Question 2. TRUE
This question was about OKUN's law, which shows that when GDP growth
is high, unemployment falls and when GDP growth is low or negative,
unemployment rises (Blanchard, pp. 27-28)
It does not necessary imply that the unemployment level is low, when GDP
is high or when GDP growth is higher than average. Okun's law shows
that there is a EMPIRICAL relationship between CHANGES in GDP and CHANGES in
unemployment.
Question 3. FALSE
First of all, fluctuations in investment are as important as
fluctuations in consumption. Second, only part of the fluctuation in
consumption is due to changes in confidence - part is due to changes
in wealth or current income. Even though, consumption represents close
to 70% of GDP, it is much smoother than investment, which is much more
volatile. (See Blanchard Ch 8. Volatility of Consumption and Investment
pp.159-161)
Question 4. FALSE
This was about the "Paradox of thrift". When the savings rate, (1-c1),
goes up, the marginal propensity to consume, c1, goes down. This means
that, consumption goes down and so do output and income, therefore,
investment and private savings end up being lower (this is just
looking at the goods market). Some of you, recognized that in the
general IS-LM model, a lower c1, implies that the IS shifts down (the
slope also changes), this results in a lower equilibrium output and
interest rates. The resulting effect on investment would be then
ambiguous.
The fact that investment is equal to private plus public
savings (I=S+(T-G)) does not imply that an increase in the savings
RATE (not level of savings, private or public) will translate into a higher
level of investment.
Question 5. FALSE
This question was about CREATING money, not controlling the money supply!
The central Bank creates the monetary base only, which consists of currency and
reserves, H = CU + R.
The actual money supply, M, includes checkable deposits and currency. The
former are created in the commercial banking system. The minimal reserve
requirement induces an upper bound for the creation of deposits. In the simple
model presented in the book M = ( 1+c ) / ( c + theta) * H.
Note: When foreigners change foreign against domestic currency, H might be extended against the central Bank's will, but the currency is still created by the Central Bank.
Question 6. FALSE
Reducing the Budget Deficit means either raising T or lowering G. Both are
contractionary and lead to lower demand and therefore lower equilibrium output.
The Is curve shifts left. There is no way you can decrease T-G without a
contraction effect.
However, a.) The contraction could be offset by a monetary expansion, shifting
the LM curve to the right and resulting in higher output and lower interest
rates. or
b.) The deficit reduction could increase consumers' confidence or could make
them revise their expectations of future interest rates downwards, increasing
Permanent Income and the PDV of investments and hence, shifting the IS back to
the right.
So, Budget Deficit reduction does not necessarily lead to a contraction of output.
Question 7. TRUE
Investments depends on the real interest rate, the demand for money on the
nominal interest rate, i= r + expected inflation. So, for every y, the real
interest rate r at which i gives Money Market equilibrium is decreased 1-1 by
the increase in expected inflation. So, the LM curve in ( r,Y) space is shifted
down by the same amount. So, we obtain a new equilibrium with higher output and
lower real interest rates. I = I ( r, Y), where r enters with a negative and Y
with a positive derivative, so I goes up.
Note: No Dynamics Story was necessary here.
Question 8. FALSE
By the Permanent Income Hypothesis, the perfectly rational consumer should
choose his consumption in period t only as a function of the PDV at time t of his
total wealth. So, changes in current income would have only a small impact on
current consumption.
However, there are several instances where current consumption should be by far
more significant. Those that come to mind first are
Question 1
(a). The package consists of a fiscal contraction and a monetary expansion. As a result, IS shifts down left and LM shifts down to the right. Final effect is that interest rate goes down, and output is in principle ambiguous. The most correct answer is that output will stay more or less constant or decrease, because the fed remains vigilant to inflation, but we accepted as correct the other options as long as your answer is consistent..
(b).
Effect on investment: interest rate decreases means investment goes up. Regarding
output, if said output constant then nothing else happens. if it goes down,
investment goes down to so final effect is ambiguous.
Consumption goes down because T increase. If output constant nothing else
happens. If output decreases C decreases too.
Unemployment varies negatively with output. If output constant U constant too.
(c).
Short interest rates fall today and in the future, thus long term interest
rates fall too. Therefore the prices of bonds go up (Price = $Z / (1+i)
Stock prices can decline if Y suffers a substantial decline, this is so
because Y affects the size of dividends. Otherwise the price of the stock will
rise due to a lower discount factor for future dividends (i.e. due to a lower
i).
(d).
