FINAL EXAM(Suggested Solution): Fall 1997 (12/23/97)

**PART ONE: TRUE/FALSE/UNCERTAIN**
(5 POINTS EACH)

1. FALSE

Short run

A permanent increase of nominal growth would imply an increase in money supply (LM shifts rightward). The usual effect on the nominal interest rate is a decrease (in order for people to hold more money, nominal interest rate has to be lower. Since in the short run, inflation expectations don't change, real interest rate would also go down. (Prices increase because AD shifts upwards, but not a lot initially)

Long run

In the long run, expected inflation equals actual inflation. Inflation will increase by 4% as Y goes back to Yn. The real interest rate returns to its natural rate, while the nominal reflects one-for-one the increase in inflation (Fisher effect). (See graph in page 384 of textbook)

2. FALSE

An increased budget deficit implies that the IS shifts to the right. Output goes up because (G-T) increases and through the multiplier effect. Nominal interest increase (money demand increases with increase in income). From AS-AD, we know AD shifts upwards and prices increase. Using the interest parity condition, a higher nominal interest rate implies a lower nominal exchange rate, therefore the domestic currency APPRECIATES. The real exchange rate goes further up because of the increase in prices.

If Marshall-Lerner condition holds, an appreciation of the currency has a negative impact on the trade balance, after adjustment period (J-curve)

The increase in Y in the short run has an additional effect on the trade balance, since imports increase with income. Eventually, when the country returns to the natural level of output this effect will disappear.

If you want to assume that the country has a fixed exchange rate, then you need to analyze the implications of expansive fiscal policy for the exchange regime.

3.- TRUE

A higher savings rate cannot permanently increase the growth rate of the economy. A high savings rate implies higher capital accumulation (I=sY; in the long run, Y=Yn). Why? Because of decreasing returns to capital, sustaining a steady increase in output per worker would require larger and larger increases in capital per worker, i.e. higher and higher increases in savings.

A higher savings rate, however, leads to a higher output per capita in the long run. The rate of growth of the economy in steady state is determined by technological progress and the rate of growth of the labor force. In the transition from one steady state to another, the savings rate does affect the rate of growth (it increases it). (for a more detailed discussion see p.474 in the textbook)

4.- FALSE

Solow's residual provides a rough estimate about the importance of technological growth.

g_y= a*g_k+(1-a)*g_l + technological progress

where "a" represents the share of capital in GDP. He found out that it was about 2%.

5. FALSE

Expectation of future inflation will cause workers to demand higher rate of wage increase to keep compensate for expectation of higher future cost of living. As a result, firms will raise prices of their products at a rising rate, thus leading to increase in inflation rate, or general price level, in the present period.

However, with higher expected inflation rate, the nominal interest rate tends to increase as well. With higher nominal interest rate, the price of existing bonds will decline due to its lower present value of the future nominal payments.

6. FALSE/UNCERTAIN

The relation between inflation and unemployment rate, which was established in several empirical studies for the US during 1900-1960, did disappear after the oil shock in the 1973. Though the oil shock caused a considerable increase in inflation rate for a period of time, it was not the main reason for the disappearance of the original Phillips curve. Rather it is the persistence of high inflation and the role it played in changing the way people form their expected future inflation that played a major role. (see the text)

7. FALSE

The neutrality of money simply states that change in nominal money will not have any impact on real variables (eg. real output, real interest rate, etc.) of the economy in the long run. It will eventually lead to higher price level. However, in the short run, monetary policy can be quite a powerful and effective policy tool in achieving short run economic objectives. For example, expansionary monetary policy can be used during a recession.

8. FALSE

The direct way to answer this question is to recognize that with increase use of wage indexed contracts in the economy, change in unemployment will have a larger impact on change in inflation rate. This is equivalent to having a larger alpha in the Phillips curve relation. (see Chapter 17) Therefore, it will lead to a smaller sacrifice ratio (i.e. 1/alpha) during disinflation process. Partial credit is also given for any reasonable discussion regarding to roles that difference in initial inflation rate condition, as well as credibility issue may affect the sacrifice ratio.

**PART TWO: LONG QUESTIONS
**

**Question 1
**

Using WS-PS framework to explain that unemployment benefit will change the natural rate of unemployment permanently to a lower level. (Note: not just unemployment rate is larger, but will stay larger in the long run.) (10 points).

