Exam 2 Econ 304 Chuderewicz Spring 2012

Exam 2 – Econ 304 – Chuderewicz – Fall 2014

Name ______KEY______Last 4 (PSU ID) ______

PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET – THANKS AND GOOD LUCK!!!

Total Points for exam = 224

Test time = 120 minutes

Approximately one minute for every two points

To help with time management if spreading time evenly

Question #1 with LM shock = 92 points..... 46 minutes

Question #1 with IS shock = 72 points ...... 36 minutes

Question #2 = 30 points.... 15 minutes

Question #3. = 30 points ....15 minutes

1 Exam 2 – Econ 304 – Chuderewicz – Fall 2014

1. THIS IS THE GENERAL EQUILIBRIUM PROBLEM THAT I PROMISED. YOU FIRST SOLVE FOR THE INITIAL EQUILIBRIUM AS POINT A. WE CONSIDER TWO DIFFERENT AND SEPARATE SHOCKS (I CALL THEM SCENARIOS). THE FIRST SHOCK IS TO THE LM CURVE, THE SECOND SHOCK IS AN ‘IS’ SHOCK. AGAIN, WE CONSIDER THESE SHOCKS SEPARATELY SO THAT AFTER YOU COMPLETE SCENARIO 1 (THE LM SHOCK), WE GO BACK TO THE ORIGINAL CONDITIONS AND CONSIDER THE SECOND SCENARIO WHICH IS THE ‘IS’ SHOCK.

Consider the following model of the economy

Production function: Y = AKN – N2/2 Marginal product of labor: MPN = AK – N. where the initial values of A = 8 and K = 10.

The initial labor supply curve is given as: NS = 20 + 9w.

Cd = 401 + .50(Y-T) – 500r Id = 800 – 500r G = 500 T= 100

We assume that expected inflation is zero (πe- = 0) so that money demand depends directly on the real interest rate (since i = r).

Md/P = 469 + 0.5Y- 1000r

Nominal Money supply M = 4000

1 a) (6 points) Solve for the labor market clearing real wage (w*), the profit maximizing level of labor input (N*), and the full employment level of output (Y*). Please show work.

b) (4 points) Derive an expression for the IS curve (r in terms of Y). Please show all work

c) (3 points) Find the real interest rate that clears the goods market. Please show all work

d) (3 points) Find the price level needed to clear the money market. Please show all work e) (4 points) Find the expression for the LM curve (r in terms of Y). Please show all work

2 3 4 SCENARIO #1 – AN LM SHOCK!

Now suppose that there is non-policy shock to nominal money supply so that the new nominal money supply is: M = 4120.

S1 a) (5 points) Name and explain two reasons why money supply would change the way it did. Note that this was a non-policy shock to the money supply - it was not caused by open market operations. Finish your answer commenting on whether a money shock like this is currently a concern in the United States.

S1 b) (5 points) What is the new, short run (fixed price level) expression for the LM curve? Please show all work.,

S1 c) (4 points) What is the short run, Keynesian (fixed price) level of equilibrium output and real interest rate? Please show all work.

Please label these new short run conditions to your four diagrams as point B. Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class.

S1 d) (4 points) Find the new price level associated with the long run general equilibrium.

Please label these long run conditions to your four diagrams as point C. Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class.

S1 e) (4 points) Let us focus on the movement from point A to B (the short -run) in your money market diagram. Explain why (and in what direction) the real interest rate had to change to 'clear' the money market. Be as specific as possible as we talked about this a great deal in class!

S1 f) (5 points) Now explain why output has changed in the short-run. Be as specific as possible.

S1 g) (5 points) What would the Fed have to do, exactly in order to hit their inflation target of 2% (hint: the target price level is 2% higher than the original price level). Please state the type and amount of open market operations. Assume the money multiplier is equal to 0.8, just like it is in the real world.

5 SCENARIO #2 – AN IS SHOCK! (75 points total)

We spoke of the surprise move of the Bank of Japan announcing quantitative easing in response of renewed deflationary fears partly caused by the increase in taxes. Below is an excerpt from the article we looked at.

"The BOJ’s move, scarcely expected by central-bank watchers, came after fresh data added to evidence that the April increase in the national sales tax threw the world’s third-largest economy off track."

