Download QUIZ 2: Macro – Winter 2002

QUIZ 4: Macro – Fall 2016
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For the entire quiz, make the following assumptions. (1) All consumers are non-liquidity
constrained, non-ricardian PIH, (2) Prices are held fixed unless told otherwise, (3)
expected inflation does not affect money demand, (4) the capital stock (K) is fixed, (5) all
exogenous variables (A, tax rates, government spending, Fed policy, etc.) are fixed unless
told otherwise, (7) we are considering a closed economy (NX=0), and (8) changes in N do
not independently affect investment demand. Finally, assume all changes to exogenous
are permanent and unexpected.
Question 1 (1 points each – 4 points total)
Circle all true answers to the following statement. Assume that the income effect on labor
supply is the same size as the substitution effect on labor supply. A permanent increase in
TFP (A) will:
First, we know that labor demand will shift right (as TFP increases) and the labor supply
curve will shift left (income effect). The net effect will be N* will not change (given the
assumption that the income effect on labor supply is the same order of magnitude as the
substitution effect on labor supply). Second, we know that an increase in A increases Y*
because Y*=AK*^0.3N*^0.7 (given no change in N*). As a result, the LRAS must shift to
the right.
As A increases, the SRAS will shift out as firms are more productive (anything that shifts the
labor demand to the right will shift the SRAS to the right).
Similarly, we know that real wages increase. Recall, we define MPN = 0.7A(K/N)^0.3. We
define the labor demand curve as W/P*= MPN.
As W/P increases permanently, PVLR
must increase. Thus, C will increase causing both the IS curve and the AD curve to shift to
the right (an increase in C(.)). Also, I(.) will increase as MPK increases at all interest rates.
Recall, The IS curve is defined as expenditure, that is Y= C+I+G+NX and the AD curve is
just the IS and LM curves in {Y, P} space.
We define the money demand curve as a function of Y. We know that Y increases as A
increases so the money demand curve must shift out. Anytime Y increases, money demand
shifts right. Anytime Y falls, money demand shifts left.
Given the above, all the answers are all true.
a. Shift both the IS curve and the Aggregate Demand (AD) curve to the right.
b. Shift both the Long Run Aggregate Supply (LRAS) curve and the Short Run
Aggregate Supply (SRAS) curve to the right.
c. Shift both the Labor Demand (ND) curve to the right and the Labor Supply (NS) curve
to the left.
d. Shift the Money Demand (MD) curve to the right.
Question 2 (1 point each – 5 points total)
Circle all true answers to the following statement. Assume that the income effects on labor
supply are small relative to the substitution effects on labor supply. The Fed buying bonds
on the open market will:
When the Fed buys bonds on the open market, it increases the money supply.
Let’s start with the IS-LM market. The IS curve is defined as aggregate expenditure, that is
Y= C+I+G+NX. In {Y,r} space, we can express the demand side of the economy as:
Y = C(.) + I0(.) - dI r + G.
As M increases, there is no shift in the IS curve. All the action on the demand side of the
economy is a movement along the IS curve. We define the LM curve as the result of the
money market equilibrium (real money supply = real money demand drawn in {Y,r} space).
As M increases, the LM curve shifts out. As the LM curve shifts out, r falls and I must
increase. We see this increase in the interest-rate sensitive part of I as the movement along
the IS curve.
The AD curve is simply the IS and LM curves in {Y,P} space. In other words, we define the
AD curve as Y = C(.) + I0(.) - dI r(M,P) + G . The real interest rate is a function of M and P
(holding C(.), I0(.) and G fixed). As M increases, the AD curve will shift right. You should
be able to prove this to yourself (go to the IS-LM market - an increase in M holding P fixed
will increase Y - that is all the AD curve says).
Money demand is a function of Y. As Y increases, the money demand curve shifts to the
right.
Labor supply is a function of population, value of leisure, tn, tc, and PVLR. These variables
are not affected by a change in M. Thus, the labor supply curve does not move. A, B, D, and
E are true.
a. Neither shift the IS curve to the right or the left.
b. Shift the Aggregate Demand (AD) curve to the right.
c. Shift the Labor Supply (NS) curve to the right.
d. Shift the Money Demand (MD) curve to the right.
e. Shift the LM curve to the right.
