2. b) (20 points for explanation) 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.
2.c) (20 points) 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.d) (25 POINTS) The real business cycle economists (RBC theory) came up with a story that explains exactly why money is a leading and pro-cyclical variable. In the space below, draw a money market diagram on the left, an IS/LM diagram on the right (label completely) and an aggregate demand / aggregate supply diagram below the IS/LM diagram. Discuss how the real business cycle economists (RBC) addressed this empirical reality (explain using your diagrams). Starting at the initial equilibrium, point A, let the shock that the RBC theorists use to explain this money - output correlation occur and assuming the Fed does not react, locate the new equilibrium as point B (assume prices are perfectly flexible, consistent with RBC theory). Comment on the desirability of thisadjustment in the context of the Fed's price stability objective, from a monetary policy perspective, and from a macroeconomic perspective (i.e., behavior of consumers and firms).Now consider the case where Fed does their job (recall, the Fed takes their dual mandate extremely seriously) so that these undesirable results do not occur and label as points C. Is money leading and pro-cyclical given the Fed's behavior? Explain. Why is this model referred to as reverse causation? Finish your essay by commenting on how RBC economists explain the business cycle (recurrent fluctuations in output) as well as their thoughts on whether or not policymakers, both monetary and fiscal policymakers should conduct active counter-cyclical policy.
2.e) (25 POINTS) The New-Keynesians came up with their own story as to why we observe this positive money – output correlation. 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? 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? Be 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). 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?