Posted: May 11th, 2024

Penn State ECON 304 final exam spring2016 – The Job Impact of the American Recovery and Reinvestment Plan

#1 Christina Romer and Jared Bernstein in "The Job Impact of the
American Recovery and Reinvestment Plan" calibrated the impact of the
proposed expansionary fiscal policy (we know it as an increase in G and/or a
lower T) on jobs and GDP growth (Click .thompson.com/images/thompson/nclb/openresources/obamaeconplanjan9.pdf">Here
for paper). In order to do so, they make assumptions about the size of
Government spending and tax multipliers.
One important assumption is contained in the paragraph below about the
level of the federal funds rate:

"For the output effects of the recovery
package, we started by averaging the multipliers for increases in government
spending and tax cuts from a leading private forecasting firm and the Federal
Reserve’s FRB/US
model. The two sets of multipliers are similar and are broadly in line with
other estimates. We considered
multipliers for the case where the federal funds rate remains constant, rather
than the usual case where the Federal Reserve raises the funds rate in response
to fiscal expansion, on the grounds that the funds rate is likely to be at or
near its lower bound of zero for the foreseeable future."
So in this question, we are going to employ some of the tools that we
have acquired throughout the semester to understand how this assumption,
"that the funds rate is likely to be at or near its lower bound of zero
for the foreseeable future," effects the government spending and tax
multipliers.

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a) In this
question, we are going to compare the size of the Government spending
multiplier under two different assumptions: i) the Fed sits on their hands so
that when G rises, r rises with it (the standard case), and ii) the Fed
accommodates the (real) shock to money demand so that real interest rates remain
constant.

In the space
below, draw 4 diagrams (label them 1 through 4) with 1) a closed economy
desired saving; desired investment diagram, followed by 2) an IS – LM diagram
followed by 3) a money market diagram followed by 4) an aggregate supply ; aggregate
demand diagram.

We begin at our
initial point A which is at an output well below potential GDP (i.e., there is
a significant 'output' gap). We let G rise and with the assumption that the Fed
sits on their hands (assumption i) above) we
move to point B, which corresponds to an output closer to potential GDP, but
still not quite there. We then
assume assumption ii) above so that the Fed accommodates the real shock to
money demand to keep real interest rates constant. This assumption takes us to point C, which is
at potential GDP (i.e., the output gap is gone!).

Start at an initial equilibrium and label as point
A in all diagrams, with all the associated market clearing variables denoted by
subscript A. For example, in your IS –
LM diagram, the interest rate that clears the goods and money market is labeled
as rA with the associated output at YA. Note importantly
that we are assuming fixed prices
throughout this exercise. Now let G rise to G' and show how all your graphs are
affected. In particular, locate point B in
all graphs making sure you refer to
each graph separately explaining the intuition of the movement from point A
to point B. Note, we are assuming
assumption i), the Fed sits on their hands and does not accommodate the shock
to real money demand.

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b) We now apply
assumption ii), the one Romer and Bernstein use "that the funds rate is
likely to be at or near its lower bound of zero for the foreseeable
future." In terms of our analysis, the Fed is going to make sure that real
rates remain at their initial level (i.e., they totally accommodate the real
shock to money demand). Show this accommodation as point C on all of your
diagrams. Recall that we are at full employment/potential GDP at point(s)
C. Again, make sure you refer to each graph separately explaining the intuition
of the movement from point B to point C.

c) Now compare the
government spending multiplier under assumption i) no Fed accommodation and ii)
the Fed accommodates the real shock to money demand. Be specific with regard to the multiplier as
well as the intuition. To support your intuition, draw two diagrams: the user
cost = MPKf and the two period consumption model clearly locating
points A, B, and C. Referring to your 2
graphs, explain the intuition as to why we move from point A to point B as well
as why we move from points B to C. Be sure to label your graphs completely or
points will be taken off. Make sure you
relate your discussion of your two graphs to the difference in the multiplier
depending on what the Fed does or doesn't do.

#2 We recently discussed that investment in the US economy is weak and
we also discussed how important investment is for living standards in the
future (for both workers and firms!). An excerpt from a WSJ article dated
12/1/2015 is below:

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11:59 am ET
Dec 1, 2015
.wsj.com/economics/category/business-cycles/">Business Cycles

CEOs’ Economic Outlook Dims as More Plan to Pull Back
Investment
“Companies are putting capital budgets
together right now and don’t have a clear line of sight on what their tax
bill will be on those investments,” he said on a call with reporters Tuesday. “When the tax code is uncompetitive, like
ours is, it has the effect of incentivizing investment elsewhere” in
the world.

