Exam 2 Econ 304 Chuderewicz Fall 2014 Name KEY 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 Total Points for exam 224 Test time 120 minutes Approximately one minute for every two points To help with time management if spreading time evenly Question 1 with LM shock 92 points 46 minutes Question 1 with IS shock 72 points 36 minutes Question 2 30 points 15 minutes Question 3 30 points 15 minutes 1 Exam 2 Econ 304 Chuderewicz Fall 2014 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 AKN N2 2 Marginal product of labor MPN AK N where the initial values of A 8 and K 10 The initial labor supply curve is given as NS 20 9w Cd 401 50 Y T 500r Id 800 500r G 500 T 100 We assume that expected inflation is zero e 0 so that money demand depends directly on the real interest rate since i r Md P 469 0 5Y 1000r Nominal Money supply M 4000 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 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 2 3 4 SCENARIO 1 AN LM SHOCK Now suppose that there is non policy shock to nominal money supply so that the new nominal money supply is M 4120 S1 a 5 points Name and explain two reasons why money supply would change the way it did Note that this was a non policy shock to the money supply it was not caused by open market operations Finish your answer commenting on whether a money shock like this is currently a concern in the United States S1 b 5 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 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 hit their inflation target of 2 hint the target price level is 2 higher than the original price level Please state the type and amount of open market operations Assume the money multiplier is equal to 0 8 just like it is in the real world 5 SCENARIO 2 AN IS SHOCK 75 points total We spoke of the surprise move of the Bank of Japan announcing quantitative easing in response of renewed deflationary fears partly caused by the increase in taxes Below is an excerpt from the article we looked at The BOJ s move scarcely expected by central bank watchers came after fresh data added to evidence that the April increase in the national sales tax threw the world s third largest economy off track In this part of the problem we are going to model this tax hike and the proposed response by the BOJ 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 6 7 8 IS shock the Government we can pretend it is Japan raises taxes T from 100 to 180 S2 a 4 points Derive a new expression for the IS curve r in terms of Y Please show all work S2 b 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 c 4 points Now find the long run real interest rate consistent with general equilibrium Please show all work S2 d 4 points Find the new price level associated with the long run equilibrium Please show all work Label this long run equilibrium as point C in all four of your diagrams S2 e 5 points Is this result desirable That is with perfect information would the BOJ let this long run adjustment take place Why or why not Please be as specific as possible S2 f 5 points What would the BOJ have to do in terms of the type and quantity of open market operations to keep the price level at its original level consistent with their price stability objective Assume the money multiplier is equal to 1 00 in Japan S2 g 6 points Explain how the AS AD IS LM FE and money market diagrams would be effected if the BOJ conducted the policy as in S2 f above i e to keep the price level its original level 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 trying to convince them that the economic situation was deteriorating fast and that they needed to grant the authority to the Fed to pay interest on reserves sooner rather than later So in October 2008 …