ECO403 Midterm Short Questions of Recommended Book

Chapter 19

1. Explain the role of intertemporal substitution of labor in the real business cycle theory. Based upon this theory, would you expect the real wage to be procyclical or countercyclical? (Hint: Think of labor productivity in the Robinson Crusoe example and the link between marginal productivity and the real wage.)

1. In real business cycle theory, the intertemporal substitution of labor plays the primary role in determining labor supply. People are willing to work harder only if they receive a higher intertemporal real wage. Based upon this theory, an economic boom that includes higher employment must mean that the workers are receiving a higher real wage. The higher wage is the incentive needed to boost employment. Therefore, this theory would predict that wages are procyclical.

Q2. How does labor hoarding affect the Solow residual in a recession?

2. The Solow residual is the percentage change in output minus the percentage change in inputs weighted by factor shares. In a recession, output has fallen, but if firms hoard their workers, there will not be an accompaning fall in employment. Therefore, the Solow residual will appear to fall by a larger degree due to the labor hoarding.

Q3. How does the presence of an aggregate-demand externality affect prices and output in the economy?

3. An aggregate-demand externality of the variety seen in menu cost studies leads to higher prices and lower output. This is caused by the fact that an individual firm has little incentive to change prices frequently due to the menu cost it must pay for each change. For example, if a firm has set its price too high,

it may not want to incur the menu cost to reduce the price. Society would prefer that the firm would lower its price because this would lead to a boost in sales (and output). If there are many such firms that behave this way, the externality for society becomes large.

4. Is money neutral in the short run in a model of staggered wage and price setting? Is it neutral in the long run? Explain.
5. In the staggered wage and price setting model, unexpected changes in the money supply will lead to output effects in the short run because firms are unable to adjust prices and wages. In the long run, however, firms will eventually be able to adjust to the changes in the money supply. Therefore, this model predicts that money is neutral in the long run, but not in the short run.

Chapter 18

1. Explain how the Baumol-Tobin model supports the specification of the money demand function, L(i,y).
2. The Baumol-Tobin model provides a framework in which an increase in the interest rate lead to a reduction in money demand (average money holdings) and an increase in output leads to an increase in money demand.

Q2. Suppose the banks in an economy have a reserve-deposit ratio of 10 percent and the currency-deposit ratio is 20 percent.

1. If the Federal Reserve increases the monetary base by $500 through open market operations, what will be the increase in the money supply?
2. If the Federal Reserve increases the discount rate and firms react by increasing the reserve-deposit ratio to 15 percent, what is the change in the multiplier? Will this change increase or decrease the money supply?
3. In anticipation of the Y2K problem, many people withdraw their deposits from the bank in December 1999. What impact will this have on the money multiplier, high powered money, and the money supply?

Answers:

Q2. a. The money multiplier is (0.2 + 1)/(0.2 + 0.1) = 4. An increase in the monetary base of $500 will increase the money supply by $2000 (500*4).

1. The new money multiplier is (0.2 + 1)/(0.2 + 0.15) = 3.43. This will lead to a decrease in the money supply because banks will hold more reserves and issue less loans.
2. If people withdraw their deposits, this will increase the currency-deposit ratio. This in turn will decrease the money multiplier. High powered money will decrease due to the fall in reserves caused by the decrease in deposits. The money supply will decrease due to both the reduction in the multiplier and the decrease in high powered money.

Q3. Explain how changes in the money multiplier contributed to the severity of the Great Depression. What could the Federal Reserve have done to restore the money multiplier to its original level?

3. The primary change in the money multiplier was due to the large number of bank failures. This led to an increase in the currency-deposit ratio due the drop in confidence in the banking system. The increase in the ratio led to a fall in the money multiplier and in the money supply. The large number of bank failures led the remaining banks to increase the reserve-deposit ratio, which further decreased the money multiplier and the money supply. The actions in response to the banking crisis lead to a huge fall in the money supply which in turn led to high interest rates and a fall in investment. To restore the money multiplier to its original level, the Federal Reserve would have needed to address the public's fears of the banking system by providing emergency loans and additional money to the system.