Question 3 (1 point each – 6 points total)
Circle all true answers to the following statement. Assume that the income effects on labor
supply are small relative to the substitution effects on labor supply. A permanent decline in
the marginal tax rate on income (tn) will:
You all should feel comfortable with the labor market side of this analysis by now. As t n
falls, we know that after tax wages must increase. Why? The government is taking less out of
every pay check. As after tax wages increase, the substitution effect says that the labor
supply curve will shift out as we work more. As after tax wages permanently increase, the
income effect says we will want to work less, shifting the labor supply curve in. Because the
substitution effect dominates, we know that the labor supply curve will, on net, shift to the
right. This means that before tax wages (which are endogenous) will decrease and N* will
increase. Recall, A did not change and K is fixed. The labor demand curve will not shift.
Why do we say N*(and not N) increases? The labor supply curve moves permanently to the
right as a result of this policy change. Thus, there is a new equilibrium in the labor market
which is why we say N* increases.
For the IS-LM market, as after tax wages permanently increases, PVLR increases. This
means that consumption will increase (and because the consumers in this analysis are nonliquidity constrained PIH we know they will increase consumption by the same amount in
every period). Recall, we define the IS curve as Y = C+I+G+NX. As C increases, the IS
curve will shift to the right.
For the AS-AD market, the Aggregate Demand curve is just the IS and LM curves combined
in {Y,P} space. So, as C increases the AD curve must shift out. As we saw in the labor
market analysis, N* increased. As N* increases, Y* must also increase. Thus, the LRAS
curve shifts out.
a. Shift the IS curve to the right.
b. Shift the Aggregate Demand (AD) curve to the right.
c. Shift the Labor Supply (NS) curve to the right.
d. Shift the Long Run Aggregate Supply (LRAS) curve to the right.
e. Shift the money demand curve (MD) curve to the right.
f. Neither shifts the Labor Demand (ND) curve to the right or the left.
Question 4 (1 point each – 5 points total)
For this question, circle all the answers that are true. Also, use the IS-LM framework
developed in class to answer the questions (like we did in the middle of class last week).
Focus your analysis on the short run (such that nominal wages are fixed and the labor
market is allowed to be in disequilibrium). Again, assume prices are fixed (and all other
quiz assumptions hold).
For all of these, you should GRAPH out the questions!
a. An increase in the nominal money supply (M), will cause real interest rates (r) to
fall and will neither shift the IS curve to the right or the left.
As you saw in Question 2, as M increases, the LM curve shifts out, r falls and I increases.
The increase in I (the interest rate sensitive part of I) is reflected as a movement along the IS
curve. The IS curve does not shift as C, G, and NX do not change and the autonomous part of
I does not change. True.
b. An increase in government spending (G) will cause the IS curve to shift to the
right and investment (I) to fall.
We define the IS curve Y= C+I+G+NX. As G increases, the IS curve will shift to the right
causing r to increase and the interest rate sensitive part of I to fall. True.
c. An increase in consumer confidence will cause real interest rates (r) to rise and
the money demand (MD) curve to shift to the right.
An increase in consumer confidence causes C to increase, shifting out the IS curve which
results in an increase in r and a decrease in I. As the IS curve shifts out, Y must increase.
Money demand is a function of Y. As Y increases, the money demand curve must shift out.
True.
d. An increase in business confidence will cause both real interest rates (r) and
investment (I) to rise.
An increase in business confidence will cause the autonomous part of I to increase. This will
shift out the IS curve causing r to increase. As r increases, the interest rate sensitive part of I
will fall. On net, the increase in the autonomous part of I will be greater than the decline in I
as a result of interest rates increasing. As you can see from the graph, Y must increase. The
only reason Y increases is because I increased (given C(.) and G did not change). The
intuition for this is that the only reason that r went up was because money demand went up.
The only reason that money demand went up was because Y (via I) went up. The increase in
I is necessary to have the offsetting interest rate increase. True.
e.
An increase in TFP (A) will cause both output (Y) and real interest rates (r) to
rise.
Recall from Question 1 that as A increases, C increases (as a result of an increase in PVLR).
This shifts out the IS curve which causes both Y and r to increase. True.