Final Exam: Econ 304 Fall 2014

EACH QUESTION IS WORTH 130 POINTS

DO THIS QUESTION IF A HEADS IS FLIPPED
From the WSJ: How to Energize a Lackluster Recovery Allowing the full and immediate deductibility

of capital investment would spur growth and raise wages. By Edward P. Lazear April 20, 2014 5:35 p.m.
Taxing investment reduces after-tax returns to investing. Investors care about after-tax returns and a tax
policy that lowers investment returns is especially harmful to long-term economic growthThere are
many changes that would improve the efficiency of the tax code, but cutting the tax on investment heads
the list. Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-09, is a professor
at Stanford University's Graduate School of Business and a Hoover Institution fellow.
Please answer the following questions.
1. a) (30 POINTS) In this part you are to explain exactly how lowering the effective tax rate on capital () will
work (in theory) its way through the economy in order to "spur growth and raise wages. In this discussion, you
need to differentiate between the short- run and long-run. In the space below, explain, with graphical analysis,
how lowering the effective tax rate on capital will influence real economic variables in the short run (hint, its a
demand side story). Draw 4 diagrams (label them 1 through 4), with 1) a user cost ; desired capital (K*) diagram,
followed by 2) a closed economy desired saving; desired investment diagram, followed by 3) an IS LM diagram
followed by 4) an aggregate supply ; aggregate demand diagram.
Start at an initial equilibrium and label as point A in all diagrams, with all the associated market clearing
variables denoted by subscript A. For example, in your IS LM diagram, the interest rate that clears the goods
and money market is labeled as rA with the associated output at YA. Note that YA, our initial equilibrium output,
is below full employment output = YB (we are in a recession, read on). Now let the effective tax rate on capital
fall (same as a fall in ) and show how all your graphs are affected. In particular, locate point B as the new shortrun equilibrium in all graphs (assume the standard; that is, let output rise to YB = full employment Y) while
holding the general price level fixed at P A = PB. Make sure you refer to each diagram individually explaining
how and why we get to point B (i.e., provide intuitive economic reasoning starting with how a lower effects K*
and why)!). Be sure to include a discussion of why the real interest rate has to change the way it does - hint,
the money market!
b) (20 POINTS) Now we are going to focus on the idea that in the longer run, the influence of the decrease in the
effective tax rate on capital will have supply-side effects. In particular, argue that this new investment, spurred
on by the lower effective tax rate on capital, will result in a positive productivity shock resulting in a higher A
and K" which will result in a shift upward in the production function (via increasing the MPK f and MPN!) In the
space below draw a production function with the labor market diagram below it and show what is going on in this
longer run. That is, locate the corresponding point B (from above), and then show the longer run influence as
point C in these two (supply side) diagrams. What happens to N* and w*=W/P? Explain in detail. Are these
results in the labor market consistent with sub-title of the article and the business cycle facts? Now explain why
output has changed, give two specific reasons. Note, in this part of the problem, do not worry about identifying
point A in the labor market diagram and production function diagram since point A does not exist given the
assumption that labor markets always clear at full employment (i.e., a weakness of the classical model). Be sure to
label your graphs completely (relevant shift variables) or points will be taken off.
c) (20 POINTS) Now show how graphs 1) through 4) are influenced by this longer-run development. Note again
that we assume that before these longer run developments take hold, the FE line in graph 3) and the LRAS in
graph 4) is set at YB. Now let these longer run developments take hold, i.e., these supply side effects, and label
this final equilibrium as point C. Again, please make sure you refer to each diagram individually explaining how
and why we get to point C (i.e., provide intuitive economic reasoning!). Be sure to include a discussion of why
the real interest rate has to change the way it does - hint, the money market!

