Exam 2 – Econ 304 – Chuderewicz – Spring 2010
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Exam 2 – Econ 304 – Spring 2010
1. THIS IS THE GENERAL EQUILIBRIUM PROBLEM THAT I PROMISED. YOU FIRST SOLVE
FOR THE INITIAL EQUILIBRIUM AS POINT A. WE CONSIDER TWO DIFFERENT AND
SEPARATE SHOCKS (I CALL THEM SCENARIOS). THE FIRST SHOCK IS TO THE LM CURVE,
THE SECOND SHOCK IS AN ‘IS’ SHOCK. AGAIN, WE CONSIDER THESE SHOCKS
SEPARATELY SO THAT AFTER YOU COMPLETE SCENARIO 1 (THE LM SHOCK), WE GO
BACK TO THE ORIGINAL CONDITIONS AND CONSIDER THE SECOND SCENARIO WHICH IS
THE ‘IS’ SHOCK.
Consider the following model of the economy
Production function: Y = AKN – N2/2
Marginal product of labor: MPN = 2AK – N.
where the initial values of A = 5 and K = 10.
The initial labor supply curve is given as: NS = 20 + 9w.
Cd = 70 + .50(Y-T) – 500r
Id = 100 – 500r
G = 100
T= 100
Md/P = 102 + 0.5Y- 1000r
Nominal Money supply M = 1400
We assume that expected inflation is zero (πe- = 0) so that money demand depends directly on the real
interest rate (since i = r).
1 a) (6 points) Solve for the labor market clearing real wage (w*), the profit maximizing level of labor
input (N*), and the full employment level of output (Y*). Please show work.
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In the space below, draw two diagrams vertically with the labor market on the bottom graph and the
production function on the top graph. Be sure to label everything including this initial equilibrium point as
point A. (10 points for completely labeled and correct diagrams)
b) (4 points) Derive an expression for the IS curve (r in terms of Y). Please show all work
c) (3 points) Find the real interest rate that clears the goods market. Please show all work
d) (3 points) Find the price level needed to clear the money market. Please show all work
e) (4 points) Find the expression for the LM curve (r in terms of Y). Please show all work
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Now draw three separate diagrams: (30 points total) a FE - IS – LM diagram, a desired savings
equals desired investment (Sd = Id ), and a money market diagram locating this initial equilibrium
point as point A. BE SURE to LABEL all diagrams completely (10 points for each correctly drawn
and labeled diagram…each diagram will have three different equilibriums points A, B, and C)
SCENARIO #1 – AN LM SHOCK!
S1 a) (6 points) Now suppose that the Fed increases the nominal money stock to 1512 (from 1400)
What is the new, short run (fixed price level) expression for the LM curve? Please show all work.
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S1 b) (4 points) What is the short run, Keynesian (fixed price) level of equilibrium output and real interest
rate? Please show all work.
Please label these new short run conditions on your FE, IS, LM diagrams as point B. Be sure to label
diagram completely with the inclusion of all the relevant shift variables like we did numerous times
in class.
S1 c)
(4 points) Find the new price level associated with the long run general equilibrium.
Please label this long run equilibrium on your FE, IS, LM diagrams as point C. Be sure to label
diagram completely with the inclusion of all the relevant shift variables like we did numerous times
in class.
S1 d) (10 points) Given this long run equilibrium is money neutral? Why or why not? In your answer, be
sure to define exactly what we mean by money being neutral….neutral to what???? Apply your answer to
this particular problem and refer to your diagrams – (note, this answer is worth 10 points)
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S1 e) (4 points) Compare the percent change in the price level (i.e., inflation) and the percent change in the
nominal money stock. Are your results consistent with your answer in S1 d) above? Please show all work!
Finally, draw an aggregate demand and aggregate supply curve locating points A, B, and C. Please
label everything completely. Be sure to add the SRAS curves and the LRAS curve to your two AD
curves. A completely drawn and labeled diagram is worth 10 points. Make sure you include the
relevant shift variables in parentheses.
