Erik’s Final
Macro
Fall 2016
Name (print):
_______________________________________
Signature:
_______________________________________
Section Registered
Friday Morning
MAILBOX LOCATION:
Campus
Friday Afternoon
Gleacher
Saturday
Ph.D.
Total Score on the Exam:
Part I:
Course overview (out of 15)
_______________
Part II:
Slowdown in TFP Growth (out of 21)
_______________
Part III: True/False/Uncertain (out of 30)
_______________
Part IV: Liquidity Trap (out of 16)
_______________
Part V: Quantitative Analysis (out of 8)
_______________
Part VI: Slopes and Shifts (out of 10)
_______________
TOTAL (out of 100)
_______________
Exam Preamble
1.
As always, honor code rules are in effect. You know the routine. All the usual
disclaimers apply. By taking this test (and signing on the previous page), you
pledge that you are adhering to the honor code outlined in the syllabus and Booth’s
honor code. This implies that you are not to discuss test questions with anyone until
after the answers are distributed (Saturday afternoon).
2.
There are 4 pages of scrap paper at the end. If you use it, you do not have to hand it
in. Do not hand in any loose pages (the chance of them getting lost is infinite).
3.
You have 2 hours 15 minutes for the exam. Time should not be a constraint.
4.
You are allowed:



One Piece of Paper (Cheat sheet) - Handwritten - Not Photo Copied - Both Sides
Calculator
Blank Macro Worksheets
5.
Please, Please, Please - read all the directions and assumptions that I make for each
question. Sometimes, the assumptions (short run, long run, type of consumers, etc.)
change from question to question and make a difference for the answers.
6.
Be concise! If you start rambling and say something wrong - we will have to take
points off. Note: All true/false/uncertain questions (where an explanation is
needed) should be answered in 3-4 sentences. Be aware of that and think through
your answer before you start writing.
7.
Good Luck
1
Exam Assumptions
These assumptions hold throughout the ENTIRE exam (unless told otherwise)
1) We always start at Y*,
2) All variables (consumption, investment, etc.) are real variables, unless otherwise stated,
3) Capital (K) is fixed in both the short and long run, but is allowed to change in the really long
run (or otherwise indicated).
4) NX is fixed (at zero), unless otherwise instructed,
5) No policy response takes place, unless otherwise instructed,
6) Consumers are non-liquidity constrained, non-Ricardian PIH (who have long lives such that
LL is large), unless otherwise instructed,
7) All shocks to the economy are permanent and unexpected, unless otherwise stated,
8) Expected inflation has no effect on money demand,
9) Changes in N have no effect on investment demand,
10)
TFP, oil prices, consumer confidence, business confidence, changes in the stock market,
changes in population, and changes in value of leisure (i.e., all exogenous variables) only
change when I tell you they change.
**When discussing long run changes, compare the initial condition of the economy to where
it will end up in the long run (unless told otherwise).
2
Part I: Model Overview (15 points – 3 points each)
For each of the following statements, circle the answer that makes the statement true. Only one
of the answers following each of the statements is correct. Each question is a stand-alone
question.
1. There is now a belief that there will be a large reduction in income taxes in the US during the
next year. Consider the following tax function:
T = tn Y
where T is total income tax revenues, tn is the marginal tax rate on all income, and Y is
aggregate income.
Suppose the income effect on labor supply is equal to the substitution effect on labor supply.
Which of the following are true about a large unexpected permanent decline in labor income
taxes in the long run?
a.
Before tax real wages will increase
b.
After tax real wages will increase
c.
Output will increase
d.
Both (a) and (b) are true
e.
Both (b) and (c) are true
f.
Both (a) and (c) are true
g.
(a), (b) and (c) are true.
h.
None of the above are true.
3
Part I: Model Overview (continued)
2. There is now a belief that there will be a large reduction in income taxes in the US during the
next year with the gains concentrated among high income individuals.
