QUIZ 6: Winter 2013 Name: __ANSWERS______ Section Registered T es a!m! T es "!m!

Wed

#ai$ %o$der: Q i. ass m"tions: Note:

&am" s '1st (ear) &am" s '2nd (ear) E*ening +,!-!

All consumers are non-liquidity constrained, non-Ricardian PIH (as developed in class) Expected inflation is assumed to be constant (even t ou! prices can c an!e)" # e economy is initially in lon! run equilibrium at $% & '( ) *" No monetary or fiscal policy takes place unless I tell you otherwise #+P, taxes, consumer confidence, value of leisure, population, !overnment spendin!, and t e nominal money supply do not c an!e unless I tell you t ey c an!e /o can se a 0$an1 "iece a "a"er or 0$an1 macro 2or1s,eets 2,en ans2ering t,ese 3 estions! /o s,o $d not ,and t,ese in! Q estion 1 '10 "oints 4 2 "oint eac,)

5i*en t,e mode$ de*e$o"ed in c$ass6 2,ic, o7 t,e 7o$$o2ing are nam0ig o s$( tr e a0o t a "ermanent increase in oi$ "rices8 &irc$e a$$ t,e tr e statements! W,en ans2ering t,is 3 estion6 ass me t,e 7o$$o2ing: +rices increase in t,e s,ort r n! Income e77ects on $a0or s ""$( e3 a$ s 0stit tion e77ects on $a0or s ""$(! T,e $e*e$ o7 em"$o(ment in t,e s,ort r n 'N 1) is $ess t,an t,e ne2 $ong r n $e*e$ o7 $a0or s ""$(! An( monetar( "o$ic( ta1es "$ace 0et2een t,e s,ort r n and t,e $ong r n!

Reca$$ 7rom To"ic 9 s$ides6 an increase in oi$ "rices is $i1e a decrease in T%+: 7irms can "rod ce $ess 2it, t,e same amo nt o7 N and :! T,ese c r*es 2i$$ s,i7t initia$$(: ;SRAS s,i7ts $e7t 'it is more e<"ensi*e 7or 7irms to "rod ce at eac, $e*e$ o7 o t" t) ;LM s,i7ts in as "rices increase '"rice '+) increase in t,e s,ort r n 2as t,e ass m"tion) ;AD s,i7ts $e7t 'I'!) 7a$$s as #+: 7a$$s gi*en t,e com"$ementarit( 0et2een oi$ and ca"ita$ and &'!) 7a$$s 0eca se rea$ 2ages "ermanent$( 7a$$) ;IS s,i7ts $e7t 'I'!) 7a$$s as #+: 7a$$s and &'!) 7a$$s 0eca se +=>R 7a$$s as rea$ 2ages 7a$$ in $ong r n) ;Real money supply s,i7ts in as "rices '+) increase ;Money demand s,i7ts in as / 7a$$s 'gi*en t,e s,i7t in o7 A- and SRAS) -Labor demand s,i7ts $e7t '2e get t,is 7rom t,e com"$ementarit( 0et2een oi$ and $a0or? i7 oi$ "rices increases6 3 antit( o7 oi$ decreases 0( $a2 o7 demand? as 3 antit( o7 oi$ decreases6 t,e