In this problem, we are going to assume
that a 'supply sider' wins the
election and immediately lowers the effective tax on capital to make our tax
code MORE competitive (recall that the US has the second highest effective tax
rate (on capital) in the world according to our textbook).

a) In this part
you are to explain exactly how lowering the effective tax rate on capital (τ) will
work (in theory) its way through the economy.
In this discussion, you need to differentiate between the short- run and
long-run. In the space below, explain, with graphical analysis, how lowering
the effective tax rate on capital will influence real economic variables in the
short run (hint, it’s a
demand side story). Draw 4 diagrams
(label them 1 through 4), with 1) a user cost ; desired capital (K*) diagram,
followed by 2) a closed economy desired saving; desired investment diagram,
followed by 3) an IS – LM diagram followed by 4) an aggregate supply ;
aggregate demand diagram.

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Start at an initial equilibrium and label as point A
in all diagrams, with all the associated market clearing variables denoted by
subscript A. For example, in your IS –
LM diagram, the interest rate that clears the goods and money market is labeled
as rA with the associated output at YA. Note that YA, our initial
equilibrium output, is below full employment output = YB (we still
have slack in the economy, in fact the GDP gap is currently, as of Dec 2015,
-3%). Now let the effective tax rate
on capital fall (same as a fall in τ) and show how all your graphs are
affected. In particular, locate point B
as the new short-run equilibrium in all
graphs (assume the standard; that is, let output rise to YB = full employment Y)
while holding the general price level fixed at PA = PB.
Make sure you refer to each diagram
individually explaining
how and why we get to point B (i.e., provide intuitive economic
reasoning starting with how a lower τ effects K* and why)!). Be sure to include a discussion of why the
real interest rate has to change the way it does - hint, the money market!
b) Now we are going to focus on the idea that in the longer run, the influence of the
decrease in the effective tax rate on capital will have ‘supply-side’ effects. In
particular, we argue that this new investment, spurred on by the lower
effective tax rate on capital, will result in a positive productivity shock
resulting in a higher “A and K" which will result in a shift upward in the
production function (via increasing the MPKf and MPN….these are the supply side effects) In
the space below draw a production function with the labor market diagram
directly below it and show what is going on in this longer run. That is, locate
the corresponding point B (from above), and then show the longer run influence
as point C in these two (supply – side) diagrams. What happens to N* and w*=W/P? Explain in detail. Are these results in
the labor market consistent an increase in the welfare of workers? Why or why
not? Are these results consistent with the business cycle facts? Now explain why output has changed, give two specific reasons. Note, in this
part of the problem, do not worry about identifying point A in the labor market
diagram and production function diagram since point A does not exist given the
assumption that labor markets always clear at full employment (i.e., a weakness
of the classical model). Be sure to label your graphs completely (relevant shift variables) or points will be taken off.

c) Now show how
graphs 1) through 4) are influenced by this longer-run development. Note again that we assume that before these
longer run developments take hold, the FE line in graph 3) and the LRAS in
graph 4) is set at YB. Now let these longer run developments take
hold, i.e., these supply side effects, and label this final equilibrium as
point C. Again, please make sure you refer to each diagram individually explaining how and why we get to point C (i.e.,
provide intuitive economic reasoning!). Be
sure to include a discussion of why the real interest rate has to change the
way it does - hint, the money market!

#3. The Fed's FRB/US
is a New Keynesian model (Click .la.psu.edu/~rxc122/frbusmodelofeconomy.pdf">Here for
article). Below is an excerpt from the article"

"An aspect of FRB/US that is closely related to slow market adjustment
is the behavior of inflation. In the model, firms seek to pay workers the value
of their marginal
product and to price their output as a markup over trend unit labor and
energy costs. However, labor contracts and other factors create frictions that
slow the speed at which wages
and prices adjust to shifts in demand and supply. (Commodity prices are an
exception to this behavior because they adjust quickly on world spot markets).
Such ‘‘sticky-price’’ behavior is incorporated into the equations of FRB/US
that govern the response of inflation to changes in economic conditions. An
important implication of this view of the inflation process is that
policy-directed changes in short-term nominal interest rates have a temporary
influence on the real rate of interest."

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a) Begin
with discussing why the New Keynesians believe that prices are sticky in as
much detail as possible. Then use the efficiency wage theory/model
to buttress (support) your argument (i.e., why
does the efficiency wage theory play a critical role in explaining why firms
are willing to produce more output at the same price?) Draw two graphs, one showing the effort curve
and the efficiency wage (be sure to explain how firms pick the efficiency wage)
and the other being a labor supply- labor demand diagram with the assumption
that the efficiency wage (w*) is above the market clearing (classical) wage (wclass). Why is this model so attractive in dealing
with the empirical reality in labor markets that the classical school has such
a hard time with and what is the empirical reality we are referring to? Please
apply your answer to the recent experience in US labor markets during.