Consider the
following tax function:
T  tn1 y
if y  x
T  t x  t (y x )
1
n
2
n
if y > x
where y is individual income (not aggregate income) and x is a kink in the tax code. This is a
progressive tax system similar to the US if tn2  tn1 . In this example, there is a two-tiered tax
system. Any income earned below x is taxed at a lower marginal rate of tn1. Any income
earned above x is taxed at a higher marginal rate of tn2.
Consider someone who earns just a little bit more than x (say x + ε). According to our model,
what would happen to the labor supply of someone earning a little more than x if there was a
large unexpected permanent decline in only the top marginal income rate (i.e., tn2 fell while
tn1 was held fixed)?
Hint: There is enough information to answer this question. Think it through.
a. Labor supply of that person would mostly likely increase
b. Labor supply of that person would mostly likely decrease
c. Labor supply of that person would mostly likely not change
3. Consider an economy where the labor market is in disequilibrium such that N > N*.
Suppose that no policy takes place and the self-correcting mechanism returns the economy to
its potential level. According to the model we developed in class, which of the following is
true?
a. Investment in the short run will be higher than investment in the long run.
b. Investment in the short run will be lower than investment in the long run.
c. Investment in the short run will be the same as investment in the long run.
d. It is uncertain whether investment in the short run will be higher or lower than investment
in the long run.
4
Part I: Model Overview (continued)
4. Consider an economy where the labor market is in disequilibrium such that N > N*.
Suppose that the central bank (i.e., Federal Reserve) has the sole policy goal of promoting
full employment and returns the economy to its potential level. According to the model we
developed in class, which of the following is true?
a. Investment in the short run will be higher than investment in the long run.
b. Investment in the short run will be lower than investment in the long run.
c. Investment in the short run will be the same as investment in the long run.
d. It is uncertain whether investment in the short run will be higher or lower than investment
in the long run.
5. Suppose there is an unexpected permanent increase in the nominal money supply (M).
Suppose that the economy returns to its long run equilibrium via the self-correcting
mechanism. Suppose further we start at Y*. Which of the following is true?
a. Investment will be higher in the long run (relative to its initial position)
b. The IS curve will shift to the right between the initial condition and the short run.
c. Prices will be higher in the long run (relative to its initial position)
d. (a) and (b) are true.
e. (a) and (c) are true.
f.
(b) and (c) are true.
g. All of the above are true.
h. None of the above are true.
5
Part II: The Decline in TFP Growth (21 points – 3 points each)
Throughout the course, we talked about the decline in TFP growth during the 2000s – particularly
in recent periods. In this question, we are going to explore the effects of an unexpected decline in
TFP on economic activity (assuming we start at Y*). Also, to isolate the effects of changes in
TFP, we will make the standard assumption of holding all other exogenous economic variables
constant. Note: If it helps with intuition, think of this problem as an unexpected permanent
decline in TFP relative to trend. All questions can then be thought as changes relative to trend.
For this part of the exam, we will also make the following assumptions:

The decline in TPF is such that prices of final goods (P) are held constant in the short
run.

We will assume the Fed uses monetary policy to keep us at the potential level of GDP
(i.e., the Fed has a policy goal of moving Y to its (new) potential level).

We will assume that the Fed policy takes place between the short run and the long run
(i.e., the decline in TFP will move the economy to a short run position (point 1) and then
the Fed uses monetary policy to get us from the short run back to the long run (moving us
from point 1 to point 2)).

Lastly, we will assume that there are NO income effects on labor supply.
For each of the following statements, circle the answer that makes the statement true. Only one
of the answers following each of the statements is correct.
A: Short Run Analysis of a Permanent Decline in TFP
1.
a.
2.
a.
3.
a.
The level of real wages in the short run will be ________ the initial level of real wages:
higher than
b. lower than
c. the same as
d. indeterminate relative to
The level of output in the short run (Y1) will be ________ the new level of potential
output (Y*2):
higher than
b. lower than
c. the same as
d. indeterminate relative to
The level of interest rates in the short run (r1) will be ________ the initial level of
interest rates (r0):
higher than
b. lower than
c. the same as
d. indeterminate relative to
6
Part II (continued) (21 points – 3 points each)
B.
