Allowed space is intended to indicate the length and depth of your answers. Good luck!

1. The quantity equation: M v = P Y.

1. What does the left hand side (LHS) refer to?

 

 

 

 

2. What does the right hand side (RHS) refer to?

 

 

 

3. Why does the RHS equal the LHS?

1. According to the monetarist paradigm, what effect does an increase in the money supply have on real GDP, nominal GDP, real consumption, and the price level, initially and in the long-run?

3. What are three things the Fed can do to increase the money supply? (Explain each briefly.)

4. In 1933 Keynes wrote about the economic problem that needed to be addressed by the government of Great Britain. The problem, according to Keynes, was that human resources were available for productive and desirable purposes, but were not being put to use. For each of the following four policy measures, say (and explain briefly) whether Keynes was for or against it.

1. Raise prices through trade barriers.

 

 

2. Raise government revenue by raising taxes.

 

 

3. Raise funds for firms by encouraging saving by individuals.

 

 

 

4. Raise spending by the government, even if it causes the deficit to rise.

5. Describe briefly what the multiplier is, and how it is supposed to have the effect it does. Also, explain why Keynes believed it would only be effective when there is high unemployment.

 

 

 

 

 

 

 

 

 

 

6. Explain how someone would argue that the multiplier might operate on the local level, but not on the aggregate level.

 

 

 

 

 

New Classical Theory

 

7. Explain why it might be the case that an increase in the money supply has no effect on the price level, either in the short-run or the long-run, contrary to what the quantity theory says.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Real Bills Doctrine and Policy

 

8. Suppose that bank notes are injected into the economy by private banks that make loans to productive firms that intend to repay the notes with interest.

1. Explain why such banks are likely to be quite profitable. (Use an example if it helps.)

 

 

 

 

 

2. Explain why a bank insolvency might be a self-fulfilling prophecy. Use numbers in your explanation if that helps the argument.

 

 

 

 

 

 

 

 

 

 

 

 

 

3. Explain why an increase in the reserve requirement would (a) reduce profitability for the bank’s owners and (b) reduce the likelihood that a bank run is a self-fulfilling prophecy.

5. According to the Real Bills Doctrine, an increase in the money supply is not inflationary. Why not?

 

 

 

 

 

 

6. A bank operates by issuing notes to profitable firms and keeping some gold on hand for the occasional depositor that wishes to withdraw. Suppose the government raises the reserve requirement on this bank—requires it to hold $30 in gold for every $100 of notes that it issues or has issued. Explain how this reserve requirement can be destabilizing for the economy. (Note that an increase in the reserve requirement reduces the bank instability due to bank insolvencies that are self-fulfilling prophecies. Hint. Think of the U.S. in 1931.)

11.

1. What is the IS-curve and how is it obtained?

 

 

 

 

 

2. What is the LM-curve and how is it obtained?

 

 

 

 

3. What is the effect on C, I, Y, N (the real variables) and i (the nominal variable) of

1. An increase in government spending?

 

 

 

 

2. An increase in taxes?

 

 

 

 

3. An increase in the money supply?

 

 

 

4. A decrease in the money supply?

12.

1. What is the equation? (Give the formula, and define the various terms.)

 

 

 

 

2. How do you obtain it? (Outline how you argue that it must be valid.)

 

 

 

 

 

 

3. The exchange rate between the U.S. dollar and Japanese yen is fixed at 360 yen to the dollar, and this ratio is to hold for all time. The U.S. interest rate is 4 percent. However, inflation is 2 percentage points higher in the U.S. What is the nominal interest rate in Japan?

 

 

 

 

 

4. The dollar is expected to depreciate by 3 percent per year against the German mark. U.S. interest rates are 6 percent. What is the German nominal interest rate?

13. The current year is period 0. The British and U.S. economies do not grow in this example.

1. All individuals expect that the price level in the U.S. will be 200 in year 10, and the Great Britain price level will be 100 in year 10. What exchange rate is consistent with these price levels?

 

 

 

 

 

 

 

2. Suppose the forward market is efficient and the risk premium is zero. What forward rate _tf_t+10 = ₀f₁₀ is consistent with the exchange rate of (a)?

 

 

 

 

 

 

 

 

3. Between periods 0 and 10, the U.S. interest rate is 2 percentage points below the British interest rates. How much does the dollar appreciate or depreciate between periods 0 and 10? (Give the annual average rate of depreciation or appreciation and the total over 10 years.)

 

 

 

 

 

4. The U.S. price level in period 0 is not 200, but 181.8. The U.S. money supply increases by 10 percent in period 0. The long-run effect of this increase is that the price level will rise to 200 (and the long-run is 10 years). How much does the current exchange rate appreciate or depreciate in period 0 upon the increase in the money supply? You can assume that the economy begins with PPP holding and that the British price level and interest rates never change.

14. Why does an attempt to raise the value of the domestic currency potentially hurt the domestic economy?

Nominal wages, gold parity rates.

15. In 1925 Great Britain restored the pound sterling at a parity that was above the current value of the pound (the government pound/gold parity exceeded the market parity). Why might this have caused unemployment in Great Britain? State any additional assumptions that you need to make.

16. The flow of gold is affected by the rate of interest that banks pay depositors. The higher the interest rate, the more desirable is a deposit, and since a deposit is an entitlement to some gold, higher U.S. interest rates attract gold to U.S. banks. Which two groups favored high interest rates in the U.S. and which one group favored lower U.S. interest rates? Explain. (A group may be all of the people in some country.)

17. Why did Paul Volcker wish to impose so many constraints on the banks in 1979-1982? (Say what he was intending to accomplish, why, and how.)

18. Was Paul Volcker most interested in maximizing bank profits, employment, interest rates, inflation or the value of the dollar? Give a one or two sentence answer. Only one choice is correct. (Be very careful here. "Maximize" means "try to make as large as possible." If pollution control is your number one objective, you do not try to maximize pollution.)

19. Suppose you have data on output (GDP), consumption (C), investment (inv1), money supply 1 (M1), money supply 2 (M2), the price level (CPI) and nominal interest rates (tbill). You run the following command on RATS:

set yg = log(GDP) – log(GDP{1})

set ig = log(inv1) – log(inv1{1})

set m1g = log(M1) – log(M1{1})

set m2g = log(M2) – log(M2{1})

linreg 1961:1 1992:4 yg

#constant yg{1} yg{2}

1. Suppose the coefficient estimates are

Variable Coefficient t-Stat Signif

Constant 0.00414 3.79 0.0002

YG{1} 0.264 2.95 0.0037

YG{2} 0.158 1.77 0.0781

 

How do you use these estimates to forecast output growth?

 

 

 

 

 

2. You run the regression:

linreg 1961:1 1992:4 ig

#constant tbill{0 1}

Suppose the coefficients on tbill are significantly positive. Does this refute the notion that an increase in the interest rate will tend to reduce the rate of investment? If yes, say why. If not, say why not.

 

 

 

 

3. You run the regression:

The coefficients on M2 lagged one period is significantly positive. The coefficient on M2 lagged two periods is entirely insignificant. The interest rate coefficients are significantly positive for tbill{0}, significantly negative for tbill{1} and insignificant for tbill{2}. Are these results consistent or inconsistent with the Monetarist paradigm? (Explain briefly that paradigm and why the answer is yes or no. Use the back.)