Exam 2 Econ 304 Chuderewicz Spring 2014 Name Last 4 PSU ID PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET THANKS AND GOOD LUCK 1 1 THIS IS THE GENERAL EQUILIBRIUM PROBLEM THAT I PROMISED YOU FIRST SOLVE FOR THE INITIAL EQUILIBRIUM AS POINT A WE CONSIDER TWO DIFFERENT AND SEPARATE SHOCKS I CALL THEM SCENARIOS THE FIRST SHOCK IS TO THE LM CURVE THE SECOND SHOCK IS AN IS SHOCK AGAIN WE CONSIDER THESE SHOCKS SEPARATELY SO THAT AFTER YOU COMPLETE SCENARIO 1 THE LM SHOCK WE GO BACK TO THE ORIGINAL CONDITIONS AND CONSIDER THE SECOND SCENARIO WHICH IS THE IS SHOCK Consider the following model of the economy Production function Y A K N N2 2 Marginal product of labor MPN A K N where the initial values of A 6 and K 10 The initial labor supply curve is given as NS 20 4w Initial conditions in the goods market Cd 130 50 Y T 500r Id 704 500r G 150 T 100 Md P 166 0 5Y 1000r We assume that expected inflation is zero e 0 so that money demand depends directly on the real interest rate since i r Nominal Money supply M 2000 1 a 6 points Solve for the labor market clearing real wage w the profit maximizing level of labor input N and the full employment level of output Y Please show work 2 In the space below draw two diagrams vertically with the labor market on the bottom graph and the production function on the top graph Be sure to label everything including this initial equilibrium point as point A 10 points for completely labeled and correct diagrams b 4 points Derive an expression for the IS curve r in terms of Y Please show all work c 3 points Find the real interest rate that clears the goods market Please show all work d 3 points Find the price level needed to clear the money market Please show all work e 4 points Find the expression for the LM curve r in terms of Y Please show all work 3 Now draw four separate diagrams 40 points total Top left a desired savings equals desired investment Sd Id Top right a FE IS LM diagram Bottom left a money market diagram Bottom right An AD AS diagram locating this initial equilibrium point as point A BE SURE to LABEL all diagrams completely 10 points for each correctly drawn and labeled diagram each diagram will have three different equilibriums points A B and C 4 SCENARIO 1 AN LM SHOCK Now suppose that there is shock to real money demand so that the new real money demand function is Md P 146 0 5Y 1000r S1 a 4 points Name and explain two reasons why money demand could change like this if you simply list two reasons you get half credit so please support your answers with a sentence or two and relate to the real world S1 b 6 points What is the new short run fixed price level expression for the LM curve Please show all work S1 c 4 points What is the short run Keynesian fixed price level of equilibrium output and real interest rate Please show all work Please label these new short run conditions to your four diagrams as point B Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class 5 S1 d 4 points Find the new price level associated with the long run general equilibrium Please label these long run conditions to your four diagrams as point C Be sure to label diagrams completely with the inclusion of all the relevant shift variables like we did numerous times in class S1 e 4 points Let us focus on the movement from point A to B the short run in your money market diagram Explain why and in what direction the real interest rate had to change to clear the money market Be as specific as possible as we talked about this a great deal in class S1 f 5 points Now explain why output has changed in the short run Be as specific as possible S1 g 5 points What would the Fed have to do exactly in order to keep prices at their original level consistent with their price stability objective Assume the money multiplier is equal to 0 8 just like it is in the real world 6 SCENARIO 2 AN IS SHOCK 75 points total Let s return to our original conditions Please write down the expressions for your ORIGINAL IS curve and LM curves in the space below so the grader can follow your starting points IS r LM r Now draw four separate diagrams 40 points total Top left a desired savings equals desired investment Sd Id Top right a FE IS LM diagram Bottom left a money market diagram Bottom right An AD AS diagram locating this initial equilibrium point as point A BE SURE to LABEL all diagrams completely 10 points for each correctly drawn and labeled diagram each diagram will have three different equilibriums points A B and C 7 IS shock suppose the consumption function has changed and is now Cd 110 50 Y T 500r S2 a 5 points Name and support 3 reasons why the consumption function would change like this Please refer to real world events that could did cause this to happen to the consumption function S2 b 4 points Derive a new expression for the IS curve r in terms of Y Please show all work S2 c 4 points Now solve for the short run equilibrium output Keynesian and the corresponding real rate of interest Please show all work Please label this short run fixed price equilibrium as point B on all four of your diagrams S2 d 4 points Now find the long run real interest rate consistent with general equilibrium Please show all work 8 S2 e 4 points Find the new price level associated with the long run equilibrium Please show all work S2 f 4 points Derive a new expression for the LM curve Please show all work Label this long run equilibrium as point C in all four of your diagrams S2 g 5 points Is this result desirable That is with perfect information would the Fed allow this long run adjustment to take place Why or why not Explain in as much detail as possible using a real world event hint it s a central banking nightmare S2 h 5 points What would the Fed have to do exactly in order to keep prices at their original level consistent with their price stability objective Assume the money multiplier is equal to 0 8 just like it is in the real world 9 2 30 points total We talked a lot about the Fed s balance sheet quantitative easing and the fact that since October 2008 they the Fed now pay interest on reserves 2 a 15 points In 2008 the Fed pleaded and pleaded with Congress …