b) Now draw two more diagrams depicting what is
happening in the product markets (demand, marginal revenue, marginal cost and
profits) and why firms are willing to
change output at the given price level(short run), given a positive shock
to (aggregate) demand? Begin at point A with the initial conditions and then
let the positive demand shock occur. Label the new profit maximizing price,
quantity, and profits as point B on both diagrams. Now locate points C on both
diagrams assuming that the firm did not immediately change prices and thus,
kept prices fixed, consistent with the‘‘sticky-price’’behavior alluded to in the excerpt above. Please be
very clear as to why exactly firms are willing to act like a 'vending machine'
in the short run (be willing to increase output at the same price). Shade in the additional profit when this firm
acts like a vending machine and increases output at the same price. Is this
firm behavior, being willing to increase output at the same price, consistent
with the firm’s profit maximizing objective?
Why or why not?

#4 We are going to use the table below
along with the graphic that follows to analyze two different periods in history
- the first, being the 'Hey Day' of Keynesian economics during the 1960s and
1970s and the second, the Great Recession.

Recall the Time Magazine article from
December 31, 1965..."We are all Keynesians Now" and this excerpt: 'Secretary Willard Wirtz argues
that the Government should continue pushing and stimulating the economy, even
at the risk of some inflation, in order to bring unemployment down to 3%.'

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a) Explain what the Phillips curve is and why would we expect in theory, the
relationship between these two vitally important macroeconomic statistics to
exist. That is, give the intuition as to why we would expect this relationship
to hold in the real world.

Now draw two diagrams: an AS - AD diagram
and a Phillips curve diagram locating points A, B, and C on both diagrams.

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Writing about this period and Keynesian
economics, Kydland and Prescott argued that it would better for policy makers and the economy if policymakers would
establish a rule and stick to it. Please apply this principle to your diagrams
above referring to the misery index. Why didn't Keynesian economics during this
time work, that is, why was trying to
get unemployment down to 3% a bad idea? Why did inflation and the
unemployment rate behave the way they did. Refer to the behavior of the misery
index during this period.

b) Now let's update to the great recession:
Draw two diagrams: an AS - AD diagram and a Phillips curve diagram locating
points D, E, and F on both diagrams. Please be sure to completely label your
diagrams.

Why do your results differ so much between
the 'Keynesian period above' vs. the Great Recession? - note that monetary policy and fiscal policy
were expansionary in both periods. Please explain using the intuition we
discussed in class. To support your arguments, draw the cyclically shaped
aggregate supply curve that we drew in class locating points A and C from part
a) and points E and F from this part b).

5. We discussed in
class how Federal Reserve Policy has changed dramatically in the last 10 years.

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a) Let us go back
10 years to March, 2006. Below is the first line of the FOMC statement from
March 28, 2006.
Release Date: March
28, 2006
For immediate
release
The Federal Open
Market Committee decided today to raise its target for the federal funds rate
by 25 basis points to 4-3/4 percent.
i) Explain exactly
how monetary policy worked back in March of 2006. That is, who exactly decides on changing the target for the federal
funds rate and what exactly is the
federal funds rate? How does the federal funds market operate - what is it used for?What is the
operational aspect of changing the
target for the federal funds rate as above (this is in 2006!)?

ii) Now use a
graph of the federal funds market and depict exactly how the Fed would
successfully raise the target by 25 basis points to 4 3/4 %. Begin with
conditions before the March 28, 2006 FOMC announcement and label as point A. Then show the change in conditions as point
B. Assume that reserve demand is constant. Explain how and why your graph
changes. What type of open market operations does the Fed need to conduct?

b) Now let's update to the present. As we know,
the Fed 'got off the zero bound' in December 2015. How did they do this? How did the FOMC statement change relative to
the 2006 statement. Be specific! What did the statement say exactly and how
does this new monetary regime work exactly?.

c) The FOMC is
contemplating another move at their April meeting and the decision whether to
raise rates again depends critically on the labor market report released on
Friday, April 1 (no fooling!) . Suppose that this report is extremely positive
and thus, the Fed raises rates by another 25 basis points at their April 2016
FOMC meeting. How would they do this
exactly and how and why would the federal funds rate change? How would the
statement change? (more room on next page)

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d) Now draw a
graph with time on the horizontal axis and interest rates on the vertical axis
- you need to have 3 different interest rates on the vertical axis (we did this
in class). On the graph, clearly label the period of the 'zero bound', the
period associated with the move in December of 2015, and the period after the
hike at the April 2016 meeting (as assumed above). Make sure you label your
graph completely including the horizontal axis representing time and the
vertical axis representing interest rates.

