#Micro quiz,

Part C (70 points) (1) [14 points] IS-LM Model Assume the following model of the closed economy in the short run, with the price level (P) fixed at 1.0: C =0.5(Y -T) T =1,000 I = 1,500 -250r G = 1,500 p = 0.5Y -500r AS = 1,000 (a) [2 points] Write a numerical formula for the IS curve, showing Y as a function of r alone Hint: Substitute out C, I, G, and T] (b) [2 points] Write a numerical formula for the LM curve, showing Y as a function of r alone [Hint: Substitute out M/ P] (c) [2 points] What are the short-run equilibrium values of Y, r, and national saving (S)? (d) [2 points] Assume that G increases by 1,500 (i.e., G = 3,000). By how much will Y increase in short-run equilibrium? (e) [3 points] You are the chief economic adviser in this hypothetical economy. Do you believe that fiscal policy is more potent than monetary policy? Briefly discuss [Hint: Use the slope of IS and LM curve in (a) and (b)] (f) [3 points] Write the numerical aggregate demand (AD) curve for this economy, expressing Y as a function of P (2) [10 points] Classical models in the Long Run During early 1980s, President Reagan proposed to increase defense spending and decrease taxes. Table 1 shows how the policies affected the U.S. economy. Use the Classical Model to answer the following questions (a) [3 points] Use the closed economy model and illustrate graphically how the model predicts national saving ($), investment (/), real interest rate (r), net export(N X), and real exchange rate () in the long run (b) [2 points] Are the data in the table consistent with model predictions that you found in part (a)? Briefly discuss 2 Table 1: The Reagan Deficits variable 1970s 1980s actual change 19.6 17.4 19.9 19.4 no change 1.1 6.3 NX -0.3 -2.0 115.1 129.4 Data: decade averages; all except r and & are expressed as a percent of GDP (c) [3 points] Now use the small open economy model and illustrate graphically how the model predicts national saving (S), investment (1), real interest rate (r), net export (NX), and real exchange rate () in the long run (d) [2 points] Are the data in the table consistent with model predictions that you found in part (c)? Briefly discussPart. D [10 points} If you are a Graduate student, you should answer the following questions. This is a bonus question for Undergraduate Students {8} [113 points] Suppose that the central bank strictly followed a rule of keeping the real interest rate at 3% per year. That rate happens to he the real interest rate consistent with the economy's initial equilibrium {a} [5 points] Amunle that the economy is hit by a money demand shock only. Under the central bank's rule, how will the money supply respond to a. money demand shock? 'Will the rule make aggregate demand more stable or less stable than it would he if the money supply were constant? {h} [5 pointsl amne that the economy is hit by IS shocks only. Under the central bank's rule? how will the money supply behave? Will the interestrate rule make aggregate demand more stable or less stable than it would he if the money supply 1were constant?r 1 Short Questions Answer all the following questions. Some are True I False,-i Uncertain and are explicitly denoted as such. The others are direct questions. Explain and detail your answers VERY carefully The QUALITY of your explanation determines your grade. 1. TRUE EFALSEIUNCERTAIN . In order to match the data, the REC model requires a large elasticity of labor supply. This is consistent with the mio'oeconomic evidence on the elasticity of labor supply. 2. Explain how the impulse responses for consumption and labor in the REC model change when the persistence of the productivity shock increases. How is the amount of amplification of productivity uctuations on output affected? 3. Explain what the the employmentlottery model is. Can this model generate an aggregate elasticity of labor supply which is larger than the individual elasticity of labor supply? 4. Explain what happens when the REC model is extended to incorporate endogenous capital utilization. 5. TRUE HFALEEHUNCERTAE'J [for each of the following three statements]. In the NewKeynesian model, real interest rates are countercyclical when monetary pol icy shocks are driving uctuations. In the EEC model, real interest rates are pro cyclical when productivity shocks are driving ucnrations. In both cases, real wages are procyclical. All these properties are consistent with the data. ti Consider the REC model with money in the utility function. Imagine a Taylor rule of the form 1', = p + 430,, 1'1}. 1What does local determinacy mean? 1litthat conditions on the parameters (p, on} of the Taylor rule guarantee local determinacy? Consider altematively a money supply rule M, = a?! [where M, is nominal money supply and M is a constant} yield local determinacy? Hrsv would your answer change for the New Keynesian model? T. Consider the NewKeynesian model with productivity shocks. Assume first that the labor tax is set to offset monopoly power. Characterize optimal monetary policy: Is commitment required to implement this outcome? Assume now that the labor tax is zero. Characterize optimal monetary policy under commitment and under no commitment, and explain why the two differ. 3. Consider the New-Keynesian model with cost-push shocks. Explain how to inter- pret cost-push shocks. Characterize optimal monetary policy under commitment and under no commitment, and explain why the two differ. 9. According to the RicardianEquivalence hypothesis, the purchase by the worn ment of long-term government bonds financed by selling short term government bonds reduces long term real interest rates and raises short term real interest rates. l] The Below Growth Model {3ft points} Let a be capital per unit of effective labor. [n this case, the lHobb- Douglas production function becomes y = a\