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ECO 304 Homework Lesson 10 Solution Paper

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Economics 304 Homework Lesson 10
1. (30 points) As we can see from the graphic below, the simulated real
business cycle (RBC) model fits real world data quite well with the
exception of average labor productivity (the bars on the far right hand
side of the graphic). In particular, the real world data suggests that
average labor productivity is weakly pro-cyclical with the correlation
between average labor productivity and output between 0.3 and 0.4.
The simulated correlation from the RBC model over 0.8, clearly not
consistent with the facts. Given these results, we say that the
simulated RBC model implies that average labor productivity is more
pro-cyclical than it actually is.
We then argued that when we add fiscal (Government spending) shocks
to the RBC model, this average labor productivity is too pro-cyclical
problem is lessoned since the theory implies that in a fiscal shock
world, all else constant, average labor productivity tends to be slightly
counter-cyclical. In the space below, explain in detail how average labor
productivity is slightly counter-cyclical in a fiscal shock world. Be
sure to support your arguments with a labor market diagram and a
production function labeling the initial equilibrium (before the fiscal
shock) as point A and the subsequent equilibrium (after the fiscal
shock) as point B. Be sure to explain exactly why workers and firms
change their behavior given the fiscal shock. Finish your essay by
commenting on how the RBC theorists felt about discretionary countercyclical fiscal policy and why (i.e., hands off or hands on?).
Write your essay here be sure to refer to your graphs in your
discussion.
2. (40 points total) When Milton Friedman and Anna Schwartz in a book
titled: A Monetary History of the United States, 1867-1960 uncovered
the empirical reality that money is pro-cyclical and leading, the
classical economists went to the drawing board. We discussed how
the RBC theorists explained this phenomenon through reverse
causation. We also discussed how the New Classical school explained
this phenomenon via the Lucas Island Model.

a) (20 points) In the space below, provide the RBC explanation as to

why money is leading and pro-cyclical. Be sure to include a money
market diagram, an IS-LM diagram, and an AS/AD diagram in your
answer being sure to refer to your graphs in your essay. Finish your
essay by discussing whether or not money is neutral in the RBC model
and why.
b) (20 points) In the space below, use the Lucas Island Model to
provide an explanation as to why money is leading and pro-cyclical
according to the New Classical Economists. Be sure to include a
completely labeled AS/AD diagram and an explanation of what we mean
exactly by a Lucas Aggregate supply curve (along with the intuition
underlying it). Finish your essay by discussing whether or not money is
neutral in this New Classical model and why.

ECO 304 Homework Lesson 10 Solution Paper

Complete Answer