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##### Econ 304 Final Exam Fall 2014 Solution

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Question;OpinionHow to Energize a Lackluster RecoveryAllowing the full and immediate deductibility of capital investment would spur growth and raise wages.Excerpts from articleTaxing investment reduces after-tax returns to investing. Investors care aboutafter-tax returns and a tax policy that lowers investment returns is especiallyharmful to long-term economic growth..There are many changes thatwould improve the efficiency of the tax code, but cutting the tax on investmentheads the list.Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-09, is aprofessor at Stanford University's Graduate School of Business and a Hoover Institutionfellow.Please answer the following questions.1. a) (30 POINTS) In this part you are to explain exactly how lowering the effective tax rate oncapital () will work (in theory) its way through the economy in order to "spur growth and raisewages. In this discussion, you need to differentiate between the short- run and long-run. In thespace below, explain, with graphical analysis, how lowering the effective tax rate on capital willinfluence real economic variables in the short run (hint, its a demand side story). Draw 4diagrams (label them 1 through 4), with 1) a user cost, desired capital (K*) diagram, followed by2) a closed economy desired saving, desired investment diagram, followed by 3) an IS LMdiagram followed by 4) an aggregate supply, aggregate demand diagram.Start at an initial equilibrium and label as point A in all diagrams, with all the associated marketclearing variables denoted by subscript A. For example, in your IS LM diagram, the interestrate that clears the goods and money market is labeled as r A with the associated output at YA.Note that YA, our initial equilibrium output, is below full employment output = Y B (we arein a recession, read on). Now let the effective tax rate on capital fall (same as a fall in) andshow how all your graphs are affected. In particular, locate point B as the new short-runequilibrium in all graphs (assume the standard, that is, let output rise to Y B = full employment Y)while holding the general price level fixed at P A = PB. Make sure you refer to each diagramindividually explaining how and why we get to point B (i.e., provide intuitive economicreasoning starting with how a lower effects K* and why)!). Be sure to include a discussion ofwhy the real interest rate has to change the way it does - hint, the money market!b) (20 POINTS) Now we are going to focus on the idea that in the longer run, the influence ofthe decrease in the effective tax rate on capital will have supply-side effects. In particular,argue that this new investment, spurred on by the lower effective tax rate on capital, will result ina positive productivity shock resulting in a higher A and K" which will result in a shift upwardin the production function (via increasing the MPK f and MPN!) In the space below draw aproduction function with the labor market diagram below it and show what is going on in thislonger run. That is, locate the corresponding point B (from above), and then show the longer runinfluence as point C in these two (supply side) diagrams. What happens to N* and w*=W/P?Explain in detail. Are these results in the labor market consistent with sub-title of the article andthe business cycle facts? Now explain why output has changed, give two specific reasons. Note,in this part of the problem, do not worry about identifying point A in the labor market diagramand production function diagram since point A does not exist given the assumption that labormarkets always clear at full employment (i.e., a weakness of the classical model). Be sure to labelyour graphs completely (relevant shift variables) or points will be taken off.c) (20 POINTS) Now show how graphs 1) through 4) are influenced by this longer-rundevelopment. Note again that we assume that before these longer run developments take hold,the FE line in graph 3) and the LRAS in graph 4) is set at Y B. Now let these longer rundevelopments take hold, i.e., these supply side effects, and label this final equilibrium as point C.Again, please make sure you refer to each diagram individually explaining how and why weget to point C (i.e., provide intuitive economic reasoning!). Be sure to include a discussion ofwhy the real interest rate has to change the way it does - hint, the money market!d) (20 POINTS) In the space below, discuss how the new classical economists (hint, island)addressed the business fact that money and output are positively correlated. In this part, beextremely specific in the model that was developed (tell a story) and relate the assumptions in themodel to the empirical fact above. Be sure to explain exactly why the firm changes their output,using the terms: relative shock and aggregate shock. Use the bread making example that we usedin class making sure you identify clearly, the asymmetry with regard to the real wage the firmpays and the real wage the worker receives. Include 2 graphs as we did in class and explain theintuition as to why the workers change their behavior and why the boss (firm) changes theirbehavior. Now draw an aggregate demand and aggregate supply diagram explaining how yourindividual island analysis (as given above) maps to the macro economy (include points A, B, andC as we did in