QUIZ 6: Winter 2013

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Quiz assumptions:

All consumers are non-liquidity constrained, non-Ricardian PIH (as developed in class) Expected inflation is assumed to be constant (even though prices can change). The economy is initially in long run equilibrium at Y* ; NX = 0. No monetary or fiscal policy takes place unless I tell you otherwise TFP, taxes, consumer confidence, value of leisure, population, government spending, and the

nominal money supply do not change unless I tell you they change

Note: You can use a blank piece a paper or blank macro worksheets when answering these questions. You should not hand these in.

Question 1 (10 points – 2 point each)

Given the model developed in class, which of the following are unambiguously true about a permanent increase in oil prices? Circle all the true statements. When answering this question, assume the following:

Prices increase in the short run. Income effects on labor supply equal substitution effects on labor supply. The level of employment in the short run (N1) is less than the new long run level of

labor supply. Any monetary policy takes place between the short run and the long run.

Recall from Topic 7 slides, an increase in oil prices is like a decrease in TFP: firms can produce less with the same amount of N and K.

These curves will shift initially:

-SRAS shifts left (it is more expensive for firms to produce at each level of output)

-LM shifts in as prices increase (price (P) increase in the short run was the assumption)

-AD shifts left (I(.) falls as MPK falls given the complementarity between oil and capital and C(.) falls because real wages permanently fall)

-IS shifts left (I(.) falls as MPK falls and C(.) falls because PVLR falls as real wages fall in long run)

-Real money supply shifts in as prices (P) increase

-Money demand shifts in as Y falls (given the shift in of AD and SRAS)

-Labor demand shifts left (we get this from the complementarity between oil and labor; if oil prices increases, quantity of oil decreases by law of demand; as quantity of oil decreases, the

marginal productivity of labor falls at every level of real wages; thus, rising oil prices must result in a shifted in labor demand curve)

-Labor supply should shift to the right (W/P falls as the labor demand curve shifts in; therefore, PVLR falls permanently; as we feel permanently poorer, the income effect says we will work more) Note: The net effect on N* (in the new long run) is no change. We assumed the income effect and the substitution effect offset.

-LRAS shifts to the left (an increase in oil prices is like a negative technology shock so it shifts in our productive frontier - as oil quantity falls (as oil prices increase) Y* will fall - as discussed above, there is no change in N* in the long run as the income and substitution effects cancel)

To summarize, in the short run, Y falls (as SRAS and AD shift in), Y* falls, C falls, P increases (per the exam assumptions), interest rates are ambiguous (IS shifts in and LM shifts in), Investment (I) is ambiguous (the autonomous part falls and the interest rate component is ambiguous), N falls (because - per exam assumptions N in the short run is below new N* (and N* didn't change)), and W/P falls (given P increased). We know - per exam assumptions, N < new N* in the short run and Y < new Y* in the short run.

Self Correcting Mechanism Getting us Back to Y*

In the long run, the self correcting mechanism will occur (if no policy takes place). In this case, nominal wages (W) will FALL between the short run and the long run (we need W/P to fall between the short run and the long run so, we know that the absolute value change in W between the short run and the long run will exceed the absolute value change in P between short run and long run.

As W falls, the SRAS will shift out some. This will put downward pressure on prices (between short run and long run). This will cause the LM curve (and real money supply curve) to shift right between the short run and the long run (as prices fall). This will cause interest rates to fall (as we move down IS curve). This will cause I to increase (this is not a change in I(.) - investment increases because interest rates fall. As I increases, Y will increase back to its new long run level.

Between the initial condition and the long run, the AD and IS will be shifted left - this is all do to shifts between the initial condition and the short run. Between the short run and the long run, there will be no change in AD or IS if the self correcting mechanism brings us back to Y*.

a. The Fed could better achieve both of their policy goals (i.e., keeping P close to P 0 and keeping Y close to Y*) if they decrease the nominal money supply (M).

