Download 2014 Final Exam Answers

FINAL EXAM: Macro 302 – Winter 2014
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State clearly your assumptions when you derive a result. You must always show your
thinking to get full credit. You have 3 hours to answer all questions. Good luck!
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Question 1
Prices
What is the core PCE? Discuss its advantages over core CPI. (20 pts.)
Answer:
PCE stands for ‘Personal Consumption Expenditure Deflator’.
The CPI is the ‘Consumption Price Index’. A price index is a ratio showing the price of a basket
of goods and services in various years in relation to the price of the basket in a base year. The
quantities in the basked are kept at some reference basket level and are the same as in the base
year .
PCE is a ‘Deflator’. For example, the GDP Deflator is constructed by dividing nominal
GDP (i.e. measured at current prices) by the real GDP measured with respect to the prices in the
base year. Each component of GDP has a deflator, which is computed similarly as the GDP
Deflator. The ‘Personal Consumption Expenditures’ focuses on consumer expenditure in final
goods and services (think of retail sales data for food, clothing, autos, etc.): it is the deflator used
for aggregate consumption C.
Therefore, the essential difference is that in the CPI the quantity weights of the items in the
consumer basket do not change relative to the reference basket, while in case of the PCE the
weights are allowed to change each year. Therefore the CPI fails to capture shifts in spending by
consumers toward cheaper goods and tend to overstate inflation rates. As the PCE re-weights the
consumption bundle each year, it overcomes this shortcoming of CPI.
Question 2
Fiscal stabilizations
Suppose the economy is hit by a negative shock to consumer confidence.
You are required to describe the stabilization effects of two different policies: 1. An increase
in government spending G; 2. A permanent reduction in labor income taxes.
In the first three sets of graphs describe graphically how the short run, the labor market and
the long run equilibrium will change in response to an increase in government spending in
conjunction to a fall in consumer confidence. In the second set of graphs describe graphically
how the short run, the labor market and the long run equilibrium will change in response to
permanent reduction in labor income taxes in conjunction to a fall in consumer confidence.
Assume that all workers experience zero income effects and are non-ricardian.
Compare the two policies. Which one would you recommend?
Answer:
In the following graphs it is shown that both policies can offset the negative shock of decreasing
consumer’s confidence level in the short run. However, a permanent decrease in labor income tax
has different long run consequences, as it can also boost output in the long run by increasing the
labor supply and the equilibrium level of employment in the labor market.
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Short run: increase in government spending in conjunction to a fall in consumer
confidence here (10 pts.)
LRAS
Ns
SRAS
P0
P1
W0/P0
ND
AD’
AD
Y1* Y0*
N*0
LRAS
LM
r0
IS’
IS’’ IS
Y0*
NOTES
Let us consider a partial offset of the negative shock. For the Goods Market: The drop in
consumer’s confidence depresses the private consumption, C, and hence shifts the IS curve
inwards from IS to IS’. The increase in government offsets the negative shock and shift it
backward to IS’’. The AD curve as a result shifts in and the short run equilibrium is determined
by the intersection of AD’ and SRAS. The output changes from Y0* to Y1* and the price drops from
P0 to P1.
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Labor market: increase in government spending in conjunction to a fall in consumer
confidence here. (10 pts.)
LRAS
Ns
SRAS
W0/P1
P0
P1
Unempl.
W0/P0
ND
AD’
AD
Y1* Y0*
N1* N*0
LRAS
LM
r0
IS’
IS’’ IS
Y0*
NOTES
The drop in price level increases the real wage, as the nominal wage is fixed in the short run. In
the short-run we climb up the labor demand curve to N1*, which is the employment level
corresponding to the output Y1*.
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Long run: increase in government spending in conjunction to a fall in consumer
confidence here (10 pts.)
LRAS
SRAS
Ns
SRAS’
W0/P1
P0
P1
P2
W2/P2=W0/P0
ND
AD’
AD
Y1* Y0*
N1* N*0
LRAS
LM
r0
IS’
IS’’ IS
Y0*
NOTES
In the long run, because of the self-correcting mechanism, the nominal wage is going to adjust
down to W2. In the meanwhile, the price level in the AD_AS space is adjusting to P2. The real
wage in the long run will converge to the original one, i.e. W2/P2=W0/P0 clearing the labor
market. The SRAS shifts outwards and goes through the intersection point of AD’ and LRAS. In
the long run the output converges back to Y0* and the price level further drops to P2.
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Short run: permanent reduction in labor income taxes in conjunction to a fall in consumer
confidence here (10 pts.)