class). Write out the expression for the Lucas aggregate supply curve explainingthe intuition underlying the Lucas Aggregate supply curve. In the last part of your essay, discusswhat determines the power of monetary policy (in terms of changing output) in this model,what determines how long the short run is, and whether or not you believe that this model isa solid basis for conducting countercyclical monetary policy. Finish the essay by commentingon the following: This model was developed back in the 1960s and 1970s and it is now 2014.Do you believe the model is more relevant or less relevant today relative to when it was written?Explain.e) (20 POINTS) The real business cycle economists (RBC) showed that in their model, realwages are pro-cyclical, consistent with the business cycle facts. In the space below, draw twodiagrams vertically with a production function on top and a labor market diagram on the bottom.Start at point A and then show specifically, why wages are pro-cyclical in this RBC model. Makesure you explain exactly why wages change the way in a profit maximizing context (and labeldiagram completely). Also explain why workers change their labor supply decision(s). Using anaggregate supply / aggregate demand diagram, show that wages are indeed pro-cyclical bymapping points A and B from the production function / labor market diagram to the AS / ADdiagram. Use and refer to your diagrams as to the cyclicality of average labor productivity and thegeneral price level. Are wages and average labor productivity ever counter-cyclical in the RBCmodel? - if so, label as point C on your production function / labor market diagram. Please tell astory about this counter-cyclical real wage just like a RBC economist would. Be very specific.Finish your essay by explaining how the real business cycle economists explain unemploymentand variations in the unemployment rate.f) (20 POINTS) The new Keynesians showed that wages are sticky and pro-cyclical. They alsoshowed that the existence of involuntary unemployment is a normal phenomenon. In the spacebelow, use the theory and the appropriate graphs that the new Keynesians use to explain thestickiness, the pro-cyclical nature of the real wage, and the existence of involuntaryunemployment. Be sure to explain precisely how the wage is determined in this model and theintuition underlying the sticky and pro-cyclical nature of the real wage. Finally, use theappropriate diagram to show that employment is pro-cyclical. To do so, start at full employmentat point A and consider an adverse shock to aggregate demand (point B). Now explain whyemployment fell and discuss what Keynes would prescribe to fix the problem and get us back tofull employment. Why did Keynes favor fiscal policy over monetary policy?DO THIS QUESTION IF A TAILS IS FLIPPED2. Christina Romer and Jared Bernstein in "The Job Impact of the American Recovery andReinvestment Plan" calibrated the impact of the proposed expansionary fiscal policy (we know itas an increase in G and/or a lower T) on jobs and GDP growth (Click Here for paper). In order todo so, they make assumptions about the size of Government spending and tax multipliers. Oneimportant assumption is contained in the paragraph below about the level of the federal fundsrate:" For the output effects of the recovery package, we started byaveraging the multipliers for increases in government spending andtax cuts from a leading private forecasting firm and the FederalReserves FRB/US model. The two sets of multipliers are similarand are broadly in line with other estimates. We consideredmultipliers for the case where the federal funds rate remainsconstant, rather than the usual case where the Federal Reserveraises the funds rate in response to fiscal expansion, on thegrounds that the funds rate is likely to be at or near its lowerbound of zero for the foreseeable future."So in this question, we are going to employ some of the tools that we have acquired throughoutthe semester to understand how this assumption, "that the funds rate is likely to be at or near itslower bound of zero for the foreseeable future," effects the government spending and taxmultipliers.2. a) (40 points total: 20 points for correct and completely labeled graphs and 20 points fordiscussion) In this question, we are going to compare the size of the Government spendingmultiplier under two different assumptions: i) the Fed sits on their hands so that when G rises, rrises with it (the standard case), and ii) the Fed accommodates the (real) shock to money demandso that real interest rates remain constant.In the space below, draw 4 diagrams (label them 1 through 4) with 1) a closed economy desiredsaving, desired investment diagram, followed by 2) an IS LM diagram followed by 3) a moneymarket diagram followed by 4) an aggregate supply, aggregate demand diagram.We begin at our initial point A which is at an output well below potential GDP (i.e., there is asignificant 'output' gap). We let G rise and with the assumption that the Fed sits on their hands(assumption i) above) we move to point B, which corresponds to an output closer to potentialGDP, but still not quite there. We then assume assumption ii) above so that the Fedaccommodates the real shock to money demand to keep real interest rates constant. Thisassumption takes us to point C, which is at potential GDP (i.e., the output gap is gone!).Start at an initial equilibrium and label as point A in all diagrams, with all the associated marketclearing variables denoted by subscript A. For example, in your IS LM diagram, the interestrate that clears the goods and money market is labeled as r A with the associated output at YA. Noteimportantly that we are assuming fixed prices throughout this exercise. Now let G rise to G' andshow how all your graphs are affected. In particular, locate point B in all graphs making sureyou refer to each graph separately explaining the intuition of the movement from point A topoint B. Note, we are assuming assumption i), the Fed sits on their hands and does notaccommodate the shock to real money demand.