Homework 2 Key ECON 351 PDF

Homework 2 ECON 351 Review Questions (9 points) Question 1 Answer the following questions according to the classical/neoclassical theory of produc- tion. A) How is the real wage of workers determined? 1 point. In the classical/neoclassical model workers are...

Homework 2 ECON 351 Review Questions (9 points) Question 1 Answer the following questions according to the classical/neoclassical theory of produc- tion. A) How is the real wage of workers determined? 1 point. In the classical/neoclassical model workers are paid their marginal product. Put an- other way, a worker gets paid the exact amount by which he or she increases output holding other input constant. B) How is the real rental rate of capital determined? 1 point. In the classical/neoclassical model capital is paid its marginal product. Put another way, capital earns the exact amount by which it increases output holding other inputs constant. C) For a given level of technology, workers will earn higher real wages when capital is: higher or lower? Why? 2 points. Workers will earn a higher real wage in economies with greater amounts of capital. Each additional worker should be able to produce more when capital is greater (i.e. MPL is higher) and should therefore earn a higher wage. D) Show graphically (including all labels, of course), using the market for loanable funds, the effect of an increase in taxes. Assume there is no change in government spending. In equilibrium, what happens to national savings, investment, and the real rate? 5 points. The vertical axis should be labeled with the real interest rate, r, and the horizontal axis measures quantities of savings and investment. Recall that Y is fixed. So as T increases, disposable income falls, causing consumption to fall. This must be matched by an increase in investment when the interest rate falls to bring equilibrium in the market for goods and services. Public savings, T − G will increase, and private savings, 1 Y − T − C, decreases (but by less than public savings increases since the change in T will be large than the change in C(Y − T )). National savings will increase overall. Graphically, the savings curve (the vertical one) will shift right, pushing the real interest rate downwards. Chapter 4 Questions (23 points) Question 2 Discuss the differences between the three types of money. Give an example of each. 3 points. The three types of currencies are fiat, commodity, and representative. A fiat currency is one that is not backed by any other resource. Almost all currencies today are fiat currencies. They work simply because the government says they are legal tender. A commodity currency is one in which the money is valuable in and of itself. For instance, when gold coins were used, the currency itself had inherent value. A representative cur- rency is one where the bills or notes in circulation are worth some commodity and could be exchanged for it. The U.S. gold standard, or the more recent Liberty Dollars, would both be examples of representative currencies. Question 3 In the United States, what organization controls the money supply? Who heads the organization, and what are its primary tools for controlling the money supply (try to come up with at least 3)? 3 points. In the United Stated, the Federal Reserve, headed by Jerome Powell, controls the money supply. Through the FOMC, they mostly buy and sell securities, but they can also change the rate of the discount window, offer an interest rate on excess reserves, or the- oretically change the required reserve ratio (even though they never do). We also talked about term auction facilities and the Fed’s more recent Quantitative Easing (which we discussed quite a bit). Question 4 What are the three qualities that make something money? 3 points. To be money, something must be a store of value, unit of account, and a medium of exchange. Question 5 Go to FRED at the St. Louis Federal Reserve and print off a graph of the M1 money stock that is monthly and seasonally adjusted. 2 points. 2 Question 6 Make two lists. Create a list for M1 which includes at least two components. Create another list for M2 including at least 3 components. Try to think about the largest components for both lists. 2 points. M1 includes currency, traveler’s checks, and checking accounts (currency and check- ing are the main ones). M2 includes M1, savings accounts, money market mutual funds, and CDs (sometimes known generically as time deposits). Question 7 Suppose that the Federal Reserve buys $50 million in government securities from the banking sector. Answer the following questions given the model of the money supply we learned in Chapter 4. A) Suppose that on the balance sheet of the Schumpetarian Development Bank, there is $50,000 worth of loans (this bank only has loans, deposits, and reserves), and the bank cannot loan out any additional money without exceeding its required reserve ratio (reserve-deposit ratio or rr). Suppose this ratio is 10%. How much must the bank have in deposits? 2 points. We know two things: we know that reserves/deposits =.1 and we know that $50, 000 + reserves = deposits. If we solve the first equation for reserves we get reserves =.1 × deposits. Substituting this into the second equation implies that $50, 000 +.1 × deposits = deposits. Solving for deposits yields $55, 556. Sorry this didn’t come out nice and neat. B) Suppose that Joe is representative of the average person that receives a loan. Joe receives a loan for $120,000 (from a different bank) and decides to hold on to $20,000 in currency. What is the currency drain in this economy (currency-deposit ratio or cr)? 1 point. 3 The key to this problem is vocab and recognizing that for any loan, loan = currency held+ amount deposited. Since cr = currency/deposit you can replace deposit with loan − currency. This implies that cr = $20, 000/($120, 000 − $20, 000) =.2. C) Using the previous two parts (specifically the values for rr and cr), what is the money multiplier in this economy? 1 point. 1+cr 1+.2 1.2 mm = cr+rr =.2+.1 =.3 =4 D) What is the total change in the money supply from the Fed’s action? 