LRAS
Ns
SRAS
P0
P1
W0/P0
ND
AD’
AD
Y1* Y0*
N*0
LRAS
LM
r0
IS’
IS’’ IS
Y0*
NOTES Again let us consider a partial offset of the negative shock. For the Goods Market, the
drop in consumer’s confidence depresses private consumption, C, shifting the IS curve inwards to
IS’. The permanent reduction in labor income taxes increases the PVLR of the consumers, who
increase their consumption (by assumption, the consumers are non-ricardian.) As a result, the IS
curve shift back to IS’’. The AD curve consequently shifts in to AD’. The short-run equilibrium is
determined by the intersection of AD’ and SRAS. The equilibrium price drops to P1, and the
output changes to Y1*.
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Labor market: permanent reduction in labor income taxes in conjunction to a fall in
consumer confidence here. (10 pts.)
LRAS
Ns
SRAS
W0/P1
Ns’
P0
P1
W0/P0
ND
AD’
AD
Y1* Y0*
N1* N*0
LRAS
LM
r0
IS’
IS’’ IS
Y0*
NOTES
For the Labor Market: The effective wage for workers is (1-t)*W/P. As the labor income tax
decreases, the effective after-tax real wage increases. Because of the substitution effect, the
workers would like to provide more labor. (The income effect is negligible –zero- by assumption.)
Then the labor supply curve Ns will shift out in the before tax space. The drop in the price level
increases the before tax real wage as the nominal wage is fixed in the short run. The demand for
labor drop consequentially to N1*, which is the employment level corresponding to the output Y1*.
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Long run: permanent reduction in labor income taxes in conjunction to a fall in consumer
confidence here (10 pts.)
LRAS’
LRAS
Ns
SRAS
SRAS’
Ns’
W0/P1
P0
P1
W0/P0
W2/P2
P2
ND
AD’
AD
Y1* Y0* Y2*
N1* N*0 N *2
LRAS
LM
r0
IS’
IS’’ IS
Y0*
NOTES
In the long run, the LRAS shift to the right as the labor supply curve shifts outward permanently.
Because of the self-correcting mechanism, nominal wage is going to adjust to W2. In the
meanwhile, price level is adjusting to P2. The real wage in the long run will decreases to the
W2/P2 < W0/P0 and clears the labor market. The SRAS shifts outwards and goes through the
intersection point of AD’ and LRAS’. In the long run the output increases to Y2*, and the price
level further drops to P2. You can also show that necessarily after tax (1-t’) W2/P2 > (1-t) W0/P0,
which justifies the increase in PVLR discussed earlier on.
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Question 3
Press Release Federal Open Market Committee of the Federal Reserve
Release Date: March 19, 2014
“For immediate release
Information received since the Federal Open Market Committee met in January indicates
that growth in economic activity slowed during the winter months, in part reflecting
adverse weather conditions. Labor market indicators were mixed but on balance showed
further improvement. The unemployment rate, however, remains elevated. Household
spending and business fixed investment continued to advance, while the recovery in the
housing sector remained slow. Fiscal policy is restraining economic growth, although the
extent of restraint is diminishing. Inflation has been running below the Committee's
longer-run objective, but longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum
employment and price stability. The Committee expects that, with appropriate policy
accommodation, economic activity will expand at a moderate pace and labor market
conditions will continue to improve gradually, moving toward those the Committee
judges consistent with its dual mandate. The Committee sees the risks to the outlook for
the economy and the labor market as nearly balanced. The Committee recognizes that
inflation persistently below its 2 percent objective could pose risks to economic
performance, and it is monitoring inflation developments carefully for evidence that
inflation will move back toward its objective over the medium term.
The Committee currently judges that there is sufficient underlying strength in the broader
economy to support ongoing improvement in labor market conditions. In light of the
cumulative progress toward maximum employment and the improvement in the outlook
for labor market conditions since the inception of the current asset purchase program,
the Committee decided to make a further measured reduction in the pace of its asset
purchases. Beginning in April, the Committee will add to its holdings of agency
mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per
month, and will add to its holdings of longer-term Treasury securities at a pace of $30
billion per month rather than $35 billion per month. The Committee is maintaining its
existing policy of reinvesting principal payments from its holdings of agency debt and
agency mortgage-backed securities in agency mortgage-backed securities and of rolling
over maturing Treasury securities at auction. The Committee's sizable and stillincreasing holdings of longer-term securities should maintain downward pressure on
longer-term interest rates, support mortgage markets, and help to make broader financial
conditions more accommodative, which in turn should promote a stronger economic
recovery and help to ensure that inflation, over time, is at the rate most consistent with
the Committee's dual mandate.[..]”
This excerpt covers the first part of the most recent FOMC statement by the Fed. Discuss
first why deflationary pressures, as indicated in the second paragraph should be a concern
of the Fed. Then discuss why the third paragraph was interpreted by market participants
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as a tightening of monetary policy, a “hawkish” statement to use common terminology.
(30 pts.)
Answer:
The deflationary pressures should be a concern for the Fed, because they affect
aggregate demand through the following channels:
(1) Deflation discourages consumption and investment and hence aggregate demand in
the economy. Firms borrow to make investment, some consumer to finance their
expenditures. The effective borrowing cost (real interest rate) is determined by r=i-e.
