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Long Question 2: Fire at Will [46 pts.] 1. Starting from the wage setting relation and the price setting relation, derive an expression for aggregate supply. Make sure you clearly explain each steps in the derivation. [11 pts.] Italy's Prime Minister, Mr. Mario Monti, has presented to the Italian parliament a proposal to change labor laws. The Italian government claims that the new measures would \"create a dynamic, exible and inclusive iobor market, one side to In} creole good working conditions fuj\". We interpret these proposals as a decrease in ring and hiring costs, Le. a decrease in the variable 2:, the parameter in the wage setting relation. 2. Using the wage setting relation and the price setting relation you derived in part 1, predict what will happen to the unemployment rate in the medium rim n if these labor proposals are approved by parliament. [Iipts.] 3. How will the change predicted in part 2 a'ect the ASAD equilibrium? Show using the ASfAD graph. Let E be the initial medium rum equilibrium. Let the rst short-run equilibrium the economy transitions to be labeled as E\" and the new medium run equilibrium as E\". [E pts.] 4 3 Long Question 2: A Modification of the Diamond- Dybvig model (30 points) Consider the standard version of the Diamond-Dybvig model discussed in class. A bank has access to two investment technologies. There is a short term technology which yields 1 in period t = 1 for every unit invested in period f = 0. There is also a long term technology which yields R > 1 in period t = 2 for every unit invested. The bank can choose to liquidate its long term investment in t = 1, in which case it gets L 1. What is the maximum amount of that a bank could promise to patient consumers under the assumption that only impatient consumers will withdraw of at t = 1? (5 points) 2. How much should the bank invest in each technology to fulfill its promise of (ci, c; )? (5 points) Now we change our assumptions. We assume that instead of the bank there is a firm which has access to exactly the same two technologies as the bank. The only difference is that instead of the deposit contract, for each dollar invested in the firm, the firm offers a share. A "share" is the right to receive a payment Dj at t = 1 and Dy at t = 2 independent of whether who owns the share is patient or impatient. In t = 1, consumers can sell or buy the shares of the firm, only after receiving D, and finding out whether they are impatient or patient. The sequence of events is as follows: In t = 0 people give their one unit of endowment to the firm. In t = 1 the firm pays Dj. After D, has been paid and consumers find out whether they are patient or impatient, consumers can sell or buy the shares of the firm. In t = 2 the firm pays D2 = R(1 - D,), since we are assuming that the firm makes zero profit. 3. Let us first assume the price of the shares is such that patient consumers can buy all of the shares of impatient consumers by giving them their Dy dividends. Show that if Dj = (1-#)c; then impatient consumers consume ci and patient consumers consume c. (5 points)Long Question 1: Animal Spirits [26 pts.] Consider the following quote on investment from The General Theory of Employment, Interest and Money, the seminal book written by John Maynard Keynes in 1936: "[.../ most [...] of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere [...] if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die [...)." For the purpose of this test, we assume that what Keynes meant by "animal spirits" was really "business confidence". This implies that investment I does not only depend on interest rate and income, but on "business confidence" as well. In light of this fact: 2 1. How does this affect the shape of aggregate demand? Starting from the investment curve and moving to the IS-LM model, graphically derive both an optimistic AD (i.e. an AD curve which embeds high business confidence) as well as a pessimistic AD (i.e. an AD curve which embeds low business confidence). [13 pts.] 2. If animal spirits (business confidence) do indeed play a role in the economy, what does their presence imply about the potential tools policymakers have at their disposal for affecting output in the short run? Apart from monetary and fiscal policy, suggest a new type of policy that could be used for increasing or decreasing output in the short run (be specific in how the policy would affect output). [13 pts.]Q1 [50 MARKS]. Three researchers are estimating the relationship between expenditure on cinema tickets (C1) and total monthly expenditure (Y1) using a cross-sectional survey of 1500 households in England during May 2014. All three have also been asked to look at the effect of children on cinema attendance and they have been given data on the number of children Ki in each household from which a dummy variable D( has been constructed taking the value 1 if Ki>0 and 0 otherwise. The variable E1 is the years of education of the head of household, and residuals for each of the three researchers' models AAA are denoted EL 52; 53) respectively, i is the household identier. Researcher 1 estimates the following relationship: (1)01 : 5.48 + 2.48 Ya- 0.25 Y1?- - 1.328 n+5; (1.24) (2.41) (2.16) (4.21) Number of observations = 1500 Researcher 2 estimates: (2)1110): 1.22 + 0.72 Y( - 0.38 Y'D-l - 0.42 Di+s'2} (0.26) (5.13) (3.28) (2.72) Number of observations 2 1320 Researcher 3 estimates: (3) In Ci = 1.32 + 1.38 In Y, - 0.1 1 K; + 0.28 E. + 31 (0.54) (6.56) (1.09) (1.10) Number of observations =1280 In all the above regressions, the numbers in brackets are absolute values of t-ratios. a) For each regression, discuss the effect of total monthly expenditure on cinema tickets expenditure. b) Researcher 3 claims to be able to reject the hypothesis that the income elasticity of spending on cinema tickets is equal to 1. Do you agree? Explain your reasoning. c) Which one of these three specifications provides evidence that the income elasticity depends on children? Find the income elasticity for those with and without children in this specification and in each case state whether cinema tickets are a necessity or a luxury. d) Why do all three researchers' specifications have different numbers of observations? Does this worry you or suggest that any of the specifications are better than any of the others? Explain your reasoning. Q2 150 MARKS]. Recent years have seen a fall in labour market participation of older workers. The following data are descriptive statistics from two random samples of individuals aged 50 to 64 in Amherst in year 2000 and year 2010. 50-59 60-64 All 50-64 Year: 2000 Working 6200 2022 8222 Not working 4500 2576 7076 All 10700 4598 5298 Year: 2010 Working 5850 1624 7474 Not working 3960 2608 6568 All 9810 4232 14042 a) For each year, compute simple estimates of the effect of reaching age 60-64 on whether an individual is employed. b) State the conditions under which you could interpret your answers to part (a) as causal effects. Do you think these conditions are likely to hold in this case? Would you consider the estimates in part (a) to be evidence that this 'effect' has changed over time? Explain your reasoning. 2