4.
a.
5.
a.
6.
7.
Long Run Analysis (With Fed Intervention)
The level of prices in the long run (P2) will be ________ the initial level of prices (P0):
higher than
b. lower than
c. the same as
d. indeterminate relative to
The level of consumption (C2) in the long run will be ________ the initial level of
consumption (C0):
higher than
b. lower than
c. the same as
d. indeterminate relative to
Relative to the initial short run supply curve (SRAS), the short run aggregate supply
curve in the long run will be ________.:
a.
shifted to the left
b.
shifted to the right
c.
unchanged
d.
shifted either to the left or to the right depending upon the size of the shifts in the
short run relative to the long run.
Between the short run and the long run, investment in the economy ______ .:
a.
will increase
b.
will fall
c.
will remain the same
d.
will either rise or fall depending on what happens to prices between the
short run and the long run.
7
Part III: True/False/Uncertain (30 points total – 5 points each)
As always, your explanation determines your entire grade! No credit will be given for writing
true when the answer is true but your logic is wrong. These are just like the questions on the
midterm or the practice finals.
Note:
When answering compound questions, you must discuss whether each part is true,
whether each part is false, or whether one is true and one is false. For example, if I say “a
permanent increase in G shifts both the IS and LM curves to the right in the short run”, you must
discuss whether both parts are true (or false) to get full credit. Does it shift the IS curve to the
right in the short run? Does it shift the LM curve to the right in the short run?
These questions will be graded essentially on a 0/2/5 scale (although, we reserve the right to
deviate if we think it is appropriate). All answers below are unambiguously true, unambiguously
false, or uncertain given the models we developed in class.
Lastly, for each question, the assumptions stated on page 1 hold (unless told otherwise!)
Each question should be answered in 3-4 well constructed sentences.
A.
There has been discussion recently of permanently increasing government spending (G)
to fund infrastructure. Suppose that the economy starts at Y* and all consumers are
non-liquidity constrained (non-ricardian) PIH consumers.
In a closed economy, a permanent and unexpected increase in government spending will
decrease both investment and household (private) saving in the long run.
B.
For Japan, raw materials such as aluminum and nickel are an important input into
production. Suppose that there is a very large unexpected increase in the price of
aluminum and nickel on the world market. Finally, suppose that the Bank of Japan has a
dual policy goal of price stability and full employment. Lastly, assume net exports (and
exchange rates) are permanently fixed (no need to think about NX at all in this problem).
Given the above assumptions, when there is a large unexpected increase in aluminum and
nickel prices on the world market, the Bank of Japan can achieve both policy goals by
buying bonds on the open market.
8
Part III: True/False/Uncertain (continued)
C.
Suppose the economy is initially at Y*. Suppose further that the Fed engages in a
monetary policy action which contracts the money supply (decreases M).
All else equal, a contractionary monetary policy (decreasing M) yields smaller short run
declines in output (Y) in an open economy (where exchange rates are flexible and where
countries trade with each other) than in a closed economy (where NX is always equal to
zero).
D.
Consider the labor market developed in class. Suppose that both TFP (A) permanently
increases and the marginal tax rate on labor income (tn) permanently increases. Lastly,
assume that income effects on labor supply exactly offset substitution effects on labor
supply.
Theoretically, our model of the labor market predicts that a permanent increase in TFP
(A) coupled with a sharp increase in labor income taxes (tn) would unambiguously
increase equilibrium before tax real wages (W/P), unambiguously increase equilibrium
after tax real wages, and unambiguously have no effect on equilibrium hours worked in
the population (N). Make sure you address all parts when answering the question.
9
Part III: True/False/Uncertain (continued)
E.
In 2009, stock prices plummeted. At that time, many people believed the decline in stock
market wealth to be temporary. Ex-post, such beliefs were correct as the stock market
quickly rebounded. Consider an economy with non-Ricardian, non-liquidity constrained
permanent income consumers (as described in class). Also, consider our full labor
market model where both income and substitution effects exist on labor supply. Finally,
consider agents where their remaining length of life is short (LL is finite and small).