1 point. ∆M = mm × ∆M B = 4 × $50 million = $200 million Question 8 Explain using our model why the money supply during the Great Depression actually decreased despite an increase in the monetary base. 2 points. During the Great Depression there was an increase in the monetary base; however, at the same time there was a drastic reduction in the size of the money multiplier. As more banks went out of business, individuals tended to hold more money (i.e. cr rose) and banks tended to hold more money in reserve (i.e. rr increased) because they were afraid to give out loans. In our model the money supply is proportional to the monetary base. If the monetary base stayed the same, but the money multiplier falls, you end up with a smaller money supply. Question 9 Suppose that an economy has value of rr=.2 and cr=.2. A) What is the money multiplier for this economy? 1 point. cr+1 The money multiplier is cr+rr. You should be familiar with how to derive this as we did 1+.2 in class. Plugging in the values results in mm =.2+.2 = 1.2.4 = 3. B) Suppose that the Fed wants to decrease the money supply by $300 million. What action should it take and why? 2 points. Remember that ∆M = mm × ∆M B. So if they want to change the money supply by −$300 million = 3 × ∆M B. Solving for ∆M B = −$300 million/3 = −$100 million. They need to sell $100 million worth of securities like government bonds. 4 Chapter 5 Questions (18 points) Question 10 Suppose that the money demand function takes the form (M/P )d = L(i, Y ) = Y /(5i). A) If output grows at rate g, at what rate will the demand for real balances grow (as- suming constant nominal interest rates)? Show your work. 2 points. If output grows at rate g, then Y /5i will also grow by rate g. If the algebra is helpful for you, try doing (new − old)/old where new = 1.05Y /5i and old = Y /5i. This would assume that g = 5%. You’ll find that the growth rate is 5%. B) What is the velocity of money in this economy? Show your work. 2 points. Set real money supply to money demand: M/P = Y /5i. Rearrange it so that it looks like the Quantity Equation: M × 5i = P Y. This implies that V = 5i. C) If inflation and nominal interest rates are constant, at what rate, if any, will ve- locity grow? 2 points. Remember that V = 5i. If i is not changing, then V is not changing. If the level of velocity does not change through time, velocity growth is zero. Question 11 Explain the terms “classical dichotomy” and “monetary neutrality” in the context of the classical model. 2 points. Note that we covered this concept extensively in class, although we did not get to where I explicitly used the term. I consider it fair game for the exam, but it will likely have less prominence than in previous years. The classical dichotomy refers to the fact that nominal variables should not have an impact on real variables in the classical model. For instance, in the long run, changes in the money supply affect the price level but not real GDP which is determined by factors of production. Monetary neutrality is closely related to the classical dichotomy. It specifically says that changes in monetary variables, that are inherently nominal like the money supply and price level, should not affect real variables like output. This result relies heavily on the assumption of perfectly flexible prices. Keep in mind that both of these results will evaporate quickly when we start to think about the short-run. 5 Question 12 Use what you know about the Fisher Effect and the Quantity Theory to answer the following question: if the real interest rate is 5%, the nominal interest rate is 7%, and national income grows at 6%, what is inflation and the growth in the money supply? 3 points. First use the Fisher equation, r = i − π. From this we can deduce that inflation is 7% − 5% = 2%. Next use the Quantity Theory of Money (the questions assumed that v = 0): π = m − y. So we have 2% = m − 6%, therefore the money supply must grow at 8% per year. Question 13 Is the Quantity Theory of Money wrong? Explain based on how it fits the data. Given how much we discussed this in class I am looking for a bit more substance (think 3-4 sentences). 3 points. We looked at two different sets of data. The data that Mankiw presented aggregated the data into decades for the U.S. and also presented a scatterplot for all countries. Both of the graphs that he presented were consistent with the implications of the Quantity The- ory. However, there are different methods for determining the “long-run.” In the blog post from the Asymmetric Economist, Professor Check used 10-year rolling windows. Doing this, and netting out real GDP growth, resulted in a very different picture. It showed the Quantity Theory explained the data well until about 1992 and pretty poorly after that. Likely, the Fed started thinking more closely about inflation, ruining our otherwise neat relationship. So is the Quantity Theory wrong? Depends on who you ask. I would say it is does not accurately describe our recent history, but it does help us develop intuition for how things would work in a perfect world. Question 14 Answer the following questions about inflation: A) List 3 expected costs of inflation with a short description. 2 points. Shoeleather costs are costs associated with searching for lower prices and/or visiting the ATM to withdraw money more often. Menu costs are costs associated with changing prices on menus (or catalogs, billboards, grumpy old men, etc.). It also distorts relative prices since prices do not all rise uniformly. It can also distort tax rates, since capital gains taxes are pain on nominal returns rather than real returns. B) Give one example of how inflation can redistribute income. 1 point. 6 Inflation can redistribute income from lenders to borrows (in favor of borrowers if in- flation is higher than expected) or from employers to workers (in favor of employers if inflation is greater than expected). C) Explain the concept of seigniorage. Does the U.S. rely on it to raise revenue? 1 point. Governments can raise money through taxes, borrowing, or printing money. The latter is known as seigniorage. Most governments around the world use seigniorage to some extent, and the United States is on the low end with only about 3% of revenue coming from printing money. This is also sometimes known as an inflation tax since it reduces real purchasing power of citizens. 7