margina$ "rod cti*it( o7 $a0or 7a$$s at e*er( $e*e$ o7 rea$ 2ages? t, s6 rising oi$ "rices m st res $t in a s,i7ted in $a0or demand c r*e) ;Labor supply s,o $d s,i7t to t,e rig,t 'W@+ 7a$$s as t,e $a0or demand c r*e s,i7ts in? t,ere7ore6 +=>R 7a$$s "ermanent$(? as 2e 7ee$ "ermanent$( "oorer6 t,e income e77ect sa(s 2e 2i$$ 2or1 more) Note: T,e net e77ect on NA 'in t,e ne2 $ong r n) is no c,ange! We ass med t,e income e77ect and t,e s 0stit tion e77ect o77set! ;LRAS s,i7ts to t,e $e7t 'an increase in oi$ "rices is $i1e a negati*e tec,no$og( s,oc1 so it s,i7ts in o r "rod cti*e 7rontier ; as oi$ 3 antit( 7a$$s 'as oi$ "rices increase) /A 2i$$ 7a$$ ; as disc ssed a0o*e6 t,ere is no c,ange in NA in t,e $ong r n as t,e income and s 0stit tion e77ects cance$) To s mmari.e6 in t,e s,ort r n6 / 7a$$s 'as SRAS and A- s,i7t in)6 /A 7a$$s6 & 7a$$s6 + increases '"er t,e e<am ass m"tions)6 interest rates are am0ig o s 'IS s,i7ts in and ># s,i7ts in)6 In*estment 'I) is am0ig o s 't,e a tonomo s "art 7a$$s and t,e interest rate com"onent is am0ig o s)6 N 7a$$s '0eca se ; "er e<am ass m"tions N in t,e s,ort r n is 0e$o2 ne2 NA 'and NA didnBt c,ange))6 and W@+ 7a$$s 'gi*en + increased)! We 1no2 ; "er e<am ass m"tions6 N C ne2 NA in t,e s,ort r n and / C ne2 /A in t,e s,ort r n! Se$7 &orrecting #ec,anism 5etting s Dac1 to /A In t,e $ong r n6 t,e se$7 correcting mec,anism 2i$$ occ r 'i7 no "o$ic( ta1es "$ace)! In t,is case6 nomina$ 2ages 'W) 2i$$ %A>> 0et2een t,e s,ort r n and t,e $ong r n '2e need W@+ to 7a$$ 0et2een t,e s,ort r n and t,e $ong r n so6 2e 1no2 t,at t,e a0so$ te *a$ e c,ange in W 0et2een t,e s,ort r n and t,e $ong r n 2i$$ e<ceed t,e a0so$ te *a$ e c,ange in + 0et2een s,ort r n and $ong r n! As W 7a$$s6 t,e SRAS 2i$$ s,i7t o t some! T,is 2i$$ " t do2n2ard "ress re on "rices '0et2een s,ort r n and $ong r n)! T,is 2i$$ ca se t,e ># c r*e 'and rea$ mone( s ""$( c r*e) to s,i7t rig,t 0et2een t,e s,ort r n and t,e $ong r n 'as "rices 7a$$)! T,is 2i$$ ca se interest rates to 7a$$ 'as 2e mo*e do2n IS c r*e)! T,is 2i$$ ca se I to increase 't,is is not a c,ange in I'!) ; in*estment increases 0eca se interest rates 7a$$! As I increases6 / 2i$$ increase 0ac1 to its ne2 $ong r n $e*e$! Det2een t,e initia$ condition and t,e $ong r n6 t,e A- and IS 2i$$ 0e s,i7ted $e7t ; t,is is a$$ do to s,i7ts 0et2een t,e initia$ condition and t,e s,ort r n! Det2een t,e s,ort r n and t,e $ong r n6 t,ere 2i$$ 0e no c,ange in A- or IS i7 t,e se$7 correcting mec,anism 0rings s 0ac1 to /A! a" # e +ed could better ac ieve bot of t eir policy !oals (i"e", ,eepin! P close to P * and ,eepin! $ close to $%) if t ey decrease t e nominal money supply (-)" %A>SEEI7 t,e %ed decreases t,e nomina$ mone( s ""$(6 t,e A- and ># c r*es 2i$$ s,i7t in! We 1no2 t,at s,i7ting in t,e A- c r*e 2i$$ ac,ie*e o r "rice o0Fecti*e 0eca se a 7a$$ in demand corres"onds 2it, a "rice decrease! Go2e*er6 gi*en t,at / is 0e$o2 ne2 /A in t,e s,ort r n6 a dec$ine in nomina$ mone( s ""$( 2i$$ act a$$( 7 rt,er red ce / 'ta1ing s 7 rt,er a2a( 7rom /A)! b" .nder t e self-correctin! mec anism, nominal /a!es (0) /ill unambi!uously fall bet/een t e s ort run and t e lon! run" TRUE! See a0o*e! 5i*en t,at N is 0e$o2 ne2 NA in t,e s,ort r n 't,is 2as a 3 i. ass m"tion)6 2e 1no2 t,at W 2i$$ ,a*e to 7a$$ to c$ear t,e $a0or mar1et!

c" .nder t e self-correctin! mec anism, t e 1- curve /ill unambi!uously s ift ri! t bet/een t e s ort run and t e lon! run" TRUE! See a0o*e! d" .nder t e self-correctin! mec anism, t e I2 curve /ill unambi!uously s ift to t e ri! t bet/een t e s ort run and t e lon! run" %A>SE! See a0o*e! e" .nder t e self-correctin! mec anism, t e absolute value c an!e in nominal /a!es (0) bet/een t e s ort run and t e lon! run /ill unambi!uously exceed t e absolute value c an!e in prices (P) bet/een t e s ort run and t e lon! run" TRUE! See a0o*e!

Q estion 2 '10 "oints 4 2 "oint eac,) W,ic, o7 t,e 7o$$o2ing are nam0ig o s$( tr e a0o t a "ermanent dec$ine in $a0or income ta<es 'tn)8 Ass me t,e income e77ect on $a0or s ""$( is greater t,an t,e s 0stit tion e77ect on $a0or s ""$(! A$so ass me t,e econom( ret rns to t,e $ong r n *ia t,e se$7;correcting mec,anism! &irc$e a$$ tr e ans2ers! As 2e sa2 in S ""$ementa$ Notes 11:

