Problem Set 6 EC 1210 Fall 2013 Rahman Due Date: Monday, December 9th (at the beginning of class)

INSTRUCTIONS: USE YOUR OWN PAPER TO ANSWER THE FOLLOWING QUESTIONS. Please turn in your problem sets with your name clearly marked on the front page and all pages stapled together. You are encouraged to work together, but you must hand in your own work. You must show your work for credit and answer in complete sentences when appropriate (such as when the question asks you to describe or explain).

1) Illustrate the short-run and long-run impact of an unexpected monetary contraction using both the ADAS model and the Phillips curve. Assume the economy starts at full employment.

2) The firms and workers in Alpha form expectations adaptively. The firms and workers in Omega form expectations rationally. Their otherwise identical economies are initially in equilibrium at the natural level of output with 10 percent inflation. The central banks of both Alpha and Omega make credible commitments to reduce the growth rates of money until they achieve 2 percent inflation. Compare and contrast the adjustment process to the new equilibrium at the lower rate of inflation in both countries.

3) Assume that people form expectations rationally and that the sticky-price model describes the aggregate supply curve in the economy. For each of the following scenarios explain whether or not monetary policy can have real effects on the economy. a. The central bank determines monetary policy using the same information available to all firms and at the same time firms are setting prices, so that both firms and policymakers have all of the same information. b. The central bank determines monetary policy after firms have set prices using information not available at the time prices were set.

4) Suppose economists believe that taxes have an important effect on the labor supply. They argue that higher taxes cause people to want to work less and that lower taxes cause them to want to work more. Consider how this effect alters the macroeconomic analysis of tax changes. a. If this view is correct, how does a tax cut affect the natural level of output?

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Problem Set 6 EC 1210 Fall 2013 Rahman b. How does a tax cut affect the aggregate demand curve? The long-run aggregate supply curve? The short-run aggregate supply curve? c. What is the short-run impact of a tax cut on output and the price level? How does your answer differ from the case without the labor-supply effect? d. What is the long-run impact of a tax cut on output and the price level? How does your answer differ from the case without the labor-supply effect? 5) Consider some other special cases of the mother of all models described in the appendix of chapter 14. Starting with this comprehensive model, what extra assumptions would you need to yield each of the following specialized models? a. The model of the classical large open economy in the appendix to Chapter 6. b. The Keynesian cross in the first half of Chapter 11. c. The IS-LM model for the large open economy in the appendix to Chapter 13.

6) For each of the following policies indicate whether the policy is i. a monetary or a fiscal policy, ii an active or a passive policy, and iii a policy by rules or with discretion: a. the central bank follows a policy of allowing the money supply to grow at a constant 4 percent per year; b. a government follows a policy of keeping government spending over a calendar year equal to government revenue over the calendar year; c. the central bank uses judgment to adjust the growth of the money supply based on expectations of what will happen to output and inflation over the next five years. d. the government keeps tax laws unchanging and allows government spending to change, depending on which spending bills are passed by the legislature. e. the central bank follows a policy of adjusting the money supply according to a formula based on deviations of unemployment from the natural rate of unemployment.

7) Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and an inflation rate of 10 percent. Assume that there is a short-run tradeoff between inflation and unemployment as described by a Phillips curve. Use the Phillips curve to graphically illustrate why a central bank that desires both low inflation and low unemployment has the incentive to renege on an announced policy to reduce inflation to 3 percent, if people set wages and prices on the expectation of 3 percent inflation and the central bank has the discretion to change its monetary policy after these expectations are set.

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Problem Set 6 EC 1210 Fall 2013 Rahman 8) In each case identify whether the situation is a case of adverse selection or moral hazard. Explain. a. Jasper knows, but the car rental company does not know when he is trying to rent a car during a blizzard in Wisconsin, that Jasper grew up in a tropical climate and has no idea how to drive in cold weather and snowy conditions. b. Joan has received a loan from the bank to finance the purchase of more inventory for her quilt shop, but she intends to use the money (without telling the bank) to take a safari in Africa. c. Some companies sell annuities, which are policies that make periodic payments as long as the purchaser lives. Jane is trying to buy an annuity. Jane knows, but the annuity issuers do not know, that people in Jane's family routinely live to age 100.

9) Suppose Bank A has a leverage ratio of 20 and Bank B has a leverage ratio of 10. Explain the meaning of these ratios and what would happen to each of these banks if the value of their assets fell by 6 percent.

10) Provide one argument in favor of and one argument against each of the following proposals to prevent future financial crises. a. require shadow banks to hold more capital, b. give the FDIC resolution authority over shadow banks, c. impose higher capital requirements on larger banks,

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