Question;Christina Romer and Jared Bernstein in;The Job Impact of the American Recovery and Reinvestment Plan;calibrated the impact of the proposed expansionary fiscal policy (we know it as;an increase in G and/or a lower T) on jobs and GDP growth (ClickHere for paper).;In order to do so, they make assumptions about the size of Government spending;and tax multipliers. One important;assumption is contained in the paragraph below about the level of the federal;funds rate;For;the output effects of the recovery package, we started by averaging the;multipliers for increases in government spending and tax cuts from a leading;private forecasting firm and the Federal;Reserve?s;FRB/US model. The two sets of multipliers are similar and are broadly in line;with other estimates. We considered;multipliers for the case where the federal funds rate remains constant, rather;than the usual case where the Federal Reserve raises the funds rate in response;to fiscal expansion, on the grounds that the funds rate is likely to be at or;near its lower bound of zero for the foreseeable future.;So in this question, we are going to employ;some of the tools that we have acquired throughout the semester to understand how;this assumption, "that the funds rate is likely to be at or near its lower;bound of zero for the foreseeable future," effects the government spending;and tax multipliers.;2. a) (40;points total: 20 points for correct and completely labeled graphs and 20 points;for discussion) In this question, we are going to compare the size of the;Government spending multiplier under two different assumptions: i) the Fed sits;on their hands so that when G rises, r rises with it (the standard case), and;ii) the Fed accommodates the (real) shock to money demand so that real interest;rates remain constant.;In the space;below, draw 4 diagrams (label them 1 through 4) with 1) a closed economy;desired saving, desired investment diagram, followed by 2) an IS ? LM diagram followed;by 3) a money market 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 a significant '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 potential GDP, but still not quite;there. We then assume assumption ii);above so that the Fed accommodates the real shock to money demand to keep rates;constant. This assumption 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 market clearing variables denoted by;subscript A. For example, in your IS ?;LM diagram, the interest rate that clears the goods and money market is labeled;as rA with the associated output at YA. Note importantly;that we are assuming fixed prices;throughout this exercise. Now let G rise to G' and show how all your graphs are;affected. In particular, locate point B;in all graphs making sure you refer to;each graph separately explaining the intuition of the movement from point A to;point B.;2. 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." In terms 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 point C 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 the movement from point B to;point C.;2.c) (20;points) Now compare the government spending multiplier under assumption i) no;Fed accommodation and ii) the Fed accommodates the real shock to money;demand. Be specific with regard to the multiplier;as well as the intuition. To support your intuition, draw two diagrams: the;user 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 as well as why we move from points B to C. Be sure to label your graphs;completely or points will be taken off.;Make sure you relate your discussion of your two graphs to the;difference in the multiplier 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 that explains exactly why money is;a leading and pro-cyclical variable. In;the space below, draw a money market diagram on the left, an IS/LM diagram on;the right (label completely) and an aggregate demand / aggregate supply diagram;below the IS/LM diagram. Discuss how the;real business 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 this money - output correlation;occur and assuming the Fed does not;react, locate the new equilibrium as point B (assume prices are fixed in;the short-run). Now discuss what would happen in the long-run commenting;(again, the Fed does nothing) on the desirability of this long-run adjustment.;Now consider the case where the Fed does their job so that these undesirable;results do not occur and label as points C. Is money leading and pro-cyclical;given the Fed's behavior? Why is this;model referred to as reverse causation?;Is money neutral or not? Explain.;Finish your essay explaining how;RBC economists explain the business cycle (recurrent fluctuations in;output) as well as their thoughts on whether;or not policymakers should conduct active counter-cyclical policy.;e) (25;POINTS) The New-Keynesians came up with their own story as to why we observe;this positive money ? output correlation.;Begin with discussing why the New;Keynesians believe that prices are sticky in as much detail as possible. Then use the efficiency wage theory/model;to buttress (support) your argument (i.e., why does the efficiency wage theory;play a critical role in explaining why firms are willing to produce more output;at the same price?). Draw two graphs;one showing the effort curve and the efficiency wage (be sure to explain how;firms pick the efficiency wage) and the other being a labor supply labor demand;diagram with the assumption that the efficiency wage (w*) is above the market;clearing (classical) wage (wclass).;Why is this model so attractive in dealing with the empirical reality in;labor markets that the classical school has such a hard time with? Now draw another diagram depicting what is;happening in the product markets (demand, marginal revenue, marginal cost and a;profit function) and why firms are;willing to change output at the given price level(short run) given the;change in the money stock. Be clear as;to why exactly firms are willing to act like a 'vending machine' in the short;run (increase output at the same price).;Is this firm behavior, being willing to increase output at the same;price, consistent with the firm?s profit maximizing objective? Why or why not?
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