Usually, the nominal interest rate, i, is fixed in a loan contract. Hence, a deflation
(decreasing in e) in effect increases the real borrowing cost, r. As a result, investment
and consumption will go down.
(2) More in general and kind of outside our model, deflation depresses private
consumption and hence the aggregate demand in the economy through expectations.
When the consumers have expectation that the price level in the future is going to
decrease, they tend to postpone consumption to the future. As a result, the current private
consumption will go down.
In the third paragraph, it is mentioned that the Fed is going to decreases its new holdings
of agency mortgage-backed securities and longer-term Treasury securities per month.
(“Beginning in April, the Committee will add to its holdings of agency mortgage-backed
securities at a pace of $25 billion per month rather than $30 billion per month, and will
add to its holdings of longer-term Treasury securities at a pace of $30 billion per month
rather than $35 billion per month.”) Tapering the quantitative easing implemented by the
Fed should be considered contractionary monetary policy, as through this unusual type
of open market operation, the Fed is injecting lower reserves into the economy in
exchange of specific long maturity assets (not the overnight reserves, the fed funds) and
hence it lowers the money supply (or more precisely, decreases the rate of growth of
money supply.)
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Question 4
Investment
Determine if the following statements related to ‘Investment Demand’ as discussed in our
model are TRUE or FALSE and WHY. (5 pts. each)
1.
Real Fixed Investment and Real GDP are negatively correlated
Answer:
FALSE. Real Fixed Investment and Real GDP fluctuate together, i.e. it is procyclical.
2.
Investment is as volatile as consumption.
Answer:
FALSE. Investment is typically more volatile than consumption in OECD data.
3.
New single family housing units are part of aggregate investment.
Answer:
True. New Residential structures are part of aggregate investment (even if they are bought and
used by private consumers).
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4.
The amount of replacement investment due to depreciation is a large fraction of
investment in a typical year.
Answer:
True. Note that the gross investment is composed of the net investment, Kt+1-Kt , and the
investment to replace the depreciation, Kt. Given the larger amount of capital stock, Kt, in the
economy, the second component is a large fraction of investment in a typical year.
5.
The user cost of capital affects negatively the marginal product of capital.
Answer:
False.
When firms set their capital optimally, the user cost of capital equals to the marginal product of
capital (MPK), i.e. UC=MPK. The MPK is not function of the user cost of capital directly, rather
K is set so to match UC. When UC is high MPK will also need to be high and K low (due to the
diminishing returns to K).
6.
Government spending in infrastructure and capital equipment are part of
aggregate investment.
Answer:
FALSE. Government spending in infrastructure and capital equipment are counted as
government expenditure in the national accounts.
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Question 5
Describe this chart, which was created on Thursday April 10th 2014 using the online
market data center of the Wall Street Journal. What is that it represents? Give at least two
possible reasons that could explain why the curve was steeper on April 10, 2014 than
April 10, 2013 (they do not have to be realistic, but simply possible according to our
simple model of the curve). (20 pts.)
Answer:
The Figure shows the yield curve of the treasury bonds, i.e. the annualized nominal
interest rate paid by US treasury bonds of different maturities on that date.
Recall that the long term nominal interest rate between period 0 and 2 is determined by
(1+i0,2)2=(1+i0,1)( 1+i1,2)
where i0,1 and i0,2 are the interest rate on a one year and two year treasury respectively
and i1,2 is the interest rate on a one year treasury starting one period from now.
Also, it,t+1=rt,t+1+et,t+1+t,t+1, where t,t+1 captures the default premium and term
premium.
Based on these relations, we can conjecture that the steeper yield curve (i.e. larger i0,2)
can be explained by the following reasons:
(1) The future real rates r1,2 got larger. (Investors now require a larger real return on a
one year treasury starting one period from now).
(2) Increase in expected inflation, e1,2 got larger. (Investors relative to a year ago expect
the future inflation rates are going to be higher).
(3) Increase in risk premium or term premium in the future, 1,2 got larger. (Investors
now perceive that the default risks will increase in the future)
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Question 6
PIH
According to the permanent income hypothesis permanent shocks to disposable income should be
associated with a larger marginal propensity to consume than temporary shocks. Why? (10 pts.)
Answer:
The Permanent Income Hypothesis Theory predicts that the marginal propensity to consume in
case of a transitory change in income ought to be much lower compared to that stemming from a
permanent change in income.
According to the Permanent Income Hypothesis Theory, current consumption is determined by
the sum of discounted value of future income streams, i.e. present value of lifetime resources
(PVLR). A permanent income shock changes PVLR by a larger magnitude than a temporary
shock and hence has a larger impact on current consumption. Note that the marginal propensity
to consume is defined as MPC=C/Y, where the C and Y denote the contemporary consumption
and income respectively. Given the same current income Y, a permanent shock has larger effect
on C and hence has larger effect on MPC.
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