FALSE—If the Fed decreases the nominal money supply, the AD and LM curves will shift in. We know that shifting in the AD curve will achieve our price objective because a fall in demand corresponds with a price decrease. However, given that Y is below new Y* in the short run, a decline in nominal money supply will actually further reduce Y (taking us further away from Y*).

b. Under the self-correcting mechanism, nominal wages (W) will unambiguously fall between the short run and the long run.

TRUE. See above. Given that N is below new N* in the short run (this was a quiz assumption), we know that W will have to fall to clear the labor market.

c. Under the self-correcting mechanism, the LM curve will unambiguously shift right between the short run and the long run.

TRUE. See above.

d. Under the self-correcting mechanism, the IS curve will unambiguously shift to the right between the short run and the long run.

FALSE. See above.

e. Under the self-correcting mechanism, the absolute value change in nominal wages (W) between the short run and the long run will unambiguously exceed the absolute value change in prices (P) between the short run and the long run.

TRUE. See above.

Question 2 (10 points – 2 point each)

Which of the following are unambiguously true about a permanent decline in labor income taxes (tn)? Assume the income effect on labor supply is greater than the substitution effect on labor supply. Also assume the economy returns to the long run via the self-correcting mechanism. Circle all true answers.

As we saw in Supplemental Notes 11:

Large tax cuts should increase Consumption (C) today (assuming Ricardian equivalence does NOT hold). This will shift out both the AD curve and the IS curve. As prices increase (given AD shifted out), LM will shift in a little. The net effect of IS shifting out and LM shifting in is that interest rates will rise. As interest rates rise, Investment will fall. This is NOT a shift in the IS curve - it is a movement up the IS curve. Nothing will happen to the SRAS curve (no change in W, A, or oil prices). Nothing will happen to the labor demand curve. We will just move up and down the labor demand curve in the short run. The labor supply curve will shift (see below). But that is NOT relevant in the short run because we are off our labor supply curve in the short run.

Here is an illustration of the AD-SRAS market.

SRAS0

P1 (a) (b) P0

AD0 AD1

Y*0 Y1

In the long run, we need to look at the labor supply curve.

Recall, the substitution effect says that you will work more (labor supply shifts out, N* increases and after tax wages increase – note difference between before and after tax wages – we have done this all before!). The income effect says that as after tax wages increase, PVLR will increase and we don’t need to work as much – this will shift labor supply in causing N* to fall and after tax wages to increase further. If the income effect dominates:

Ns0

Ns1

W/P (z2) (a)

(b)

N*z2 N*0 N1 N

(Arrow measures distance between N1 and N*z2)

If income effect dominates, labor supply will shift in (on net). Labor will fall and equilibrium will be at point (z2). N* will fall and after tax real wages will rise.

Note: If we are producing at N1 in the short run, we are really far from our equilibrium labor (N*z2) if the income effect dominates.

To get back to equilibrium in the long run, the self correcting mechanism will kick in. We will demand wage increases (W will increase). The short run aggregate supply curve will shift in. The new equilibrium will be an intersection of the new SRAS (shifted left between short run and long run), the new AD curve (shifted right between initial condition and short run) at the new level of Y* (shifted left as N* falls). This will be at a higher level of prices. Given this, we know that LM will shift in (as M/P falls) causing r to increase and I to fall (between short run and long run).

a. Consumption (C) will unambiguously fall between the short and the long run.

FALSE. Consumption increases the moment taxes fall (as PVLR increases). Consumption then stays at its new level. There is no change in consumption between the short run and the long run.

b. The money demand curve will unambiguously shift left between the short run and the long run.

TRUE. See above. Between short run and long run, Y falls. So, we know money demand shift in when Y falls.

c. The real money supply (M/P) will unambiguously shift left between the short run and the long run.

TRUE. See above. As P increases between short run and long run (from self correcting mechanism), M/P will fall.

d. The labor demand (Nd) curve will unambiguously shift left between the short run and the long run.

FALSE. The labor demand curve = MPN = W/P. The labor demand curve will not shift as a result of the change in labor income taxes as A, K are not changing. We will move along the labor demand curve as the labor supply curve shifts in as a result of the strong income effect.

e. The level of N in the short run (N1) will unambiguously be higher than the new level of N** in the long run.

TRUE. See above.