April 2012 Final Examination

Macroeconomics -- Honours ECON 352D2 April 24, 2pm

Examiner:

Markus Poschke

Assoc Examiner: Francisco Alvarez-Cuadrado

INSTRUCTIONS:

This is a CLOSED BOOK examination. You are permitted hard-copy TRANSLATION dictionaries ONLY. No CALCULATOR required or permitted. This examination consists of 6 short questions and 3 long questions. Solve five of the six short questions. Solve all long questions. There are 180 points in total. Points per question are indicated. The exam is printed on a total of 4 pages, including this cover page. This examination is PRINTED ON BOTH SIDES of the paper This examination paper M UST BE RETURNED

Course: ECON 352D2, Macroeconomics -- Honours

Page number: 1

Economics 352D2 Winter 2012

Final Exam

Solve ve out of the following six short questions (12 points each)
1. Imagine that you are a macroeconomic policy advisor to the Canadian government. Which model would you use as a base for your advice? (No right or wrong answer here; the quality of your argument counts.) 2. The key mission of the Bank of Canada is ensuring price stability or low and stable ination. Explain briey why high and/or unstable ination is costly. Volatile (unstable) ination implies that agents cannot forecast prices well. Since many of our actions depend on our expectations of future prices. For instance, if wages are paid with a delay, labor supply depends on future prices. Financial investments in nominal assets depend on future ination. Negotiated prices for any contract with future delivery (e.g. large construction projects) depend on future ination. As a consequence, more volatile ination implies more unavoidable mistakes, or suboptimal actions. Volatile ination also implies random redistribution between savers and borrowers. High ination discourages actions with future payos where the return cannot be adjusted to reect the higher ination rate. An example is labor supply, which may be lower if expected ination is high. If in contrast wages are adjusted to reect higher future ination, this may negatively aect labor demand because higher future wages may reduce current prots (e.g. if rms nance part of the wage bill with debt). In general, high ination encourages agents to incur costs to economize on the use of real money balances. These costs wouldnt be necessary with no/low ination and therefore are waste. 3. The cost of adjusting prices is low, so Keynesian models with nominal rigidities clearly do not make any sense. Comment. Main points to mention: this may dier across sectors. More importantly, even if prices arent rigid, wages may be so, in particular downwards, for various reasons you could give, like the cost of negotiating. Of course, as discussed in class, this may be less true for new employment relationships, so the overall degree of wage rigidity may depend on how important these are. You might also want to mention that this then is a plausible way of generating non-neutrality of money, as often thought empirically tting. 4. If there is a tax on interest income, the eect of temporary TFP shocks on the real economy in the real business cycle model becomes longer-lasting. True or false? Explain. A tax on interest income reduces the incentive to transfer resources to the future. Because of the consumption smoothing motive, consumers would like to transfer some of the gains from a temporary TFP shock to the future. With a tax on interest income, less of this transfer will take place, so the eect of temporary TFP shocks on the real economy will last less long. So the claim is false. 5. Some backward people think that a central banks tool is printing money. Explain briey how the following are related to (changing) the money supply and the central banks policy stance: 2

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Final Exam

(a) nominal interest rate targeting (b) quantitative easing (c) qualitative easing (d) the ECBs long term renancing operation Nominal interest rate targeting as discussed in the book: the central bank xed r and M adjusts automatically. The policy stance is controlled by changing r. This works well for M d shocks. Quantitative easing is an expansion of the CBs balance sheet, keeping asset composition constant. (2 points.) Its therefore very close to simply an expansion of the money supply. (Its OK if they say its the same.) (1 points.) Qualitative easing is a change in the composition of the CBs balance sheet, in particular a shift towards more longer term/risky assets. (1.5 points.) The objective is to reduce the interest rate on long term/risky borrowing, the most important part for the private sector. (1.5 points.) The LTRO is similar to quantitative/qualitative easing, but with loans instead of asset purchases, (1.5 points.) and also expands the money supply (1.5 points). (Which of the two its close to depends on the quality of the collateral; its ne if they make either analogy.) 6. The recent Great Recession in the U.S. was unusually severe. This was so because the economy was hit by a combination of shocks. List three such shocks and explain how they eected the economy. For each shock, also explain how you would represent it in one of the models we have been studying. (Do not derive full results.) Possibilities: Credit crunch: rms cannot access credit they need to nance their labor or intermediate inputs (or not at a reasonable price) LD shifts left. Accelerator eect: due to asset prices declines, collateral loses value and rms and households cannot borrow to nance inputs, investment or durables consumption LD and/or YD/IS shifts left. Uncertainty: consumers increase precautionary saving and reduce consumption YD/IS shifts left. Uncertainty discourages investment YD/IS shifts left. Negative wealth eect because of falls in asset prices: consumption demands falls YD/IS left.

