QUIZ 3: Macro Winter 2014 Name: __ANSWERS_______ Section Registere : !ri a" a#m# !

!ri a" $#m# Sat%r a" a#m# Mai')o' er: *am$%s 1st "ear *am$%s 2n "ear +,Q%estions 1 3 &14 $oints tota' 1 $oint eac,( For each of the following questions circle ALL of the answers that are unambiguously true. Use only the models we have derived in class. All exogenous variables (A, taxes, G, consumer confidence, business confidence, the monetary base, etc. are held fixed unless ! tell you otherwise. A'so / is ass%me to 0e )i1e t,ro%g,o%t t,e $ro0'em . All other usual assum"tions a""ly. Finally, we will assume that #icardian $quivalence does not hold. !or 2%estions 1334 5e 5i'' ass%me t,at income e))ects on 'a0or s%$$'" are o) e2%a' magnit% e to s%0stit%tion e))ects on 'a0or s%$$'"# Remem0er4 a'' ot,er e1ogeno%s 6aria0'es are ,e' )i1e in t,ese 2%estions# !or e1am$'e4 i) . increases4 "o% are N78 to ass%me t,at eit,er 8!+ or ta1 rates c,ange# Q%estion 1: An %ne1$ecte $ermanent increase in 8!+ &A( 5i'': &circ'e one( .'eac,er

First, let%s see what ha""ens in the labor mar&et. !f A increases "ermanently, we &now the labor demand curve must shift out ('() * +.,A(-.) /+.0 . 1.( increases "ermanently, so (2L# must increase. As (2L# increases, the income effect says we should wor& less (labor su""ly shifts in . 3he substitution effect says that we should wor& more as leisure has become relatively more ex"ensive as wages rise. 3he substitution effect is the movement along the curve. 4ecause the substitution and income effects are of equal magnitude, we &now that 1.( will increase but ) will remain at the same level as )5.

1e define the L#A6 curve as 75 * A-/.0)/.,. 4ecause the income and substitution effects are of equal magnitude, )5 does not change. 1e said that - is fixed. As A increases "ermanently, 75 increases so the L#A6 curve must shift out. 1e define the !6 curve as 7*89!9G9):. As 1.( increases "ermanently, (2L# must increase. As (2L# increases, we &now 8 must increase shifting the !6 curve to the right. Also, the increase in 3F( will increase !(. ; the autonomous "ortion of investment (an increase in 3F( will increase '(-, all else equal . For structural deficits, in lecture we defined structural deficits as< G 9 3r ; (tn 75. As we determined above, 75 must be increasing as A increases. 3hus, structural deficits will decrease. 3he reason is that tax revenues will increase at 75 = even if tax rates do not change. 6ummary< All answers are true. a. 6hift the labor demand curve ()> to the right (on net b. 6hift the labor su""ly curve ()6 to the left (on net c. 6hift the long run aggregate su""ly curve (L#A6 to the right d. 6hift the !6 curve to the right e. #educe structural deficits Q%estion 2: An %ne1$ecte $ermanent increase in go6ernment s$en ing &.( 5i'':

First, the labor mar&et< 1e &now that firms o"timi?e by hiring labor at the "oint where '() * 1.(5. !n other words, we define the labor demand curve as '() * +., A(-.) /+.0. !n our assum"tions, we said that G does not affect A and - is fixed. 6o, as G increases there is no effect on labor demand. 1e also &now that the labor su""ly curve shifts as (o"ulation, (2L#, 2alue of leisure, tn, or tc change. !t%s im"ortant here to note that G is distinct from 3r and #icardian equivalence does not hold ("er our assum"tions . 6o, G does not affect (o"ulation, (2L#, 2alue of leisure, tn, or tc. 3hus, there is no effect on labor su""ly. 1e define L#A6 as 75 * A-/+.0)/+.,. !n the assum"tions, we said G does not affect A and - is fixed. 3hus, an increase in G has no effect on 75 and L#A6 does not shift. 1e define the !6 curve as 7*89!9G9):. As G increases, the !6 curve must shift out. a. 6hift the labor demand ()> curve to the right (on net b. 6hift the labor su""ly curve ()6 to the left (on net c. 6hift the long run aggregate su""ly curve (L#A6 to the right d. 6hift the !6 curve to the right

Q%estion 3:

An %ne1$ecte $ermanent ecrease in 'a0or income ta1es &tn( 5i'':

First, the labor mar&et. 1e define the labor demand curve as '() * +., A(-.) /+.0. As tn changes, there is no effect on A and - is fixed. 6o, there is no change to the labor demand curve. As taxes decrease "ermanently, after tax wages must increase (the government is ta&ing less out of every "aychec& . As after tax wages increase "ermanently, (2L# must increase. 3he income effect tells us the labor su""ly curve will shift in. As after tax wages increase, the substitution effect tells us we want to ta&e less leisure (wor& more as leisure has become relatively more ex"ensive. 3he labor su""ly curve must shift out. 4ecause we told you in the set=u" that the income and substitution effects are of equal magnitude, the combined effect will be that the labor su""ly curve will be in the same "osition as the initial equilibrium before the tax change. 1e define the L#A6 curve as 75* A-/+.0)/+.,. 1e &now that the tax "olicy change does not affect A (by assum"tion ; A is fixed in this exam"le . 1e also &now that - is fixed. Finally, we &now that because the income and substitution effects are of equal magnitude that the labor su""ly curve does not shift on net so )5 has not changed. 3hus, the L#A6 curve does not shift. 1e define the !6 curve as 7* 89!9G9):. As after tax wages increase "ermanently, (2L# must increase. As (2L# increases, we &now 8 increases. 3hus, the !6 curve shifts out. For structural deficits, in lecture we defined structural deficits as< G 9 3r ; (tn 75. 1e &now G does not change, 3r does not change. As we determined above, 75 does not change. 4ut, tn is decreasing so government revenues are falling. 3hus, structural deficits will increase. a. 6hift the labor demand ()> curve to the right (on net b. 6hift the labor su""ly ()6 curve to the left (on net c. 6hift the long run aggregate su""ly (L#A6 curve to the right d. 6hift the !6 curve to the right e. #educe structural deficits Q%estion 4 &3 $oints( 8onsider an economy with a required reserve ratio (m of +.+@ (@ "ercent . 6u""ose that the only "erson that holds cash is me and that ! have A,@+ in cash held outside the ban&ing system. 6u""ose no other currency is ever held outside of the ban&ing system (forever more, the currency to de"osit ratio will be ?ero . Finally, su""ose that ban&s lend to their limit in that they never hold excess reserves (m5 * m . Given the above assum"tions, by how much will the money su""ly increase when ! ta&e my A,@+ and de"osit it into the ban&ing systemB (ut your answer in the box. 6how your wor&. 1e will grade this question as either being all correct (0 "oints or wrong (+ "oints . Hint: This problem may involve slightly more thought than it appears on the surface.

Cere%s what we have initially< 3he required reserve ratio is @D< $ri& has A,@+ outside the ban&ing system and no one else in the economy ever holds cash< 4an&s never hold excess reserves Cere%s what we have in this "roblem< !nitial de"osits in the U.6. ban&ing system< 3he required reserve ratio is @D< $ri& has A+ outside the ban&ing system and no one else in the economy ever holds cash< 4an&s never hold excess reserves 3otal de"osits * !>.m 'oney 6u""ly * F3> 9 F38 F3> * ,@+..+@ * AE@,+++ F38 * =A,@+ 6o 'oney 6u""ly * AE@,+++ = A,@+ * AEG,H@+ !n other words, some of the increase in total de"osits resulted from $ri& reducing his total currency held outside the ban&ing sector (3> went u" and 38 went down . 3his ha""ens when the initial de"osit started as a "art of 38. Cowever, when the Fed "uts money into the economy ; that initial de"osit is )I3 originally "art of 38. !n that case, the change in 3> would equal the change in the money su""ly (assuming no one in the economy holds cash and ban&s lend to the limit . AEG,H@+ Q%estion 9 &3 $oints( !n the (lanet 'oney story J3he !nvention of 'oneyK, the re"orters tal&ed about the "olicies within one large country that caused its citi?ens to believe that their currency again had value. (3his story encom"assed all of Act E of the radio "iece . 1hat was that countryB 7our answer should be only one word. 4ra?il (As discussed in class, we all get 0 "oints for this . !> m * * A,@+ @D m 38 m5 * @D

* A,@+ * m

38 * A+ m5 * m 3> * ,@+.+.+@ * AE@,+++