d) (20 POINTS) In the space below, discuss how the new classical economists (hint, island) addressed the
business fact that money and output are positively correlated. In this part, be extremely specific in the model
that was developed (tell a story) and relate the assumptions in the model to the empirical fact above. Include a
completely labeled AS AD diagram in your answer and be sure to explain why output changes, given a change
in the money stock. Be sure to explain exactly why the firm changes their output, using the terms: relative shock
and aggregate shock. Use the bread making example that we used in class making sure you identify clearly, the
asymmetry with regard to the real wage the firm pays and the real wage the worker receives. Include 2 graphs as
we did in class and explain the intuition as to why the workers changes their behavior and why the boss (firm)
changes their behavior. Now draw an aggregate demand and aggregate supply diagram explaining how your
individual island analysis (as given above) maps to the macro economy (include points A, B, and C as we did in
class). Write out the expression for the Lucas aggregate supply curve explaining the intuition underlying the
Lucas Aggregate supply curve. In the last part of your essay, discuss what determines the power of monetary
policy (in terms of changing output) in this model, what determines how long the short run is, and whether or
not you believe that this model is a solid basis for conducting countercyclical monetary policy. Finish the
essay by commenting on the following: This model was developed back in the 1960s and 1970s and it is now
2014. Do you believe the model is more relevant or less relevant today relative to when it was written? Explain.
e) (20 POINTS) The real business cycle economists (RBC) showed that in their model, real wages are procyclical, consistent with the business cycle facts. In the space below, draw two diagrams vertically with a
production function on top and a labor market diagram on the bottom. Start at point A and then show specifically,
why wages are pro-cyclical in this RBC model. Make sure you explain exactly why wages change the way in a
profit maximizing context (and label diagram completely). Also explain why workers change their labor supply
decision(s). Using an aggregate supply / aggregate demand diagram, show that wages are indeed pro-cyclical by
mapping points A and B from the production function / labor market diagram to the AS / AD diagram. Use and
refer to your diagrams as to the cyclicality of average labor productivity and the general price level. Are wages
and average labor productivity ever counter-cyclical in the RBC model? - if so, label as point C on your
production function / labor market diagram. Please tell a story about this counter-cyclical real wage just like a
RBC economist would. Be very specific. Finish your essay by explaining how the real business cycle economists
explain unemployment and variations in the unemployment rate.
f) (20 POINTS) The new Keynesians showed that wages are sticky and pro-cyclical. They also showed that the
existence of involuntary unemployment is a normal phenomenon. In the space below, use the theory and the
appropriate graphs that the new Keynesians use to explain the stickiness, the pro-cyclical nature of the real wage,
and the existence of involuntary unemployment. Be sure to explain precisely how the wage is determined in this
model and the intuition underlying the sticky and pro-cyclical nature of the real wage. Finally, use the appropriate
diagram to show that employment is pro-cyclical. To do so, start at full employment at point A and consider an
adverse shock to aggregate demand (point B). Now explain why employment fell and discuss what Keynes would
prescribe to fix the problem and get us back to full employment. Why did Keynes favor fiscal policy over
monetary policy?

DO THIS QUESTION IF A TAILS IS FLIPPED

2. Christina Romer and Jared Bernstein in "The Job Impact of the American Recovery and Reinvestment Plan"
calibrated the impact of the proposed expansionary fiscal policy (we know it as an increase in G and/or a lower T)
on jobs and GDP growth (Click Here for paper). In order to do so, they make assumptions about the size of
Government spending and tax multipliers. One important assumption is contained in the paragraph below about
the level of the federal funds rate:
" For the output effects of the recovery package, we started by averaging the multipliers for
increases in government spending and tax cuts from a leading private forecasting firm and the
Federal Reserves FRB/US model. The two sets of multipliers are similar and are broadly in
line with other estimates. We considered multipliers for the case where the federal funds
rate remains constant, rather than the usual case where the Federal Reserve raises the
funds rate in response to fiscal expansion, on the grounds that the funds rate is likely to
be at or near its lower bound of zero for the foreseeable future."