Economics 352D2 Winter 2012

Final Exam

2
2.1

Three long questions

The short run (52 points)
1. Explain and show how the full Keynesian sticky wage model is built. What are the main relationships? Explain briey what each curve depicts. A derivation of the sticky wage model was expected, along with the description of the curves and how they interrelate. This is straight from Williamsons book. 2. Imagine that the economy starts o in a situation where the labor market clears. Then it is hit by an unexpected, temporary decrease in TFP. Show the eects of the shock using graphs. Explain every shift of a curve. What are the eects on the interest rate, output, price level, wage and employment? The shock shifts LD and therefore AS to the left. The higher price level makes LM shift left, too. As a secondary eect due to higher r, the labor supply curve shifts outwards. Graphs as well as brief explanations required. The net eect on the variables: interest rates up, output down, price level up, nominal wage stays constant by assumption, real wage down. The eect on employment depends on the relative sizes of the shift in labor demand and the change in the real wage due to the increase in P. If your assumptions were right, you got the credit. 3. Do these eects t the business cycle facts? Yes. Some credit was given even if the shock in (b) was wrong, as long as you compared them with the right business cycle facts. 4. What happens as the nominal wage adjusts? (Assume for this that wage adjustment is faster than the return of productivity to its initial level, i.e. maintain productivity at its low level induced by the shock here). As time goes by, the nominal wage falls towards the market clearing level. Each reduction in W engenders a lower real wage and therefore higher employment and a shift of AS to the right. This stops once the real wage implied by the nominal wage and P has reached its market clearing level. You could draw here something like a vertical long run aggregate supply curve in the AD-AS graph. This shifts left with the productivity shock. Strictly speaking, this is not the long run because the shock is temporary, but then again, were assuming that nominal wages adjust faster than productivity returns to its initial value. Clearly, once the nominal wage has adjusted fully and the labor market clears, the economy enters the situation that a market-clearing economy would have entered right away after the shock. 5. Using graphs, illustrate one policy with which the government could speed up this process. Describe two factors to consider when deciding whether to implement such a policy. The government could speed up the process either by monetary policy (increase in money supply) or by scal policy (increase in government expenditure). Explanation + graphs required. 4

Economics 352D2 Winter 2012

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Both policies imply higher prices, but speed up the adjustment. Therefore, in deciding whether to use them, a government/central bank would need to evaluate the gain in speed (how slow is the adjustment otherwise) and the cost of the increase in prices, which depends on the slope of AS and on how costly ination is perceived to be. 6. Show, using graphs, the eects of the same shock in an economy where the nominal wage is exible. How do the interest rate, output, the price level, the real wage and employment change? As in the course: the LD and YS curves shift left, implying lower output and employment, lower w and higher r. Higher r causes a slight secondary shift in labor supply to the right. Money demand falls because of lower Y and higher r, implying higher prices. 7. How do these changes compare to those in a) the short run and b) the long run of the Keynesian model? Qualitatively, they are the same for both a) and b). Quantitatively, the fall in output and employment is larger in the short run of the Keynesian model than in the long run. But the long run, when the nominal wage has adjusted fully, is just like the RBC model. So rigid nominal wages in the short run lead to larger uctuations in quantities (output, employment).

2.2

Fighting ination (38 points)

Suppose that the economy is in a long-run equilibrium where the ination rate is greater than the optimal rate, i . Then the central bank acts to reduce the ination rate to i . 1. Suppose that the central bank decides to take drastic action, and reduces the ination rate within one period to i . Also, suppose that the private sector has adaptive expectations, so the current expected ination rate is last periods actual ination rate. Show in a diagram the path real aggregate output and the ination rate take over time. Let the long-run level of output be YLR . The economy starts at (YLR , i). The central bank reduces i to i , shifting the economy along the Phillips curve. Output falls. In the following period, expectations adjust, and households expect ination to remain at i . This shifts the Phillips curve, so that it passes through (YLR , i ). In this period, with the ination choice of i , output thus recovers to its long-run value. 2. Now, suppose that the central bank takes the same drastic action, but that the private sector has rational expectations. Explain what the private sector expects and why. Show in a diagram the path followed by output and the ination rate over time. With rational expectations, the expected rate of ination immediately declines to i , the Phillips curve shifts, and the economy immediately moves to (YLR , i ). Therefore, the economy does not have to endure a period of low output to end the excessive ination. 3. Now, suppose that the central bank follows a gradual strategy of reducing the ination rate in a number of steps to i . Under this strategy, show what dierences there are between adaptive and rational expectations for the path of output and the ination rate over time. 5

