The gold standard is an example of (commodity money / commodity-backed paper currency / barter currency / fiat money).

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1 Name: Number: Nova School of Business and Economics Macroeconomics, st Semester Prof. André C. Silva TAs: Erica Marujo, Paulo Fagandini, and Pedro Freitas Midterm 2 Maximum points: 20. Time: 1h. Pages: 10. The exam is closed books, closed notes. No calculators are allowed. You may write on the back of the pages if you need space. 1. (2 pts) A shock to an economy caused an increase in interest rates and a decrease in real output. What should be the effect on the price level? Justify. Use the graph for the money market to answer. 1

2 2. (0.5 each, 4 pts total) Select the best answer. The Ricardian equivalence theorem implies that (government debt policy must be handled correctly for the economy to prosper / government spending is neutral / an increase in government spending has no effect on the economy as long as there is an equal change in taxes / the timing of taxes collected by the government is neutral). The gold standard is an example of (commodity money / commodity-backed paper currency / barter currency / fiat money). The real return of money is (zero / minus the real interest rate / minus the nominal interest rate / minus the inflation rate). The money growth rate and the inflation rate (are negatively correlated / are positively correlated, but the relationship is noisy / are positively correlated, and the relationship is tight / are uncorrelated). The Solow residual attempts to measure the amount of output not explained by (technological progress / the direct contribution of labor and capital / economic forecasts/theamountofanation shumancapital). A government policy consistent with real business cycle theory would be for (government to vary its spending in response to shocks to total factor productivity / the monetary authority to expand and contract the nominal money supply in response to real shocks/ government to smooth out tax distortions over time / government to vary its lump-sum tax collections in response to changes in total factor productivity). The Phillips curve shifts because (private behavior adapts to monetary policy / expected inflation changes / the central bank attempts to exploit the Phillips curve /alloftheprevious). Fluctuations in the target interest rate in the New Keynesian model lead to all of the following except (procyclical real wages / procyclical employment / countercyclical prices / procyclical consumption). 2

3 3. (2 pts) What is the commitment problem faced by central banks? How to solve it? Explain. 3

4 (Additional space.) 4

5 4. (6 pts) An economy has production function = ( ) 1,where denotes output, denotes capital, labor, and productivity gains. We have +1 =1+ and +1 =1+, (1) with 0 and 0. Investment is given by =,where is constant, 0 1, and capital follows +1 = +(1 ), (2) where is the rate of depreciation of capital, 0 1. Let and denote output and capital in effective units. Variables in effective units take into account productivity. a. (4 pts) Find an equation that relates effective capital in the future +1 as a function of current capital. What is the growth rate of output per capita,,in the steady state? 5

6 (Additional space.) 6

7 b. (2 pts) Suppose that the savings rate increases. What is the effect of this increase on the growth rate of output per capita? Explain. Use a graph of output per capita over time. 7

8 5. (6 pts) Consider a sudden decrease in current capital caused by a natural disaster. Suppose that the economy is closed. a. (4 pts) What will be the effect of this change on real wages, hours worked, real interest rates, and GDP? Use the diagrams and.justify. 8

9 b. (2 pts) Would it be beneficial for this economy to set up limits for interest rates? Explain. 9

10 (Additional space.) 10

11 SOLUTION SKETCH (2 pts) A shock to an economy caused an increase in interest rates and a decrease in real output. What should be the effect on the price level? Justify. Use the graph for the money market to answer. Answer An increase in interest rates decreases the real demand for money. The reason is that an increase in increases the opportunity cost of money. In the same way, a decrease in decreases the real demand for money. The reason is that less money is demanded in real terms when economic activity is smaller. So, decreases with and decreases with. In the diagram, the line ( ) shifts to the left, as in the figure below. As a result, the price level decreases. M s s M, M d 2. The Ricardian equivalence theorem implies that (government debt policy must be handled correctly for the economy to prosper. / government spending is neutral. / an increase in government spending has no effect on the economy as long as there is an equal change in taxes. / the timing of taxes collected by the government is neutral.) Thegoldstandardisanexampleof(commoditymoney. /commodity-backed paper currency. / barter currency. / fiat money.) The real return of money is (zero / minus the real interest rate / minus the nominal interest rate / minus the inflation rate). 11