In this part of the problem, we are going to model this tax hike and the proposed response by the BOJ.

Let’s return to our original conditions: Please write down the expressions for your ORIGINAL IS curve and LM curves in the space below (so the grader can follow your starting points).

IS: r = ______

LM: r = ______

7 8 IS shock - the Government (we can pretend it is Japan) raises taxes (T) from 100 to 180.

S2 a) (4 points) Derive a ‘new’ expression for the IS curve (r in terms of Y). Please show all work

S2 b) (4 points) Now solve for the short-run equilibrium output (Keynesian) and the corresponding real rate of interest. Please show all work. Please label this short run (fixed price) equilibrium as point B on all four of your diagrams.

S2 c) (4 points) Now find the long run real interest rate consistent with general equilibrium. Please show all work.

S2 d) (4 points) Find the new price level associated with the long run equilibrium. Please show all work

Label this long run equilibrium as point C in all four of your diagrams.

S2 e) (5 points) Is this result desirable? That is, with perfect information, would the BOJ let this long-run adjustment take place? Why or why not? Please be as specific as possible.

S2 f) (5 points) What would the BOJ have to do, in terms of the type and quantity of open market operations, to keep the price level at its original level, consistent with their price stability objective? Assume the money multiplier is equal to 1.00 in Japan.

S2 g) (6 points) Explain how the AS - AD, IS-LM-FE, and money market diagrams would be effected if the BOJ conducted the policy as in S2 f) above (i.e., to keep the price level its original level).

9 2. (30 points total) We talked a lot about the Fed's balance sheet, quantitative easing, and the fact that since October 2008, they (the Fed) now pay interest on reserves.

2.a) (15 points) In 2008, the Fed pleaded and pleaded with Congress trying to convince them that the economic situation was deteriorating fast and that they needed to grant the authority to the Fed to pay interest on reserves sooner rather than later. So in October, 2008, the Fed was officially granted the authority to pay interest on reserves (please locate October 2008 on Balance Sheet diagram below). Explain exactly why the Fed so badly wanted this authority and explain exactly what they did (in terms of monetary policy) as soon as they were granted this authority (refer to the Balance Sheet below). Be sure to include in your answer what would have happened and why if the Fed behaved the exact same way without (being granted) the authority to pay interest on excess reserves.

LOCATING OCT 2008 ON BS - (2 POINTS)

(10 POINTS) WHY THEY WANTED AUTHORITY - THE ECONOMY NEEDED A LOT OF LIQUIDITY AND THE FED WAS RUNNING OUT OF BALANCE SHEET CAPACITY - THEY USED UP 380 BILLION OF GS STERILIZING PREVIOUS INTERVENTIONS AND IT BECAME CLEAR THAT THEY WOULD RUN OUT OF BALANCE CAPACITY (NOT ENOUGH GS TO STERILIZE) THE AUTHORITY TO PAY INTEREST ON RESERVES GAVE THE FED UNLIMITED BALANCE SHEET CAPACITY AND THEY USED THAT UNLIMITED BALANCE SHEET CAPACITY IMMEDIATELY AND PUMPED TRILLIONS OF $ OF LIQUIDITY IN THE SYSTEM. THEY COULD DO THIS ONCE THEY GOT THE AUTHORITY SINCE THEY KNEW THE BANKS WOULD HOLD THE ER AND IT WOULD NEVER ENTER INTO THE MULTIPLE DEPOSIT EXPANSION PROCESS.

(3 POINTS) IF THEY WOULD HAVE DONE SAME THING WITHOUT AUTHORITY, THE MS MIGHT HAVE BLOWN UP, WE MIGHT INFLATE, VALUE OF DOLLAR MIGHT PLUMMET, ETC.

10 2.b) (15 points) Many are worried that if the banks starting lending out their excess reserves all at once, inflationary pressures will build given that the money supply could 'blow up.' Under what conditions (i.e., why) would the banks start getting rid of their excess reserves and what exactly could the Fed do about. I am looking for 3 specific policy responses from the Federal Reserve. Be sure to explain how each policy response would put a lid on money growth (i.e., the so-called exit strategy).

