Solution: HW #2. Title: Business Cycles & Forecasting. Part I Conceptual questions (70%)

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1 Solution: HW #2 Title: Business Cycles & Forecasting Course: Econ 392 Fall/2015 Instructor: Dr. I-Ming Chiu Part I Conceptual questions (70%) Q1. Which of the following policies would a Keynesian expect to produce the largest increase in income? Please explain. a. A tax cut of $200. b. An increase in government spending of $200. c. A "balanced budget" (i.e., G = T) increase in government spending of $200. Choice (b) an increase in government spending affects national income directly. Therefore, it has the largest effect on GDP. Choice (a) has an indirect impact on income via consumption. How much households want to spend after the tax rebate depend on their marginal propensity to consume. Choice (c) has a smallest effect on income because an increase in G will be offset by an increase in taxes. However, its net effect on income is still positive but small. Q2. Money deposited for a term is not left in bank vaults but is loaned out by the banks (subject to minimum reserve requirements). The above statement means that a dollar on deposit can flow back into the banking system one or more times and that dollar can expand the money supply. a) What is the minimum reserve requirements referred to? b) What terminology do economists use to refer to the process described? c) If required reserve ratio is raised and people decide to hold more cash instead of depositing, how is the money supply affected? a. The U.S. has a fractional reserve banking system; a certain portion of bank deposits must be kept as required reserves. It can be in the form of vault cash or deposits with the Fed. b. money multiplier process. c. The money multiplier is going to be smaller and so is money supply. Q3. Under the pressure from the Congress, the U.S. Federal government has been working hard to reduce, or at least not to expand, the budget deficits and national debts. Meanwhile, the Fed keeps pumping money into the economy since the financial crisis took place in 2008~09 period. Using the IS-LM model to illustrate how both policy actions, simultaneously, affect real GDP and interest rate. 1

2 r r 1 r 2 LM 1 LM 2 b a IS 1 IS 2 Note: IS shifts to the left (blue arrow) due to contractionary fiscal policy. LM shifts downwards due to expansionary monetary policy. The outcome is a lower interest rate and the impact on GDP is uncertain because there is an offsetting effect. 2 1 Q4. a) Please provide three explanations regarding why the aggregate demand (AD) has a negative slope according to the Keynesian model. b) Suppose that the aggregate supply (AS) is flat (i.e., a horizontal line and this may indicate the economy is operating under its full capacity), how does a currency depreciation affect equilibrium real GDP? [Hint: you need to explain how AD shifts given the currency depreciation] a) There are three channels that include wealth effect, international trade effect, and real money effect. ou have to elaborate each channel in the test if the same question is asked. b) AE 45 0 AE1 = C + I + G + NX(E 1 ) AE1 = C + I + G + NX(E 0 ) P P* AD 1 AD 2 AS Note: A currency depreciation results in a larger NX (red arrow) and therefore the aggregate spending is larger. Aggregate demand is stronger and real GDP is larger (blue arrow). If the AS is flat, then price remains the same at p*

3 Q5. Conduct a Google search to find the most recent FOMC policy action (the one took place on September 16 & 17 th. What was their main decision after the meeting and why did they make such a decision? Follow the link below and you ll find a press release for the recent FOMC meeting. Q6. Please explain how an expansionary monetary policy affects interest rate (r) and real GDP () according to the following IS-LM graph. (Hint: you have to consider the impacts of monetary policy in both goods and money market) As money supply increases, interest rate drops. This is reflected as a downward (or rightward) shift of the LM (r 1 to r 2 ) in the diagram. The lower interest rate (r 2 ) may encourage more spending (i.e. investment mostly) in the goods market and results in a larger. The increase in ( 1 to 2 ) may cause a larger demand for money in the money market and r increases accordingly (r 2 to r 3 ). r LM 1 LM 2 r 1 r 3 r 2 IS 1 2 Q7. Please explain why the short-run aggregate supply has a positive slope and the long-run aggregate supply is vertical in the price-real GDP space (P and ). a) In the short run, price rises and real wage decreases and this may result in large supply of output due to a temporary increase in the labor demand (i.e., P ; a positive slope of AS). In the long run, as workers renegotiate their wage contract, the real wage would remain about the same and therefore output resumes its initial level. 3

4 Part II: Computational questions (30%) Q1. A mathematical Keynesian model is shown as follows (20 pts): Goods market: = C + I + G + NX C = *DI (DI: disposable income = - T) I = *r (r: inerest rate) G = 1100 NX = * T = 0.2* (a proportional income tax system) Money market: Real money supply: ( P M )S = 1000 Real money demand: ( P M ) d = *r (r: inerest rate) a) How large is the equilibrium GDP? b) Is the govenemnt running a budget surplus or deficit when is in equilibrium? How large is it? c) Is there a trade surplus or deficit when is in equilibrium? How large is it? d) Suppose the potential GDP (the maximum amount of product an economy can produce) equals 6400, what kind of economic problem may occur in the economy and what policy actions should be taken to solve this problem? e) How large is the new govement spending needed to achieve the potential level of GDP? [Hint: Equate money supply with demand to solve for interest rate r. Substitute r to investment equation to find I. Add up C, I, G and NX to find total spending, which is a function of. Equate this spending equation with to find equilibrium GDP (i.e., solve for ).] a) 1000 = r, r = 15% or 0.15 I = *0.15 = 700 AE = C + I + G + NX = *( 0.2*) * = * (Notice that 0.5 is the slope of expenditure line and the corresponding expenditure multiplier is 1/(1-0.5) = 2) = AE = * = 6000 b) G = 1100, T = 0.2*6000 = 1200, budget = G T = -100 (budget surplus) c) NX = *6000 = 0 (trade is in balance; exports = imports) d) Since 6000 < 6400 recession expansionary fiscal, monetary policy or both. e) We can assume the unknow additional governement spedning is x, so AE NEW = x + 0.5*6400. Equate AE NEW with x = 6400, so x = 200 and G NEW = = Alternatively, by knowing that the expenditure multiplier is 2 ( = 2), so additional government spending is 200 ( ). New G should be =

5 Q2. Use R (10 pts) Cigna Corp/Closed Price (09/01/2015 ~ 09/30/2015) Sep Sep Sep Sep Index CI.Close Min. : Min. : st Qu. : st Qu. :139.0 Median : Median :139.8 Mean : Mean : rd Qu. : rd Qu. :141.6 Max. : Max. :142.8 # R code begins here rm(list=ls()) library(quantmod) getsymbols("ci", src = "yahoo") head(ci) da.sep = window(ci,start=as.date(" "), end=as.date(" ")) #"window": subset the data and retrieve the ones in September 2015 dim(da.sep) head(da.sep) CI.Close.Price = da.sep[,4] plot(ci.close.price, main=paste("cigna Corp/Closed Price", "\n", "(09/01/2015 ~ 09/30/2015)")) summary(ci.close.price) # R code ends here 5