Download QUIZ 7: Macro – Winter 2011 Name

QUIZ 7: Macro – Winter 2011
Name:
______________________
You must always show your thinking to get full credit.
Question 1
Some economists argue that the key to achieve a low interest rate is more expansionary monetary
policy. Other economists argue that the key is larger private saving and/or the reduction of budget
deficits. Who is right? (7 pts.)
A monetary expansion increases output and decreases interest rates in the short run, but in
the long run it does not affect any of them.
A decrease in the budget deficit decreases output and interest rates in the short run and
may, therefore, decrease investment. But in the long run, the interest rate decreases and
output returns to the natural rate, so that investment necessarily increases.
Therefore, with respect to the short-run, any of the economists is right or wrong, since both
policies contribute to decrease in the interest rates.
In the long run, only the ones in favour of the larger private saving and/or the reduction of
budget deficits are right.
Question 2
What does the concept of ‘Money Neutrality’ mean? Is there any evidence that money is neutral
in the short run? (5 pts.)
In the long run the increase in nominal money supply (a monetary expansion) is reflected
entirely in a proportional increase in the price level, namely it has no effect on output and
the interest rate. Economists refer to the absence of long-run effects of money on output
and the interest rate by saying that ‘money is neutral in the long-run’.
However, as seen in question 3 part 1, a short-term effect of an increase in money supply is
an expansion (the AD shifts out because real money balances temporarily increase and real
rates go down, fostering investment). These effects are however possible only because we
are assuming that wages are sticky so firms are able to produce more without increasing
their nominal wage bill.
The ‘Money Neutrality’ does not mean that monetary policy cannot or should not be used:
an expansionary monetary policy can, for example, help the economy move out of a
recession and return faster to its natural level. But it is a warning that monetary policy
cannot sustain higher output forever. There is ample empirical evidence of monetary nonneutrality in the short run (Friedman and Schwartz book for instance), but also ample
evidence of long-run money neutrality.
Question 3
For each of the following changes, state which curve or curves are affected initially (IS, LM, AS,
AD) and in which direction they will initially shift. (Assume that before the change output is at its
natural level).
1. An increase in the nominal money supply
2. A decrease in consumer confidence
Taking into account both the short-run and the long-run movements of these curves, fill out the
table below using the following notation: ‘I’ (increase), ‘D’ (decrease), ‘A’ (ambiguous change)
or ‘N’ (no change). Please briefly explain.
1. Increase in nominal
money supply
2. Decrease in
Consumer Confidence
Output
Level
I
D
Short-Run
Interest
Price
Rate
Level
D
I
D
D
Output
Level
N
N
Long-Run
Interest
Price
Rate
Level
N
I
D
D
Your explanation for point 1. (9 pts.)
1. An increase in the nominal money supply:
As a result of a monetary expansion, in the short run, the AD curve shifts to the
right. Output is higher and so is the price level.
Over time, the adjustment of expectations comes into play. As long as output
exceeds its natural level, wages rise and the price level increases, shifting the SRAS
curve up. The economy moves up along the AD curve. The adjustment process stops
in the long run, when output has returned to its natural level, and the price level is
higher.
Concerning the dynamic effects of a monetary expansion in terms of the underlying
IS-LM model, the short-run effect is to shift down the LM curve. Over time, the
price level increases, reducing the real money stock and shifting the LM curve back
up. The economy thus moves along the IS curve: the interest rate increases and
output declines. Eventually, the LM curve returns where it was before the increase
in nominal money. In the long run, output and the interest rate return to its initial
values.
Your explanation for point 2. (9 pts.)
2. A decrease in consumer confidence:
As a result of a decrease in consumer confidence, and assuming that output is
initially at its natural level of output, AD shifts to the left. In the short run, output
and prices are lower.
Over time, as long as output is below its natural level, the aggregate supply curve
keeps shifting down, and the economy moves down along the aggregate demand
curve until output is back at its natural level. Although in the long run, output
returns to its natural level, the price and the interest rate are lower than before the
change.
The change in the interest rate can be followed from IS-LM curves movements in
the short and long run. Initially, as consumer confidence decreases, the IS curve
shifts to the left. Because prices decline in response to the decrease in output, the
real money stock increases, leading to a partly offsetting shift of the LM curve
downwards. Both output and interest rates are lower in the short run than before.
Over time, as long as output is below its natural level, prices decrease and the LM
curve shifts down. Eventually, output is back to its natural level, but interest rates
are lower now than before.