(3 POINTS) CONDITIONS - LENDING OPPORTUNITIES NEED TO IMPROVE SO THAT 25 BASIS POINTS (THE RATE THEY GET FROM FED) DOES NOT LOOK FAVORABLE ANYMORE. OTHER SHORT TERM INTEREST RATES RISING ABOVE 25 BASIS POINTS WOULD DO THE TRICK COUPLES WITH IMPROVING ECONOMIC CONDITIONS AND LENDING OPPORTUNITIES.

4 POINTS FOR EACH REASON

1) RAISE INTEREST PAID ON RESERVES, MAKE IT MORE COSTLY TO GET RID OF RESERVES - THIS WOULD KEEP THE EXCESS RESERVES OUT OF THE MULTIPLE EXPANSION OF DEPOSITS

2) RAISE THE RESERVE REQUIREMENT RATIO - THIS WILL TURN EXCESS RESERVES INTO REQUIRED RESERVES IMMEDIATELY, KEEPING THEM OUT OF THE MULTIPLE EXPANSION OF DEPOSITS

3) CONDUCT OPEN MARKET SALES THEREBY DRAINING OR MOPPING UP THE EXCESS RESERVES, THIS IS OF COURSE THE OPPOSITE OF QE -IF BANKS DO NOT HAVE THE ER, THEY CAN'T LEND THEM OUT!

11 3. (30 points total)

3. a) (10 points) Explain what happened to the money multiplier and why during the Great Depression - be sure to write out expression for money multiplier and discuss what happened to its components and why. Then discuss what happened to the money multiplier as soon as the Fed got the authority to pay interest on reserves in October 2008.

ONE POINT FOR EXPRESSION

THREE POINTS EACH

C/D RATIO ROSE - NO FDIC INSURANCE - CAUSING THE MM TO FALL

ER/D RATIO ROSE - NOT A GOOD LENDING ENVIRONMENT / MEET THE LIQUIDITY NEEDS OF THEIR BEST CUSTOMERS - THIS ALSO CAUSED MM TO FALL.

WHEN FED GOT THE AUTHORITY, THE MM PLUMMETED AS THE ER/D RATIO SHOT STRAIGHT UP - BANKS HELD ONTO MOST OF THE LIQUIDITY IN THE FORM OF ER

3. b) (10 points) Many criticize the Fed for not reacting appropriately during the Great Depression. Explain these criticisms and if the Fed would have it to do over again, what would they do exactly? Be sure to support your answer by using the definition (expression) of the money supply.

MM FELL DURING THE GD AND THE FED DID NOT CONDUCT THE NECESSARY OMO TO KEEP THE MONEY SUPPLY FROM FALLING

DO IT OVER AGAIN, PUMP UP THE MB VIA OPEN MARKET PURCHASES TO MORE THAN OFFSET THE FALL IN THE MONEY MULTIPLIER SO THAT THE MONEY SUPPLY WOULD HAVE RISEN RATHER THAN FALLING.

3.c) (10 points) According to a WSJ article that we looked at in class, forward guidance was much more powerful and effective than quantitative easing during this past financial crisis / recession. What do the authors mean when they say more powerful and how exactly is forward guidance supposed to work? Be sure to include the equation we used in class. Is the Fed still using forward guidance? Explain.

(3 POINTS FOR WHAT POWERFUL MEANS)

MORE POWERFUL IN THE SENSE OF LOWERING LONG TERM INTEREST RATES AND THUS, MORE POWERFUL IN THE SENSE OF INFLUENCING ECONOMIC ACTIVITY.

(4 POINTS FOR HOW FORWARD GUIDANCE WORKS)

FORWARD GUIDANCE WORKS BY LOWERING THE EXPECTED PATH OF SHORT TERM INTEREST RATES AND THEREBY LOWERING LONG TERM INTEREST (SEE EQUATION) RATES STIMULATING CONSUMPTION, INVESTMENT AND NET EXPORTS - IN ADDITION, WHEN BONDS BECOME LESS ATTRACTIVE, HOUSEHOLDS BUY STOCKS, DURABLE GOODS, ETC FURTHER STIMULATING THE ECONOMY.

12 (2 POINTS FOR EXPRESSION)

(1 POINT)

YES, THEY ARE USING FORWARD GUIDANCE - THE KEY WORDS ARE "CONSIDERABLE TIME"