Short run: Because this program is not supported by tax but by borrowing, we see AD/IS curve shift to the right in the short-run. Also, price will also increase in the short-run due to the increasing bargaining power of the labor. Therefore, LM/AS curve shift to the left. The answer for the short run is: high interest rate, ambiguous output level and unemployment rate. AS_AD and IS-LM frameworks should be used to show the reasoning. (12.5 point).

Long run: The economy will reach its new natural state: lower output level and higher unemployment rate, which is determined by the WS-PS analysis before. IS-LM should be used to show that interest rate is higher. (12.5 point)

**Question 2**

a.) the economy is operating at the natural rate of unemployment, u, and output, g. Therefore, u(t) = 5%, from Okun's Law ( u(t) - u) = 0 = - .5( g(y(t)) - g), so g(y(t)) = 3%. Inflation, I, is 10 % and therefore, the money market equation tells us that g(m(t)) must be = 3% + 10% = 13%.

b.) u(t) = u( t-1) = 5%. Plugging into the Phillips curve one period after another, the desired path of disinflation gives us uniquely the implied path of unemployment. With these numbers, we can calculate the path of output growth using Okun's law period by period. Finally, output growth and inflation add up to the growth rate of the money supply in every period. The implied numbers ( all in percents) are:

time t t+1 t+2 t+3 t+4
I 10 7 3 3 3
u(t) 5 8 9 5 5
g(y(t)) 3 -3 1 11 3
g(m(t)) 13 4 4 14 6

c.) To calculate the total sacrifice, we simply have to add up the excess unemployment (u(t) - u) in each year. In t+1 there are 3% excess unemployment, in t+2 there are 4%, in all other periods there isn't any. So the total sacrifice is seven percent.

d.) The Phillips curve with coefficient 1 and expected inflation = I (t-1) tells us that we have to pay for every percentage point of reduction ( I(t) - I(t-1)) with one point year of excess unemployment. This holds regardless how we distribute the disinflation over time, the total sacrifice for a reduction from 10% to 3% will always be 7%.

The credibility of announcements of a changed government policy can have a significant impact on the cost of inflation reduction, though. If the Fed announces a new inflation target for year t, say 3%, and everybody actually believes it, then I(t) expected is just 3%. So, in t, we could have actual inflation of 3% without any excess unemployment at all! The intuition for this is as follows: If wage setters ( workers and firms, bargaining) expect lower price increases, they will, at least the way we set it up, reach wage agreements with lower wage increases. Given these, firms have lower costs and can, due to (imperfect) competition achieve only lower price increases. So inflation falls given the rate of unemployment, due to expectations only. This does not necessarily favor fast processes over slow ones. While there is more opportunity to mess up your reputation during a long process, there is also opportunity to build it up in the first place.

Finally, it is debatable whether revised expectations can translate into different wage setting immediately, since wages aren't necessarily free to move every year ( staggering). The updating of expectations is more complicated then.

**Question 3**

a) (5 points) The decision of the governor of the Siam bank of increasing the reserve ratio reduces the money multiplier. The increase in reserves reduces the amount of deposits that banks are able to re-lend. Money supply in the economy is equal to the monetary base (H) multiplied by the money multiplier. Given that H remains constant, the money supply in Siam decreases with this policy measure.

b) (10 points) We are assuming that we have a closed economy, thus the increase in the reserve ratio represents a monetary contraction. Using the IS-LM and the AS-AD model we can solve for the short run and long run effects of a monetary contraction.

In the short run the LM curve shifts to the left/up. The decrease in M reduces the real balances in the economy, in order to clear the money market the interest rate increases (nominal and real), this actually decreases investment, leading to a contraction in output and therefore in investment. To solve for the short run level of prices we use the AS-AD model. AD shifts to the left/down: we have lower quantity of money, thus for the same level of transactions (or output) we will have lower prices.

In the long run, assuming that the economy was initially at the natural level of output, the initial decrease in prices and output will push wages down which will decrease prices, shifting to the right/down the AS curve, up to the point when the economy reaches again Yn. The decrease in prices increase real balances; this reduces interest rates, causing an increase in investment and therefore in output. This is neutrality of money; the only effect in the long run will be lower prices (even lower than the short run level). Output, investment, consumption, nominal and real interest rate all return to their initial level before the increase in the reserve ratio.

c) (10 points) Bond prices are inversely related to interest rates, thus the increase in the interest rates decreases their price. In the case of the stock, the price of a stock is the expected present discount value of dividends. In this case, dividends decrease by the decrease in output and the discount factor is higher by the increase in the interest rate. If the policy was anticipated, markets would already be adjusted, thus the expected movements in prices of bonds and stocks will be lower (in the extreme, with perfect capital markets there is not change at all in prices).