6) The two tables
below show the response of various interest rates to previous FOMC statements.
The first Table shows the response to the Dec 16, 2016 FOMC statement where the
Fed got off the zero bound by raising rates. The second Table shows the
response of various interest rates to the most recent meeting when the FOMC
decided not to change interest rates. please answer the questions below.

Table 1
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Table 2

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a)We are focusing
on the reaction of the 1-year, 2-year, and 3-year Treasury constant maturities
to the FOMC statement of Dec 16, 2015. What was the reaction, in basis points,
of the 1-year, 2-year, and 3-year interest rates to the Dec. 16 announcement
(compare to Dec 15, the day before the announcement) and how do these changes
relate to the change in the federal funds rate (top row) between Dec. 16 and
Dec. 17? Explain why there was such a
large difference in the movement of the Federal Funds rate relative to the
other 3 interest rates.

b)We now focus on
the reaction of the 1-year, 2-year, and 3-year Treasury constant maturities to
the most recent FOMC statement of March 16, 2016. What was the reaction, in
basis points, of the 1-year, 2-year, and 3-year interest rates to the March 16
announcement (compare to March 15, the day before the announcement) and how do
these changes relate to the change in the federal funds rate (top row) between
March 16 and March 17? Explain why there
was such a large difference in the movement of the Federal Funds rate relative
to the other 3 interest rates.

c)The first line
of a WSJ article we discussed in class that was written the night of Wednesday, March 16, 2016 is below:

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The
Federal Reserve eased monetary policy on Wednesday, and the global economy is
safer for it.

Explain exactly
how the Fed eased monetary policy on Wednesday, March 16, 2016. Are your results from part b) consistent with easier
monetary policy? To support your answer, what happened to the one year interest
rate expected one year from now - our notation is i12e.

d)Regarding the
lessons learned from the research on forward guidance, did the Fed employ the lesson learned from the research
following their March 15 - 16, 2016 FOMC meeting? Why or why not - explain.
What was the lesson learned and how exactly did we learn the lesson on forward
guidance?

e) Now draw a
graph with time on the horizontal axis and interest rates on the vertical axis
- you need to have 3 different interest rates on the vertical axis (we did this
in class). On the graph, clearly label the period of the 'zero bound', the
period associated with the move in December of 2015, and the period after the
hike at the April 2016 meeting (we assume another 25 basis point at their April
meeting). Make sure you label your graph completely including the horizontal
axis representing time and the vertical axis representing interest rates. Explain
why the federal funds rate will change when the Fed changes interest rates.

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#7 We
discussed the business cycle fact that government purchases is a pro-cyclical
economic statistic.

a) First, explain
how the real business cycle theorists explain the pro-cyclical behavior of
government purchases. In the space below, draw three diagrams - a labor market
diagram, a production function diagram, and an IS - LM - FE diagram. Start at
point A and let G rise. Show and explain how each of your three diagrams are
effected by the increase in G and label as
point B. Be sure to explain how each of your diagrams are effected - the
intuition of moving from points A to B. Do the real business cycle theorists
believe that it is a good idea to fight recessions with expansionary fiscal
policy as defined by increases in G? Why or why not? Explain.

b) Now explain how
the New Keynesians explain the pro-cyclical behavior of government purchases.
In the space below, draw a savings - investment diagram, an IS, LM, FE diagram,
and an aggregate demand - aggregate supply diagram. Start at point A and allow
the increase in G to move us to point B. Be sure to label all your diagrams
completely. What does the power of this fiscal policy critically depend
on. Be sure to mention the state of the
economy in your discussion. Does
investment get crowded out in this model and if so, what determines the degree
of crowding out? Why do critics dislike the idea of crowding out so much,
especially with regard to investment getting crowded out?

#8 We
discussed the business cycle fact that money is a pro-cyclical economic
statistic.

a) First, explain
how the real business cycle theorists explain the pro-cyclical behavior of
money. In the space below, draw three diagrams, a money market diagram, an IS -
LM - FE diagram, and an aggregate demand - aggregate supply diagram. Start at
point A and describe how the business cycle theorists explain the fact that
money is leading and pro-cyclical as we move from point A to point B. Be sure
to explain the move from point A to B in all three diagrams. Now show what
would happen if the Fed did nothing and label as points C. Is this result
desirable, why or why not? Do the real business cycle theorists believe that it
is a good idea to fight recessions with expansionary monetary policy as defined
by increases in M? Why or why not? Explain.

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b) Now explain how
the New Keynesians explain the pro-cyclical behavior of money. In the space
below, draw a money market diagram, an IS - LM - FE diagram, and savings - investment diagram, an IS, LM, FE
diagram, and an aggregate demand - aggregate supply diagram. Start at point A
and allow the increase in M to move us to point B. Be sure to label all your
diagrams completely. What does the power
of expansionary monetary policy depend on? Be sure to mention the state of the
economy in your discussion.

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