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SCENARIO #2 – AN IS SHOCK! (A new Grader)
Let’s return to our original conditions: Please write down the expressions for your ORIGINAL IS curve
and LM curves in the space below (so the grader can follow your starting points).
IS: r = ___________________________
LM: r = __________________________
Now draw another set of diagrams, i.e., three separate diagrams, identical to the first part of this
problem (i.e., we are starting at the same equilibrium point = point A): a FE - IS – LM diagram, a
desired savings equals desired investment (Sd = Id ), and a money market diagram locating this initial
equilibrium point as point A. Be sure to LABEL all diagrams completely (10 points for each
correctly drawn and labeled diagram)…each diagram will have three different equilibriums points
A, B, and C. (30 points total)
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In this scenario #2, there is a shock to the desired investment function. The new desired investment
function is
Id = 150 – 500r
S2 a) (4 points) Name three reasons why the desired investment function like this.
S2 b) (4 points) Derive a ‘new’ expression for the IS curve (r in terms of Y). Please show all work
S2 c)(4 points) Now solve for the short-run equilibrium output (Keynesian) and the corresponding real rate
of interest. Please show all work. Please label this short run (fixed price) equilibrium as point B.
S2 d) (4 points) We now consider the long run when prices adjust. Find the new price level associated
with the long run equilibrium. Please show all work
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S2 e) )(4 points) Derive a new expression for the LM curve. Please show all work.
S2 f) (4 points) Solve for the real rate of interest in this long run equilibrium.
Label this long run equilibrium as point C in all three of your diagrams.
2. We discussed the money supply process in some detail along with the concept of quantitative easing. In
particular, we argued that the Fed, with the most astute student of the Great Depression (GD) at the helm
(Ben Bernanke), appears to have learned their lesson from the Great Depression(GD). Please answer the
following questions.
a) (10 points) What lesson did the Fed learn from the GD exactly? That is, if you wanted to blame the Fed
for the GD, where would we start. In the space below, write an essay criticizing the Fed for their behavior
during the GD making sure to address the behavior of the money multiplier (and its components), the
monetary base, and the nominal money supply during the GD.
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b) (10 points) If we could go back in time and you could be the Fed Chair during the GD, what would you
do different?? Make sure you refer to percent changes in your answer. As a hint, what would you make
sure of when it comes to the percent change in the monetary base? Please no questions about this part – I
am not giving you any more hints!
c) (5 points) Let’s fast forward to the recent financial crisis and quantitative easing. How can we tell if the
Fed truly learned their lesson from the GD and how can we be sure that their behavior is consistent with
quantitative easing? Be as specific as possible.
In the space below, draw two diagrams: a real money supply, real money demand diagram on the left hand
side and a IS – LM diagram on the right hand side (you can leave off the FE line, no need for it in this
problem). Start at an initial equilibrium, call it point A with the associated real rate = rA and the initial real
money supply = (MA / PA), and the initial level of output YA. Be sure to use a vertical real money supply
curve as we do in class. We also are holding prices fixed in this problem = P A. (20 points for correct and
completely labeled diagrams)
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Now depict the situation during the GD where the Fed ‘screwed’ up and label as point B on both of your
diagrams. As always, be sure to label your diagrams completely. Note that with prices fixed, output varies
throughout this problem so label the corresponding change in this part of the problem with the subscript B
(i.e., rB, YB, and (MB / PA). (recall, P is fixed at PA). We are also assuming that we are always at the point
where the goods market and the money market clears.
Now fix this problem. That is, if you were to pursue a quantitative easing strategy similar to the current
policy (i.e., learn the lesson), how would things change? That is, label as point C the new conditions
consistent with quantitative easing. Again, use the subscript C accordingly (the price level is still fixed)
e) (5 points) Finally, why are so many concerned with this quantitative easing strategy? Use the quantity
theory of money to support your answer.
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