equal the increase in government spending (this rules out
answer (a)). In order for that to happen, interest rates need to be the same in both scenarios in
the long run (this rules out answer (c)). Given that there is no change in real wages in the long
(in both scenarios) and both scenarios are at the same level of real wages in the short run, the
change in real wages between the short run and the long run are the same in both scenarios
(ruling out answer (b)). However, in scenario 1 (self correcting mechanism), W rises between
the short run and the long run (causing W/P to rise). In scenario 2, W does not rise between
the short run and the long run – instead P falls back to its original level. Therefore, d is the
correct answer.
a. The change in investment (I) in the economy between the short run and the long run is
bigger in scenario 1 vs. scenario 2.
b. The change in real wages (W/P) in the economy between the short run and the long run is
bigger in scenario 1 vs. scenario 2.
c. The change in real interest rates (r) in the economy between the short run and the long
run is bigger in scenario 1 vs. scenario 2.
d. The change in nominal wages (W) in the economy between the short run and the long run
is bigger in scenario 1 vs. scenario 2.
e. All of the above are true.
f.
None of the above answers are true.