# Could use the help with econ questions

*label*Economics

*timer*Asked: May 3rd, 2015

**Question description**

2. a) (30 POINTS) 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 r_{A} with the associated output at Y_{A}. 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.

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 = MPK^{f} 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 this adjustment 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.**

**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 (w

_{class}). 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