So in this question, we are going to employ some of the tools that we have acquired throughout the semester to
understand how this assumption, "that the funds rate is likely to be at or near its lower bound of zero for the
foreseeable future," effects the government spending and tax multipliers.
2. a) ( 40 points total: 20 points for correct and completely labeled graphs and 20 points for discussion) In this
question, we are going to compare the size of the Government spending multiplier under two different
assumptions: i) the Fed sits on their hands so that when G rises, r rises with it (the standard case), and ii) the Fed
accommodates the (real) shock to money demand so that real interest rates remain constant.
In the space below, draw 4 diagrams (label them 1 through 4) with 1) a closed economy desired saving; desired
investment diagram, followed by 2) an IS LM diagram followed by 3) a money market diagram followed by 4)
an aggregate supply ; aggregate demand diagram.
We begin at our initial point A which is at an output well below potential GDP (i.e., there is a significant
'output' gap). We let G rise and with the assumption that the Fed sits on their hands (assumption i) above) we
move to point B, which corresponds to an output closer to potential GDP, but still not quite there. We then
assume assumption ii) above so that the Fed accommodates the real shock to money demand to keep real interest
rates constant. This assumption takes us to point C, which is at potential GDP (i.e., the output gap is gone!).
Start at an initial equilibrium and label as point A in all diagrams, with all the associated market clearing
variables denoted by subscript A. For example, in your IS LM diagram, the interest rate that clears the goods
and money market is labeled as rA with the associated output at YA. Note importantly that we are assuming fixed
prices throughout this exercise. Now let G rise to G' and show how all your graphs are affected. In particular,
locate point B in all graphs making sure you refer to each graph separately explaining the intuition of the
movement from point A to point B. Note, we are assuming assumption i), the Fed sits on their hands and does
not accommodate the shock to real money demand.
2. b) (20 points for explanation) We now apply assumption ii), the one Romer and Bernstein use "that the funds
rate is likely to be at or near its lower bound of zero for the foreseeable future." In terms of our analysis, the Fed is
going to make sure that real rates remain at their initial level (i.e., they totally accommodate the real shock to
money demand). Show this accommodation as point C on all of your diagrams. Recall that we are at full
employment/potential GDP at point(s) C. Again, make sure you refer to each graph separately explaining the
intuition of the movement from point B to point C.
2.c) (20 points) Now compare the government spending multiplier under assumption i) no Fed accommodation
and ii) the Fed accommodates the real shock to money demand. Be specific with regard to the multiplier as well
as the intuition. To support your intuition, draw two diagrams: the user cost = MPK f and the two period
consumption model clearly locating points A, B, and C. Referring to your 2 graphs, explain the intuition as to
why we move from point A to point B as well as why we move from points B to C. Be sure to label your graphs
completely or points will be taken off. Make sure you relate your discussion of your two graphs to the difference
in the multiplier depending on what the Fed does or doesn't do.

2.d) (25 POINTS) The real business cycle economists (RBC theory) came up with a story that explains exactly
why money is a leading and pro-cyclical variable. In the space below, draw a money market diagram on the left,
an IS/LM diagram on the right (label completely) and an aggregate demand / aggregate supply diagram below the
IS/LM diagram. Discuss how the real business cycle economists (RBC) addressed this empirical reality (explain
using your diagrams). Starting at the initial equilibrium, point A, let the shock that the RBC theorists use to
explain this money - output correlation occur and assuming the Fed does not react, locate the new equilibrium as
point B (assume prices are perfectly flexible, consistent with RBC theory). Comment on the desirability of this
adjustment in the context of the Fed's price stability objective. Now consider the case where Fed does their job
(recall, the Fed takes their dual mandate extremely seriously) so that these undesirable results do not occur and
label as points C. Is money leading and pro-cyclical given the Fed's behavior? Explain. Why is this model
referred to as reverse causation? Is money neutral or not? Explain. Finish your essay by commenting on how
RBC economists explain the business cycle (recurrent fluctuations in output) as well as their thoughts on
whether or not policymakers, both monetary and fiscal policymakers should conduct active countercyclical policy.
e) (25 POINTS) The New-Keynesians came up with their own story as to why we observe this positive money
output correlation. Begin with discussing why the New Keynesians believe that prices are sticky in as much
detail as possible. Then use the efficiency wage theory/model to buttress (support) your argument (i.e., why does
the efficiency wage theory play a critical role in explaining why firms are willing to produce more output at the
same price?). Draw two graphs, one showing the effort curve and the efficiency wage (be sure to explain how
firms pick the efficiency wage) and the other being a labor supply labor demand diagram with the assumption that
the efficiency wage (w*) is above the market clearing (classical) wage (w class). Why is this model so attractive in
dealing with the empirical reality in labor markets that the classical school has such a hard time with? Now draw
two more diagrams depicting what is happening in the product markets (demand, marginal revenue, marginal cost
and profits) and why firms are willing to change output at the given price level (short run), given the change in
the money stock. Be clear as to why exactly firms are willing to act like a 'vending machine' in the short run (be
willing to increase output at the same price). Is this firm behavior, being willing to increase output at the same
price, consistent with the firms profit maximizing objective? Why or why not?