A temporary decline in stock market wealth for older workers (where LL is small) will
lead to both a decline in consumption and an increase in labor supply. [Be sure to discuss
both parts of the question to get full credit].
F.
Suppose we are initially at Y* and government spending (G) unexpectedly permanently
increased. Between the short run and the long run, the economy will correct itself.
The self-correcting mechanism will cause the IS curve to shift to the left between the
short run and the long run as investment falls.
10
Part IV: Liquidity Traps, Expected Inflation and The Election of Trump (16 points)
A liquidity trap is defined as period when nominal interest rates are at zero (or something slightly
below zero) and output is still below its potential level. In this scenario, expectations are very
important. The Fed has very little power to get us out of a liquidity trap given that they cannot
further reduce the nominal interest rate. If individuals expect deflation (because the selfcorrecting mechanism may kick in), deflationary pressures will build and real rates will rise.
Such a scenario could lead to a self-fulfilling deflationary spiral.
In this question, we will talk about nature of liquidity traps. We will also talk about how the
election of Trump may have moved the U.S. economy away from a deflationary trap.
A.
Given our discussion in class, why are nominal interest rates bounded below at zero (or
something slightly below zero)? Why can’t nominal interest rates be -3% or -5%? Your
answer should not be more than 2-3 well constructed sentences. However, be specific
using the intuition provided in class. (3 points)
B.
Given our discussion in class, can real interest rates be negative?
C.
If the Fed is relatively helpless in a liquidity trap, are there any tools available to Congress
and Presidents to help get an economy out of a liquidity trap? If so, what are those tools?
Again, your response should be 2-3 well constructed sentences. (2 points)
If so, how? (2 points)
11
Part IV: Liquidity Traps, Expected Inflation and The Election of Trump
D.
In this part of the question, we will examine how expectations of future nominal interest
rates jumped after Trump was elected using the yield curve.
For this problem assume that risk/liquidity premiums on Treasuries are always equal to
zero (ρ0,1 = ρ1,2 = ...= 0). Assume also that arbitrage across Treasuries of different
durations hold such that expected returns are always equated.
D1. Here is actual data from 11/1/2016 (the week before the election):
i0,1 = 0.65 percent/year (annual nominal interest rate on a one year Treasury starting 11/1/16).
i0,3 = 0.99 percent/year (annual nominal interest rate on a three year Treasury starting 11/1/16).
These rates were relatively constant during 2016. Given this information, what was the
market’s expectation of the annual nominal interest rate on a two year loan starting one
year ahead (i1,3) prior to Trump being elected? This question will be graded on a 0/3 scale.
Work needs to be shown for full credit. Put your answer in the box. (3 points)
D2. Here is actual data from 12/1/2016 (three weeks after the election):
i0,1 = 0.82 percent/year (annual nominal interest rate on a one year Treasury starting 12/1/16).
i0,3 = 1.45 percent/year (annual nominal interest rate on a three year Treasury starting 12/1/16).
Given this information, what was the market’s expectation of the annual nominal interest
rate on a two year loan starting one year ahead (i1,3) after Trump was elected? This
question will be graded on a 0/3 scale. Work needs to be shown for full credit. Put your
answer in the box. (3 points)
12
Part IV: Liquidity Traps, Expected Inflation and The Election of Trump
E.
Given our discussions in class, why did the election of Trump cause future nominal interest
rates to jump? Use the model developed in class to guide your discussion. In particular,
use the curves developed in class to bolster your argument. Use words (as opposed to
graphs) to answer the question. Your answer should not be more than 3-4 well constructed
sentences. (2 points)
F.
Given the above discussion, why would your answer to part (E) help to alleviate concerns
of a liquidity trap? Again, be specific including its effect on the inflation expectations of
workers and firms going forward. (1 points)
13
Part V: Quantitative Analysis (8 points total – 4 points each)
In each of these next three questions, we will try to mathematically assess some of the
relationships we built in class. Each question has different assumptions. Use the assumptions
embedded in the questions. Otherwise, all assumptions from the beginning of the exam still
hold.