12 The money growth rate and the inflation rate (are negatively correlated / are positively correlated, but the relationship is noisy / are positively correlated, and the relationship is tight / are uncorrelated). The Solow residual attempts to measure the amount of output not explained by (technological progress / the direct contribution of labor and capital /economic expectations / the amount of a nation s human capital). A government policy consistent with real business cycle theory would be for (government to vary its spending in response to shocks to total factor productivity / the monetary authority to expand and contract the nominal money supply in response to real shocks/ government to smooth out tax distortions over time / government to vary its lump-sum tax collections in response to changes in total factor productivity). The Phillips curve shifts because (private behavior adapts to monetary policy / expected inflation changes / the central bank attempts to exploit the Phillips curve / all of the previous). Fluctuations in the target interest rate in the New Keynesian model lead to all of the following except (procyclical real wages / procyclical employment / countercyclical prices / procyclical consumption) (2 pts) What is the commitment problem faced by central banks? How to solve it? Explain. Answer The commitment problem is related to the possibility of central banks to stimulate the economy in the short run by relying on a Phillips Curve. If, in addition to its ability to follow the target for inflation, the monetary authority is evaluated positively by short-run increases in GDP, then a monetary authority might increase the supply of money to increase GDP. This action may increase inflation in the short run but may be compensated by an increase in output. The commitment problem arises when the public understands this temptation. If this happens, the public adjusts inflation expectations to higher levels, as the public understands that the monetary authority gains in the short run by short-run increases in inflation. A central bank may announce its intentions to keep inflation low. However, the public understands that the central bank is not able to commit to this policy. A solution to the commitment problem is to state in the clearest way possible that the objective of the central bank is to maintain inflation low. Moreover, it should be 12

13 clear to the public that the performance of the monetary authority will be evaluated by the ability to keep inflation low. Other actions that are part of the solution to the commitment problem are setting up policies that make the central bank independent from the government. In this way, the government would have little ability to influence the central bank to stimulate the economy in the short run. Similarly, the government would have little ability to finance itself through the central bank. We see these actions put in practice in various central banks. It is very common, for example, to find a clear statement of the central bank saying that its main objective is to maintain price stability (6 pts) An economy has production function = ( ) 1,where denotes output, denotes capital, labor, and productivity gains. We have +1 =1+ and +1 =1+, (1) with 0 and 0. Investment is given by =,where is constant, and capital follows +1 = +(1 ), (2) where is the rate of depreciation of capital, 0 1. Let and denote output and capital in effective units. Variables in effective units take into account productivity. a. (4 pts) Find an equation that relates effective capital in the future +1 as a function of current capital. What is the growth rate of output per capita,,in the steady state? Answer Equation (2) implies = ( ) 1 +(1 ) +1 (1 + )(1+ ) = +(1 ). In the steady state, is constant. We have =. Therefore, is also constant in the steady state. As =,aconstant implies that that grows at the same rate of. Therefore, output per capita,, grows at the same rate of productivity growth. Output per capita grows at the rate. b. (2 pts) Suppose that the savings rate increases. What is the effect of this 13

14 increase on the growth rate of output per capita? Explain. Use a graph of output percapitaovertime. Answer Using +1 (1 + )(1+ ) = +(1 ),wehavethatanincreaseinthesavings rate implies a temporary increase in the rate of growth of. However, in the longrun, willstillconvergetoaconstantandthegrowthrateof will be equal to. Consequently, output per capita grows faster temporarily but it returns to the growth rate in the long run. The figures below illustrate the process. y y pc pc g y pc t t Fig (6 pts) Consider a sudden decrease in current capital caused by a natural disaster. Suppose that the economy is closed. a. (4 pts) What will be the effect of this change on real wages, hours worked, real interest rates, and GDP? Use the diagrams and.justify. Answer Follow the explanation and graphs of the Williamson, chapter 11, on a decrease in the current capital stock. b. (2 pts) Would it be beneficial for this economy to set up limits for interest rates? Explain. Answer First, from the reasoning above, the interest rate increases. This effect is likely to be substantial as decreases and increases. Both changes act upon in the same direction to increase. An substantial increase in might create pressure for the imposition of maximum limits to. However, imposing limits would not be beneficial. The reason is that an increase in signals consumers that it is better to decrease consumption to give room to investment. This is important as investment will crucial to the reconstruction of capital. 14

15 Another reason is that an increase in signals to other regions that investment is important where capital decreases. If the economy opens up, this will attract capital from other economies. If the whole region is still considered closed, then this is signal that investment will have to be saved for those projects that imply higher returns. 15