Name: Intermediate Macroeconomic Theory II, Fall 2008 Instructor: Dmytro Hryshko Problem Set 2 (53 points). Due Friday, November 14

Transcription

1 Name: Intermediate Macroeconomic Theory II, Fall 2008 Instructor: Dmytro Hryshko Problem Set 2 (53 points). Due Friday, November (18 points, 2 points each) Indicate for each of the statements below whether it is true or false, or elaborate on a statement if it does not require a true/false judgment. Briefly explain, supporting your argument with graphs, formulas, or simple reasoning. (a) The unemployment rate will be always greater than zero, since employers will continue firing being unsatisfied with some employees, and employees will continue searching for new jobs trying to find a better fit to their skills. (b) Technological progress may lead to an increase in the job separation rate (e.g., because employers can faster find a match, having fired their worker), and an increase in the job finding rate (e.g., on-line employment agencies can speed up the process of finding a new job for those who are currently unemployed). If the rate of growth of job finding, f, is larger than the rate of growth of job separation, s, then the natural unemployment rate will be expected to increase. (c) Prime-aged people who are discouraged and quit looking for a job are included into the pool of unemployed, and contribute to the unemployment rate statistics published by Statistics Canada. 1

2 (d) In accordance with the classical dichotomy, an increase in the aggregate price level in the economy should lead to an increase in the real production over the long run. (e) Suppose the economy is on a balanced growth path; the growth in the efficiency of labor is equal to 5%; and the growth of population is equal to 5%. If the growth of the money stock is equal to 5%, and the income velocity of money is constant, the inflation rate in the economy will be equal to 5% in the long run, and the aggregate prices will be increasing in the long run. (f) Suppose the government sets taxes on the nominal capital gains. If the ex ante nominal interest rate is equal to 2%, the expected and realized inflation rate are equal to 0%, and the tax rate on nominal gains is equal to 40%, then the investor s real purchasing power will increase by 1.2%. (g) Suppose the government sets taxes on the nominal capital gains. If the ex ante nominal interest rate is equal to 2%, the expected inflation rate is equal to 0%, realized inflation rate is equal to 2%, and the tax rate on nominal gains is equal to 40%, then the investor s real purchasing power will fall by 0.8%. 2

3 (h) Suppose the government sets taxes on the real capital gains. If the ex ante nominal interest rate is equal to 2%, the expected inflation rate is equal to 0%, realized inflation rate is equal to 2%, and the tax rate on real gains is equal to 40%, then the investor s real purchasing power will increase by 0%. (i) If the realized inflation turns out to be higher than expected inflation, we may expect that debtors lose and creditors gain in real terms. 2. (5 points) Suppose the real money demand function is: ( ) d M = L(Y, r + π e ) = 0.01 Y P r + π e, where Y is the real output, r is the real interest rate, and π e is the expected rate of inflation. Real output is constant over time at Y = 300 (i.e., Y Y = 0). The real interest, r, is fixed and is equal to 0.10 per year. Assume that income velocity of money, V, is constant. Suppose that nominal money supply is 600. The central bank announces that from now on, the nominal supply of money is going to grow at the rate of 10% per year. (a) If everyone believes this announcement what are the values of real money supply, the price level, and the nominal interest rate in the year of announcement? (Hint: What is the expected inflation rate that enters the demand for money equation?) 3

4 3. (15 points) Use the IS LM model to determine the short- and long-run effects of each of the following on the equilibrium values of the output, the real interest rate, consumption, investment, the price level, and the real money balances. Draw the relevant diagrams to show how you arrived at your answer. Assume that consumption is not responsive to changes in the real interest rate; and that the economy is initially at the natural level of output. Track the effects for normal cases, i.e., do not bother about vertical/horizontal IS/LM curves. (a) (5 points) A reduction in the effective tax rate on capital that increases desired investment at any real interest rate. (b) (5 points) A severe water shortage causes sharp declines in agricultural output and sharp increases in food prices. Assume that the long-run level of output falls but the short run fall of output is much larger (i.e., the economy is hit severely in the short run but rebounds in the long run). (Hint: The AD curve will be stable since it relates the changes in output to the changes in the aggregate level of prices, given the money supply in the economy. The AD shifts, in response to changes in the money market, only if there are shocks to the money supply or money demand, not to prices. I.e., if the price changes the LM will shift but the AD will not.) 4

5 (c) (5 points) The expected rate of inflation rises. 4. (5 points) Suppose that investment expenditures change very little with a change in the real interest rate. Show what this implies for the slope of the IS curve, and for the relative effectiveness of monetary and fiscal policy in stabilizing real output. Explain your results. Draw the relevant diagrams. 5

6 5. (10 points) The central bank is considering two alternative monetary policies: ˆ holding the money supply constant and letting the interest rate adjust, or ˆ adjusting the money supply to hold the interest rate constant. In the IS LM model, which policy will better stabilize output under the following conditions? Draw the relevant diagrams, and explain how you arrived at your answer. (a) (5 points) All shocks to the economy arise from exogenous changes in the demand for goods and services. (b) (5 points) All shocks to the economy arise from exogenous changes in the demand for money. 6