This policy will reduce expected interest rates, therefore long term
interest rates are reduced (remember the yield curve), thus prices of bonds
today increase.
It is probably that the stock price will increase today, due to the lower
future interest rates. But it could be the case that the increase in future
taxes decreases future income, causing lower future dividends. Thus, the
effect today is uncertain.
One point here, the policy is expected tomorrow, so tomorrow there won't be
any change in prices (given no additional news in the future). But the
announcement of the policy is today and it was not expected, that is reason why
today we do have a change in the prices of bonds and stocks.
Question 2
[Note: Each part worths five points]
(a). The CPI is the price of purchasing a fixed basket of goods. It takes a group of goods that represents the consumption of the average urban dweller (done by surveys, not randomly neither theoretically) and get the price for that basket each year and compare it to the prices of that same basket in a base year.
(b). Basically there are 4 biases:
(c). This question was about prices (CPI), not consumption, income or standard of living.
The main idea was to check how the different biases on the CPI affect both groups. Some possible answers:
Yuppies are more affected by the quality bias, meaning that their true CPI is lower than the actual CPI. This would imply that the true inflation rate for them is lower than the true CPI for the welfare people.
Welfare people are more likely to do bargain hunting and shopping at discount stores, meaning that their true CPI is lower than the actual CPI. This would imply that the true inflation rate for them is lower than the true CPI for the yuppies. But as some people argue, only well-off people can pay fees or have cars to go to this stores, so the answer can be the other way around.
Some people argue that since yuppies don't care about the price they paid, merchants can increase the price of the goods yuppies consume freely, while if they increase it to the poor people they will go an substitute goods. This question gives a good answer about the price LEVEL of the goods for the yuppies (i.e. Designer's jeans vs. Outlet jeans). Therefore, you have to give a good answer to explain why the GROWTH has been higher.
Finally, you can't use the behavior of prices in the last years as an evidence for your argument without considering the biases present there. For example, you can't say that the increase in the price of the goods that the yuppies implies that their true CPI has been increasing, because we already know that the quality bias is present there.
From the given model, we can write the IS relation as follows:
Y = Z = C + I + G = c0 + c1*(Y-T) + d0 + d1*Y + d2*i + G.Thus, we can rewrite the relation as a function of Y.
Y = [1/(1-c1-d1)] * [c0 - c1*T + d0 - d2*i + G]or, as a function of i,
i = [(c0+d0+G-c1*T)/d2] * [(c1+d1-1)/d2]*YTherefore, the slope for IS curve is (c1+d1-1)/d2, which has negative value as expected.
2. The LM relation represents the financial market equilibrium, which states that in equilibrium, money supply(Ms) is equal to money demand(Md).
From the given equation, the LM relation is
Md = Ms = M = k*Y - h*iTo find the slope for the LM curve, write in term of i.
i = (k/h)*Y - (M/h).Therefore, the slope for LM curve is k/h, which has positive value as expected.
[Note: in this question, we ask for the expression of LM relation, which represents the combination of Y and i, in which the financial market is in the equilibrium. Thus, it is inappropriate to substitute for Y into the LM relation, since it will simply give us a single point, and not entire LM relation.
3. To derive the overall expression of Y from the two relations above, simply substitute the expression of i (from LM relation) into IS relation.
Then, we get equilibrium Y = {1/[1-c1-d1+(d2*k/h)]} * [c0+d0+G-c1T+(d2*M/h)].
[Note: this equation expresses Y as a function of all exogenous variables in the model (i.e. G,M,T) along with relevant parameters. Since i is an endogenous variable, we need to substitute for it in the above equation.]
4. In this model, decrease in consumer confidence can be represented by an increase in either c0 (autonomous consumption), or c1 (marginal propensity to consume).
As a result of this decrease, consumption will decline, leading to lower demand, and thus output. Decline in demand and output will be reflected in the IS-LM model through the shift of IS curve to the left, while LM curve stays the same. This results in lower output level and lower interest rate than the initial level.
The composition of GDP will be affected as follows:
6. The multipler in this is 1/(1-c1-d1+(d2*K/h)).
The multiplier is IS-only world is 1/(1-c1-d1), which we know is definitely greater than one given c1+d1 <1. The multiplier effect works here because a rise in Y leads to c1 increase in consumption and d1 increase in investment, while the increases in consumption and investment will further increases Y. We all know this well.
However, the multiplier in IS-LM world can be less than 1 because rising Y leads to rising i(which is because i=(k/h)Y-(M/h)), crowding out investment (as I is negatively related to i).