FINAL EXAM: Macro 302 Winter 2014

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1 FINAL EXAM: Macro 32 Winter 214 Surname: Name: Student Number: State clearly your assumptions when you derive a result. ou must always show your thinking to get full credit. ou have 3 hours to answer all questions. Good luck! 1

2 Please leave this page blank for your grade. 2

3 Question 1 Prices What is the core PCE? Discuss its advantages over core CPI. (2 pts.) PCE stands for Personal Consumption Expenditure Deflator. The CPI is the Consumption Price Index. A price index is a ratio showing the price of a basket of goods and services in various years in relation to the price of the basket in a base year. The quantities in the basked are kept at some reference basket level and are the same as in the base year. PCE is a Deflator. For example, the GDP Deflator is constructed by dividing nominal GDP (i.e. measured at current prices) by the real GDP measured with respect to the prices in the base year. Each component of GDP has a deflator, which is computed similarly as the GDP Deflator. The Personal Consumption Expenditures focuses on consumer expenditure in final goods and services (think of retail sales data for food, clothing, autos, etc.): it is the deflator used for aggregate consumption C. Therefore, the essential difference is that in the CPI the quantity weights of the items in the consumer basket do not change relative to the reference basket, while in case of the PCE the weights are allowed to change each year. Therefore the CPI fails to capture shifts in spending by consumers toward cheaper goods and tend to overstate inflation rates. As the PCE re-weights the consumption bundle each year, it overcomes this shortcoming of CPI. Fiscal stabilizations Question 2 Suppose the economy is hit by a negative shock to consumer confidence. ou are required to describe the stabilization effects of two different policies: 1. An increase in government spending G; 2. A permanent reduction in labor income taxes. In the first three sets of graphs describe graphically how the short run, the labor market and the long run equilibrium will change in response to an increase in government spending in conjunction to a fall in consumer confidence. In the second set of graphs describe graphically how the short run, the labor market and the long run equilibrium will change in response to permanent reduction in labor income taxes in conjunction to a fall in consumer confidence. Assume that all workers experience zero income effects and are non-ricardian. Compare the two policies. Which one would you recommend? In the following graphs it is shown that both policies can offset the negative shock of decreasing consumer s confidence level in the short run. However, a permanent decrease in labor income tax has different long run consequences, as it can also boost output in the long run by increasing the labor supply and the equilibrium level of employment in the labor market. 3

4 Short run: increase in government spending in conjunction to a fall in consumer confidence here (1 pts.) SRAS Ns P P1 W/P AD AD ND 1 N LM r IS IS IS NOTES Let us consider a partial offset of the negative shock. For the Goods Market: The drop in consumer s confidence depresses the private consumption, C, and hence shifts the IS curve inwards from IS to IS. The increase in government offsets the negative shock and shift it backward to IS. The AD curve as a result shifts in and the short run equilibrium is determined by the intersection of AD and SRAS. The output changes from to 1 and the price drops from P to P 1. 4

5 Labor market: increase in government spending in conjunction to a fall in consumer confidence here. (1 pts.) SRAS Ns W/P1 Unempl. P P1 W/P AD AD ND 1 N 1 N LM r IS IS IS NOTES The drop in price level increases the real wage, as the nominal wage is fixed in the short run. In the short-run we climb up the labor demand curve to N 1, which is the employment level corresponding to the output 1. 5

6 Long run: increase in government spending in conjunction to a fall in consumer confidence here (1 pts.) SRAS Ns SRAS W/P1 P P1 P2 W2/P2=W/P AD AD ND 1 N 1 N LM r IS IS IS NOTES In the long run, because of the self-correcting mechanism, the nominal wage is going to adjust down to W 2. In the meanwhile, the price level in the AD_AS space is adjusting to P 2. The real wage in the long run will converge to the original one, i.e. W 2 /P 2 =W /P clearing the labor market. The SRAS shifts outwards and goes through the intersection point of AD and. In the long run the output converges back to and the price level further drops to P 2. 6

7 Short run: permanent reduction in labor income taxes in conjunction to a fall in consumer confidence here (1 pts.) SRAS Ns P P1 W/P AD AD ND 1 N LM r IS IS IS NOTES Again let us consider a partial offset of the negative shock. For the Goods Market, the drop in consumer s confidence depresses private consumption, C, shifting the IS curve inwards to IS. The permanent reduction in labor income taxes increases the PVLR of the consumers, who increase their consumption (by assumption, the consumers are non-ricardian.) As a result, the IS curve shift back to IS. The AD curve consequently shifts in to AD. The short-run equilibrium is determined by the intersection of AD and SRAS. The equilibrium price drops to P 1, and the output changes to 1. 7

8 Labor market: permanent reduction in labor income taxes in conjunction to a fall in consumer confidence here. (1 pts.) SRAS Ns P P1 W/P1 W/P Ns AD AD ND 1 N 1 N LM r IS IS IS NOTES For the Labor Market: The effective wage for workers is (1-t)W/P. As the labor income tax decreases, the effective after-tax real wage increases. Because of the substitution effect, the workers would like to provide more labor. (The income effect is negligible zero- by assumption.) Then the labor supply curve N s will shift out in the before tax space. The drop in the price level increases the before tax real wage as the nominal wage is fixed in the short run. The demand for labor drop consequentially to N 1, which is the employment level corresponding to the output 1. 8

