Part I: (15 pts) Short-answer questions (Please answer briefly. No need to expla

Question

Part I: (15 pts) Short-answer questions (Please answer briefly. No need to explain your answers unless otherwise stated.)

(3pts) Write down the Fisher Equation (also known as the “Fisher Effect”). When is the Fisher Equation typically used – in the short run or in the long run?

(3pts) What are the three main functions of money?

(3pts) List three leading economic indicators.

(3pts) What is the direction of the relationship (positive or negative) between the natural rate of unemployment and the rates of job separation and job finding?

(3pts) What is “consumption smoothing”? What is its relevance to the consumption puzzle?

Part II: Problems and Essay Questions (Please include any relevant equations and diagrams. Keep your explanations brief.)

(15 pts) Milton Friedman and the Permanent Income Hypothesis

(5pts) What is Milton Friedman’s Permanent Income Hypothesis? Write down the key equation(s) of the model.

(10pts) How does the Permanent Income Hypothesis resolve the Consumption Puzzle? In particular, use the equations of the model from part (a) to derive the Average Propensity to Consume (APC). Explain why the APC declines with income in the short run and why it is constant (independent of income) in the long run.

(15pts) Banks and the Money Supply

(5pts) Suppose the Fed reduces the discount rate. How will this affect the monetary base, the money multiplier, and the money supply?

(5pts) Suppose that the economy enters a recession, banks are failing due to poor investments/loans, and consumer confidence is falling. How will this recession affect the currency-deposit ratio, the reserve-deposit ratio, the money multiplier, and the money supply?

(5pts) Considering the scenario in part (c), discuss at least one policy the central bank can undertake in order to keep the money supply stable.

3.(15pts) The AD-AS Model

(a) (7pts) Political Fighting in the Middle East, Iran’s nuclear program, and the emergence of ISIS caused households and businesses to be uncertain about the future of the U.S. economy. In response, households/businesses were delaying large purchases/projects until the situation was more under control and a new presidential administration was in place. Use the Aggregate Demand and Aggregate Supply diagram to discuss the predicted short-run and long-run impacts on the price level, real GDP and unemployment.

(b) (8pts) What are the policy options available to the Federal Reserve in the short and long run? Use an Aggregate Demand – Aggregate Supply diagram to support your discussion.

(20 pts) The Early 1980’s: The early 1980s were an exciting time for the economy. President Reagan was attempting a tax cut revolution while the Federal Reserve, under Chairman Paul Volcker, was attempting to control inflation. Note: in both parts (a) and (b) explain the effects in all markets (Keynesian Cross, Money Market, and the IS-LM diagram itself).

(10 pts) President Reagan’s tax policies were a crucial part of his economic plan. The most important policy tool was a massive tax cut (30 percent in three years). Use an IS-LM diagram to show how tax cuts would affect the economy. Assume that monetary policy does not change in this question.

(10 pts) Now say that President Reagan’s fiscal policies were expansionary (as in part a) while Volcker’s monetary policy was contractionary (lower money supply). How would these two contemporaneous policies be represented in a single IS-LM diagram? Can you say anything definitive about how output and interest rates would change?

(20 pts) Japan in the 1990s The 1990s were characterized as the “lost decade” for Japan. Growth in per-capita GDP was very low as the economy stagnated. As usual, economists debated at length whether Japan should try to use monetary or fiscal policy to solve its problems. The IS-LM model played a key role in these debates.

a. (5pts) To start thinking about which policy the government should follow, let’s first think about the situation in Japan and what the LM curve looks like for Japan. Interest rates were extremely low in Japan at this time. When interest rates get close to zero, the demand for money is extremely high (say close to infinity). In this case, what does the LM curve look like? Draw a picture of what the LM curve may look like for Japan.

b. (5pts) Let’s think about what happens to the LM curve when the government uses expansionary monetary policy. How does the LM curve shift and how does this affect output and interest rates? Therefore, how effective a tool is monetary policy for pulling the economy out of the recession in Japan?

c. (7pts) Given where Japan is, is fiscal policy more or less effective than the usual case (i.e. the standard case we have talked through in class)? Can you show this with an IS-LM diagram? Compare the Japan case to the usual case using an IS-LM diagram for each.

d. (3pts) How do these findings inform the choice of policy for Japan in the 1990s?

Explanation / Answer

Only 4 subparts answered as per policy.

1. Fisher equation indicates the relation between nominal rates, real rates and the inflation

1+R = (1+r) (1+h)

Where, R = nominal rate, r = real rate and h = inflation rate

Fisher equation is typically used in the long run because, the nominal rates are fixed for a certain period of time and does not change immediately with any change in the inflation. Fisher equation analysis the changes in nominal ,interest rates with response to changes in inflation rates which occur in the long run.

2. Money is a medium of exchange to facilitate transactions, in purchasing goods and services which is a commonly accepted form of exchange.

Unit of account providing common measure in assigning values to the goods and services in the form of price.

Money has high liquidity and store of value, where we can store money as wealth and easily used when required.

3. Leading indicators most often change before the economy and useful to predict the changes in economy in short run.

Three main leading indicators are

Manufacturing activity levels: The activity levels in the manufacturing segment indicate the employbility, capability of the firm, and further effecting the GDP.

Stock market: Stock markets indicate the health of the economy basing on the companies running in that economy.

M2 Money supply: The money supplied in the form of deposists, travellers checks, currency accounts, notes in circulation, money market deposits, short term deposits and money market funds. Any major changes in the M2 reflects in the economy.

4. Job seperation rate F*U = S*E

U/L = S/ (S+F),

where U/L = unemployment rate

S= Job seperation rate

F= Job finding rate

E= employed

U/L is positively related to job seperation rate and negatively related to the job finding rate. To reduce the natural rate of employment, Job seperation rate must be reduced or Job finding rate must be increased.

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