Note: You must show all your work for these questions to get full credit. These questions
can be answered with a couple of equations. Place your answers in the box. Each question will
be graded on the 0/4 scale. This is done for ease of grading. A perfect answer with the work to
back it up will be given 4 points. Any wrong answer or a correct answer with insufficient work
will receive no points. Precision is part of this problem. Use the equations to help discipline your
answers.
A. The Quantity Theory of Money (4 points)
Below, I have listed some approximate facts about the U.S. economy during the 2008-2009
recession. Here are the facts:
o
o
o
o
o
The unemployment rate increased by 4.1 percentage points during 2008-2009.
Real GDP increased by 0 percent during that time period.
Nominal interest rates (1 year Treasury) fell by 2.1 percentage points during that
time period.
The nominal money supply increased by 20.1 percent
The CPI inflation rate was 5.7 percent
What happened to the velocity of money during this time period?
below.
Put your answer in the box
14
Part V: Quantitative Analysis (continued)
B. Marginal Product of Capital (4 points)
In this question, we will use some economic relationships to uncover the real interest rate in the
economy. When answering, we will use the concepts of the model we built in class. Throughout
this question, we will assume:
(1)
There are no income effects on labor supply and the labor market always clears (we are
never in the short run). Firms could also hire a fraction of a worker (such than N need
not equal a whole number).
(2)
Interest rates are fixed in this example throughout all periods (rt = rt+1). We do this for
simplicity. Also assume that firms always maximize profits (as in class). Also, to avoid
confusion, assume nominal interest rates (i) always equal real interest rates (r).
(3)
The user cost of capital is only determined by the real interest rate.
(4)
TFP is always expected to be fixed always at its initial level.
Suppose the economy is in long run equilibrium such that the following facts about the
economy hold.
Aggregate production function:
Y = A K0.5 N0.5
Labor Supply Curve:
W/P = N0.5
Initial conditions:
K = 100 ;
(real wage = square root of N)
A=1
What is the real interest rate in this economy? If we did the math correctly, your answer should
end up being between 0 and 1. Report your answer to 3 significant digits - 0.xxx or xx.x%. Put
your answer in the box and show work.
15
Part VI: Slopes and Shifts of Curves (10 points – 5 points each)
In order to do macro policy (stimulate aggregate demand to promote full employment, fight
inflation, etc.), the Fed needs to know not only how given curves shift when economic variables
change, but also how much each curve shifts and the effect of those shifts quantitatively on the
policy variables of interest (Y, P, r, N, etc.)
In this question, I want to see if you can use what we learned in class to put some structure on the
potential magnitudes of economic changes. In essences, the magnitudes are determined by (1)
the slopes of the curves and (2) the shifts of the curves.
The following statements are true, false, or uncertain questions pertaining to the slopes and the
shifts of the main curves of the class. For each statement, assess whether it is true, false or
uncertain. As always, the explanation determines your entire grade! These questions require
some thought. You should use some scrap paper to graph out some intuition before you start
writing your answers. All answers should fit in the space provided. Your answers should provide
the intuition for the mechanisms at play.
A.
The larger the transaction demand of money, the smaller the shift in the aggregate
demand curve (AD) for a given increase in government spending (G). (5 points)
B.
The flatter (more elastic) the labor demand curve, the more inflationary a given change in
government spending (G) is in the short run. (5 points)
16
Worksheet
LRAS
Ns
SRAS
P0
W0/P0
ND
AD
Y0*
N *0
NOTES
LRAS
LM
r0
IS
Y0*
17
Worksheet
LRAS
Ns
SRAS
P0
W0/P0
ND
AD
Y0*
N *0
NOTES
LRAS
LM
r0
IS
Y0*
18
Worksheet
LRAS
Ns
SRAS
P0
W0/P0
ND
AD
Y0*
N *0
NOTES
LRAS
LM
r0
IS
Y0*
19
Worksheet
LRAS
Ns
SRAS
P0
W0/P0
ND
AD
Y0*
N *0
NOTES
LRAS
LM
r0
IS
Y0*
20