>arge ta< c ts s,o $d increase &ons m"tion '&) toda( 'ass ming Ricardian e3 i*a$ence does NHT ,o$d)! T,is 2i$$ s,i7t o t 0ot, t,e A- c r*e and t,e IS c r*e! As "rices increase 'gi*en A- s,i7ted o t)6 ># 2i$$ s,i7t in a $itt$e! T,e net e77ect o7 IS s,i7ting o t and ># s,i7ting in is t,at interest rates 2i$$ rise! As interest rates rise6 In*estment 2i$$ 7a$$! T,is is NHT a s,i7t in t,e IS c r*e ; it is a mo*ement " t,e IS c r*e! Not,ing 2i$$ ,a""en to t,e SRAS c r*e 'no c,ange in W6 A6 or oi$ "rices)! Not,ing 2i$$ ,a""en to t,e $a0or demand c r*e! We 2i$$ F st mo*e " and do2n t,e $a0or demand c r*e in t,e s,ort r n! T,e $a0or s ""$( c r*e 2i$$ s,i7t 'see 0e$o2)! D t t,at is NHT re$e*ant in t,e s,ort r n 0eca se 2e are o77 o r $a0or s ""$( c r*e in t,e s,ort r n! Gere is an i$$ stration o7 t,e A-;SRAS mar1et!

2RA2* P3 P* (a) A4* (b) A43

$%*

$3

In t,e $ong r n6 2e need to $oo1 at t,e $a0or s ""$( c r*e! Reca$$6 t,e s 0stit tion e77ect sa(s t,at (o 2i$$ 2or1 more '$a0or s ""$( s,i7ts o t6 NA increases and a7ter ta< 2ages increase 4 note di77erence 0et2een 0e7ore and a7ter ta< 2ages 4 2e ,a*e done t,is a$$ 0e7oreI)! T,e income e77ect sa(s t,at as a7ter ta< 2ages increase6 +=>R 2i$$ increase and 2e donJt need to 2or1 as m c, 4 t,is 2i$$ s,i7t $a0or s ""$( in ca sing NA to 7a$$ and a7ter ta< 2ages to increase 7 rt,er! I7 t,e income e77ect dominates:

's* 's3 05P (67) (a) (b)

'%67

'%*

'3

'

(Arro/ measures distance bet/een '3 and '%67)

I7 income e77ect dominates6 $a0or s ""$( 2i$$ s,i7t in 'on net)! >a0or 2i$$ 7a$$ and e3 i$i0ri m 2i$$ 0e at "oint '.2)! NA 2i$$ 7a$$ and a7ter ta< rea$ 2ages 2i$$ rise! Note: I7 2e are "rod cing at N1 in t,e s,ort r n6 2e are rea$$( 7ar 7rom o r e3 i$i0ri m $a0or 'NA.2) i7 t,e income e77ect dominates! To get 0ac1 to e3 i$i0ri m in t,e $ong r n6 t,e se$7 correcting mec,anism 2i$$ 1ic1 in! We 2i$$ demand 2age increases 'W 2i$$ increase)! T,e s,ort r n aggregate s ""$( c r*e 2i$$ s,i7t in! T,e ne2 e3 i$i0ri m 2i$$ 0e an intersection o7 t,e ne2 SRAS 's,i7ted $e7t 0et2een s,ort r n and $ong r n)6 t,e ne2 A- c r*e 's,i7ted rig,t 0et2een initia$ condition and s,ort r n) at t,e ne2 $e*e$ o7 /A 's,i7ted $e7t as NA 7a$$s)! T,is 2i$$ 0e at a ,ig,er $e*e$ o7 "rices! 5i*en t,is6 2e 1no2 t,at ># 2i$$ s,i7t in 'as #@+ 7a$$s) ca sing r to increase and I to 7a$$ '0et2een s,ort r n and $ong r n)!
a" 8onsumption (8) /ill unambi!uously fall bet/een t e s ort and t e lon! run" %A>SE! &ons m"tion increases t,e moment ta<es 7a$$ 'as +=>R increases)! &ons m"tion t,en sta(s at its ne2 $e*e$! T,ere is no c,ange in cons m"tion 0et2een t,e s,ort r n and t,e $ong r n! b" # e money demand curve /ill unambi!uously s ift left bet/een t e s ort run and t e lon! run" TRUE! See a0o*e! Det2een s,ort r n and $ong r n6 / 7a$$s! So6 2e 1no2 mone( demand s,i7t in 2,en / 7a$$s! c" # e real money supply (-5P) /ill unambi!uously s ift left bet/een t e s ort run and t e lon! run" TRUE! See a0o*e! As + increases 0et2een s,ort r n and $ong r n '7rom se$7 correcting mec,anism)6 #@+ 2i$$ 7a$$!

d" # e labor demand ('d) curve /ill unambi!uously s ift left bet/een t e s ort run and t e lon! run" %A>SE! T,e $a0or demand c r*e K #+N K W@+! T,e $a0or demand c r*e 2i$$ not s,i7t as a res $t o7 t,e c,ange in $a0or income ta<es as A6 : are not c,anging! We 2i$$ mo*e a$ong t,e $a0or demand c r*e as t,e $a0or s ""$( c r*e s,i7ts in as a res $t o7 t,e strong income e77ect! e" # e level of ' in t e s ort run ('3) /ill unambi!uously be i! er t an t e ne/ level of '%% in t e lon! run" TRUE! See a0o*e!