@rb when Ma ^ to Mc withToo much money! Buy bonds.Lower interest at point C and higher output at point C. Point C must be in the southeast of point B(money market). (3rd graph)Money market is at a lower interest rate and a higher output (2 nd graph). Combination ofexpansionary and fiscal policyIncrease output2. b) (20 points for explanation) We now apply assumption ii), the one Romer and Bernstein use"that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future." Interms of our analysis, the Fed is going to make sure that real rates remain at their initial level (i.e.,they totally accommodate the real shock to money demand). Show this accommodation as pointC on all of your diagrams. Recall that we are at full employment/potential GDP at point(s) C.Again, make sure you refer to each graph separately explaining the intuition of themovement from point B to point C.2.c) (20 points) Now compare the government spending multiplier under assumption i) no Fedaccommodation and ii) the Fed accommodates the real shock to money demand. Be specific withregard to the multiplier as well as the intuition. To support your intuition, draw two diagrams: theuser cost = MPKf and the two period consumption model clearly locating points A, B, and C.Referring to your 2 graphs, explain the intuition as to why we move from point A to point B aswell as why we move from points B to C. Be sure to label your graphs completely or points willbe taken off. Make sure you relate your discussion of your two graphs to the difference in themultiplier depending on what the Fed does or doesn't do.2.d) (25 POINTS) The real business cycle economists (RBC theory) came up with a story thatexplains exactly why money is a leading and pro-cyclical variable. In the space below, draw amoney market diagram on the left, an IS/LM diagram on the right (label completely) and anaggregate demand / aggregate supply diagram below the IS/LM diagram. Discuss how the realbusiness cycle economists (RBC) addressed this empirical reality (explain using your diagrams).Starting at the initial equilibrium, point A, let the shock that the RBC theorists use to explain thismoney - output correlation occur and assuming the Fed does not react, locate the newequilibrium as point B (assume prices are perfectly flexible, consistent with RBC theory).Comment on the desirability of this adjustment in the context of the Fed's price stabilityobjective. Now consider the case where Fed does their job (recall, the Fed takes their dualmandate extremely seriously) so that these undesirable results do not occur and label as points C.Is money leading and pro-cyclical given the Fed's behavior? Explain. Why is this model referredto as reverse causation? Is money neutral or not? Explain. Finish your essay by commenting onhow RBC economists explain the business cycle (recurrent fluctuations in output) as well astheir thoughts on whether or not policymakers, both monetary and fiscal policymakersshould conduct active counter-cyclical policy.The only thing is changing is the real rate of interest. At the same k*a, the MPK < UC.Investment falls.A=C, investment is flat. Preventing the crowding out.Y increases from Ya to YbRate increasea from Ra to RbOutput is going to be higher, consumption and Investment will also be higher.From A to BYb Ya / Gb GaFrom A to CYc Ya/ Gb GaGovernment will increasee) (25 POINTS) The New-Keynesians came up with their own story as to why we observe thispositive money output correlation. Begin with discussing why the New Keynesians believethat prices are sticky in as much detail as possible. Then use the efficiency wage theory/modelto buttress (support) your argument (i.e., why does the efficiency wage theory play a critical rolein explaining why firms are willing to produce more output at the same price?). Draw twographs, one showing the effort curve and the efficiency wage (be sure to explain how firms pickthe efficiency wage) and the other being a labor supply labor demand diagram with theassumption that the efficiency wage (w*) is above the market clearing (classical) wage (w class).Why is this model so attractive in dealing with the empirical reality in labor markets that theclassical school has such a hard time with? Now draw two more diagrams depicting what ishappening in the product markets (demand, marginal revenue, marginal cost and profits) and whyfirms are willing to change output at the given price level (short run), given the change in themoney stock. Be clear as to why exactly firms are willing to act like a 'vending machine' in theshort run (be willing to increase output at the same price). Is this firm behavior, being willing toincrease output at the same price, consistent with the firms profit maximizing objective? Why or why not?

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