9 Long run: permanent reduction in labor income taxes in conjunction to a fall in consumer confidence here (1 pts.) Ns SRAS SRAS W/P1 Ns P P1 P2 W/P W2/P2 AD AD ND 1 2 N 1 N N 2 LM r IS IS IS NOTES In the long run, the shift to the right as the labor supply curve shifts outward permanently. Because of the self-correcting mechanism, nominal wage is going to adjust to W 2. In the meanwhile, price level is adjusting to P 2. The real wage in the long run will decreases to the W 2 /P 2 < W /P and clears the labor market. The SRAS shifts outwards and goes through the intersection point of AD and. In the long run the output increases to 2, and the price level further drops to P 2. ou can also show that necessarily after tax (1-t ) W 2 /P 2 > (1-t) W /P, which justifies the increase in PVLR discussed earlier on. 9

10 Question 3 Press Release Federal Open Market Committee of the Federal Reserve Release Date: March 19, 214 For immediate release Information received since the Federal Open Market Committee met in January indicates that growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term. The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $3 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $3 billion per month rather than $35 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee's sizable and stillincreasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.[..] This excerpt covers the first part of the most recent FOMC statement by the Fed. Discuss first why deflationary pressures, as indicated in the second paragraph should be a concern of the Fed. Then discuss why the third paragraph was interpreted by market participants 1

11 as a tightening of monetary policy, a hawkish statement to use common terminology. (3 pts.) The deflationary pressures should be a concern for the Fed, because they affect aggregate demand through the following channels: (1) Deflation discourages consumption and investment and hence aggregate demand in the economy. Firms borrow to make investment, some consumer to finance their expenditures. The effective borrowing cost (real interest rate) is determined by r=i- e. Usually, the nominal interest rate, i, is fixed in a loan contract. Hence, a deflation (decreasing in e ) in effect increases the real borrowing cost, r. As a result, investment and consumption will go down. (2) More in general and kind of outside our model, deflation depresses private consumption and hence the aggregate demand in the economy through expectations. When the consumers have expectation that the price level in the future is going to decrease, they tend to postpone consumption to the future. As a result, the current private consumption will go down. In the third paragraph, it is mentioned that the Fed is going to decreases its new holdings of agency mortgage-backed securities and longer-term Treasury securities per month. ( Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $3 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $3 billion per month rather than $35 billion per month. ) Tapering the quantitative easing implemented by the Fed should be considered contractionary monetary policy, as through this unusual type of open market operation, the Fed is injecting lower reserves into the economy in exchange of specific long maturity assets (not the overnight reserves, the fed funds) and hence it lowers the money supply (or more precisely, decreases the rate of growth of money supply.) 11

12 Question 4 Investment Determine if the following statements related to Investment Demand as discussed in our model are TRUE or FALSE and WH. (5 pts. each) 1. Real Fixed Investment and Real GDP are negatively correlated FALSE. Real Fixed Investment and Real GDP fluctuate together, i.e. it is procyclical. 2. Investment is as volatile as consumption. FALSE. Investment is typically more volatile than consumption in OECD data. 3. New single family housing units are part of aggregate investment. True. New Residential structures are part of aggregate investment (even if they are bought and used by private consumers). 12

13 4. The amount of replacement investment due to depreciation is a large fraction of investment in a typical year. True. Note that the gross investment is composed of the net investment, K t+1 -K t, and the investment to replace the depreciation, K t. Given the larger amount of capital stock, K t, in the economy, the second component is a large fraction of investment in a typical year. 5. The user cost of capital affects negatively the marginal product of capital. False. When firms set their capital optimally, the user cost of capital equals to the marginal product of capital (MPK), i.e. UC=MPK. The MPK is not function of the user cost of capital directly, rather K is set so to match UC. When UC is high MPK will also need to be high and K low (due to the diminishing returns to K). 6. Government spending in infrastructure and capital equipment are part of aggregate investment. FALSE. Government spending in infrastructure and capital equipment are counted as government expenditure in the national accounts. 13

14 Question 5 Describe this chart, which was created on Thursday April 1 th 214 using the online market data center of the Wall Street Journal. What is that it represents? Give at least two possible reasons that could explain why the curve was steeper on April 1, 214 than April 1, 213 (they do not have to be realistic, but simply possible according to our simple model of the curve). (2 pts.) The Figure shows the yield curve of the treasury bonds, i.e. the annualized nominal interest rate paid by US treasury bonds of different maturities on that date. Recall that the long term nominal interest rate between period and 2 is determined by (1+i,2) 2 =(1+i,1)( 1+i1,2) where i,1 and i,2 are the interest rate on a one year and two year treasury respectively and i1,2 is the interest rate on a one year treasury starting one period from now. Also, it,t+1=rt,t+1+ e t,t+1+ t,t+1, where t,t+1 captures the default premium and term premium. Based on these relations, we can conjecture that the steeper yield curve (i.e. larger i,2) can be explained by the following reasons: (1) The future real rates r1,2 got larger. (Investors now require a larger real return on a one year treasury starting one period from now). (2) Increase in expected inflation, e 1,2 got larger. (Investors relative to a year ago expect the future inflation rates are going to be higher). (3) Increase in risk premium or term premium in the future, 1,2 got larger. (Investors now perceive that the default risks will increase in the future) 14

15 Question 6 PIH According to the permanent income hypothesis permanent shocks to disposable income should be associated with a larger marginal propensity to consume than temporary shocks. Why? (1 pts.) The Permanent Income Hypothesis Theory predicts that the marginal propensity to consume in case of a transitory change in income ought to be much lower compared to that stemming from a permanent change in income. According to the Permanent Income Hypothesis Theory, current consumption is determined by the sum of discounted value of future income streams, i.e. present value of lifetime resources (PVLR). A permanent income shock changes PVLR by a larger magnitude than a temporary shock and hence has a larger impact on current consumption. Note that the marginal propensity to consume is defined as MPC= C/, where the C and denote the contemporary consumption and income respectively. Given the same current income, a permanent shock has larger effect on C and hence has larger effect on MPC. 15