Name Last 4 PSU ID Final Exam Econ 304 Fall 2014 EACH QUESTION IS WORTH 130 POINTS DO THIS QUESTION IF A HEADS IS FLIPPED From the WSJ Opinion 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 ET Excerpts from article 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 longterm economic growth There 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 it s 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 1 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 r A 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 short run 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 PA 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 MPKf 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 Y B 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 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 change 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 2 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 pro cyclical 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