d) (10 points) Now Siam is an open economy, we will consider the short run and prices will be fixed. In this case, the increase in the reserve ratio increases the interest rate, according to the interest parity condition the nominal exchange rate will appreciate. More people will want to buy Siam's bonds; thus an appreciation of the Siam currency is required to have arbitrage between domestic and foreign bonds. The nominal appreciation will cause a real appreciation (prices are fixed). If the Marshall-Lerner condition is satisfied, the real appreciation hurts the trade balance (it is also true that the initial decrease in output, caused by the policy, could diminished the negative effects on the trade balance, but in general it will be hurt).

**Question 5,**

a) (10 points):

The answer comes from the Okun's Law: u(t)-u(t-1)=-b*[g(t)-gn], where u is unemployment, g growth and gn potential growth. Therefore, if from 1990 to 1992 growth was 0% and unemployment increased, these means the gn should be greater than 0. But, we now that from 1992 to the date the growth rate has been 3% and unemployment decreased, therefore the growth rate should be less than 3%. Moreover, since to return from 8% to the level of unemployment of 1990 it took us 4 years, while to get from that unemployment rate to 8% only took us 2 years, gn should be closer to 3% than to 0%.

Check that the potential growth comes from to factor: productivity growth and growth of the labor force (people working or looking for job), not employment.

Also check that nor the question neither Okun's law have something to do with the natural unemployment rate. The level of that rate was not mention in the question.

[You got partial credit for mentioning that the Okun's Law is what explain the movements in unemployment (4 pts), also for citing the article about the level of potential growth (3 pts), but the get full credit you should have answered what is above.]

b) (10 pts):

Your potential growth is going to be measured with error. Differently, your potential growth is going to be understated. Recall, potential growth is equal to productivity growth plus labor force growth. Therefore is productivity is understated, the potential growth is understated. The potential growth should be 1 or maybe 2 points higher. [3 pts]

However, this does not mean that the FED should intervene. Why?, because productivity is calculated dividing GDP by employed worker. Therefore, if productivity is measured with error, GDP is also measured with error. Consequently, is the measured GDP growth is 2.5% the actual GDP is growing at 3.5-4.5%. This means that the economy is growing at its potential rate and the FED should not intervene because what is going to cause is inflation. [7 pts]

[You got partial credit if you mention that the FED should not intervene when the economy is growing at its potential output (3 pts), however you should have justified why that is true in this case to get full credit].

c) (15 pts):

This question has actually two statements and you should have refuted both. The first one is the first sentence: That low inflation and low unemployment gives a case to the advocates of high-productivity. As you remember, this seems to be contrary to the Phillips Curve. However, the main idea of this question is to use what you know from the article to refute it (and the article is written with the theory we have been studying through the course). As it is stated in the article: "..., the 'speed limit' applies only when the economy has expanded as much as it can by taking up slack, by employing unemployed resources".

Therefore you can have growth if you are coming out of a recession. Therefore if today inflation is low and unemployment low is not contradictory, the thing is what is going to happen tomorrow. As he mentions in the article: "...wage increases have begun, and stories about labor shortages have become common".

An alternative explanations is that although wages are high, non-wage labor costs have been decreasing (as health care costs), therefore, labor costs are not increasing.

Finally you can also say that the appreciation of the dollar is making imports cheaper and allowing inflation to remain low. Any of these explanations will get you full credit (5 pts).

The second statement is about "globalization". Here you should have explained why this approach is wrong. Two alternatives to do that is mentioning the facts or going to the theory.

Fact: Global competition only occurs in the goods-producing sector -very few services are traded on international markets- and even within manufacturing these are many industries that remain largely isolated from foreign competitors. Therefore, since the US is mainly a service economy, only 15-25% of employment and value-added are actually subjected to global markets.

Theory: It does not matter is the country is subject to global competition, once any economic slack has been taken up the maximum possible growth rate of any piece of the economy is the still equal to the sum of productivity and labor force growth in that piece. Is the FED increase the money supply inflation will arise and the EXCHANGE RATE will do the job of keeping our goods competitive. So actually we will experience inflation in both home goods and imported goods. this is the famous Samuelson's Angel. (10 pts)

[To get full credit you should have EXPLAINED both of them].