Economics 352D2 Winter 2012

Final Exam

Suppose that the central bank rst reduces ination to i2 ( (i , i1 )). If expectations are adaptive, the economy moves along the Phillips curve, and output falls to Y2 . In the next period, the Phillips curve shifts down. The central bank could then further reduce ination in every subsequent period while maintaining output at Y2 , until ination hits i . The cost of disination thus are several period of output below trend. If expectations are rational, then with each gradual step down in the ination rate, the Phillips curve immediately shifts downwards by the amount of the reduction in the ination rate. Therefore, the level of output is equal to YLR throughout the gradual reduction in the ination rate. 4. In Canada and many other countries, ination increased in the 1960s and early 1970s until it reached around 10%. It only fell substantially in the early 1980s. Give a plausible explanation for this path. You can assume that the central bank fully controlled ination. Focus on the (possible) reasoning behind the central banks actions, and how it evolved over time. As discussed in the course: the central bank probably rst tried to exploit the Phillips curve, thinking that it represented a stable, long-run relationship. With experience, it became clear that this was not true, but that the central banks actions inuenced agents expectations and shifted the Phillips curve. Learning this took time because it required observing that high ination rates did not have sustained positive eect on output. Once the lesson was learned, an immediate reduction of ination may not have occurred because it was considered too costly: If the Phillips curve does apply in the short run and was considered at at the time, a reduction in ination would have had a large cost in terms of output. Even a central bank that did not believe anymore that the Phillips curve was a good representation of how the economy works had to consider that it might be wrong, and choose a course of ination reduction that avoided large costs. Indeed, the reduction in ination in the early 1980s was accompanied by a severe recession, suggesting that the Phillips curve was not vertical in the short run. Moreover, after this long history of ination, the public may have adjusted its expectations only slowly, making the transition more costly.

2.3

Migration (30 points)

Recently, I read in a foreign newspaper that the Qu ebec government wants to encourage 700,000 foreign workers to migrate to Qu ebec. (No joke.) Lets analyze this. Suppose that a large number of migrants arrive in a country, all at the same time. Suppose that they are in every respect similar to locals. Use the real intertemporal model to analyze the eects of their arrival. 1. How does the population inow aect N, w, Y and r upon impact? Labor market: There are now more people who want to work, so labor supply is larger at each level of w, and thus LS shifts right. LD is unaected, so N increases and w falls. Goods market: YS shifts right because of larger N . YD also shifts right because there are additional consumers, and because the increased marginal product of capital (because of

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Final Exam

higher employment) encourages investment. As a result, Y increases and the eect on r is in principle ambiguous. However: we know that in the long run, r will be as before. During the transition, the marginal product of capital is relatively high (k is below its steady state level). This implies larger investment demand than in the steady state, and suggests higher r. An aside: In richer models, more things can occur. (For example, immigrants could complement locals in production but not in our setting, where everyone is the same.) Notably, it isnt always the case that wages of locals fall. Empirically, this is a hotly contested issue in labor economics. 2. With time, the economy will converge to a new steady state. Explain what you expect the new steady state to look like. In the new steady state, from consumers optimal savings condition M RS = (1 + r), the interest rate will again equal 1/ . Firms optimal investment condition M P K = r + gives the new steady state capital stock. With a Cobb-Douglas production function Y = K N 1 , M P K = (K/N )1 . The capital-employment ratio will thus be the same in the old and the new steady states. This implies that M P N is also the same in both steady states. By rms optimal employment decision M P N = w, this implies that the wage returns to its original level. Hence, all per-capita quantities return to their original levels, while aggregate quantities increase by the rate at which population has increased. 3. Explain how the economy behaves during transition to the steady state. Initially, investment is large since employment increased relative to the existing capital stock and less capital per worker implies higher marginal product of capital. As investment raises the capital stock, it also increases the marginal product of labor, so LD gradually shifts right as the capital stock approaches its steady state level. As it does so, N increases further and w rises back towards its original level. As N rises, YS shifts right further. Investment demand and therefore YD retreat slightly as the steady state is approached. In the new steady state, Y is larger, but Y per capita and r are as in the original situation. In the transition, since capital per worker is below its long run level, the interest rate is higher than initially.