Economics 295: Introduction to Macro Policy Assignment 3 Due Tuesday April 2, at beginning of class Question 1 year Real GDP (billions of constant dollars) Labour Force (millions) Employment (millions XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXXa. Compute the employment rate and the level of productivity (GDP per employed worker) for each year shown in the table above. b. For each five-year period, compute the percentage change in the labour force, the employment rate and the level of productivity. c. For each five-year period, what fraction of the percentage change in GDP can be accounted for by the change in the employment rate? d. Over the entire 50-year period, what fraction of the percentage change in GDP can be accounted for by the change in the employment rate? e. Explain the differences that you detect between (c) and (d). Question 2 The Neoclassical growth theory is based on the existence of an aggregate production function, showing the relationship between labour (L), capital (K), technology (A), and real GDP (Y). The table below shows various values for L, K, and A. Assume that the production function takes the following form, ? = ?? ! !? ! ! 2 Labour(L) Capital(K) Technology(A) Real GDP(Y XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX50 a. Using the production function shown above, compute real GDP for each case and complete the table. b. In the first part of the table, capital is constant but labour is increasing. What property of the production function is displayed? Explain. c. In the second part of the table, capital and labour are increasing by the same proportion. What property of the production function is displayed? Explain. d. What type of growth is being shown in the third part of the table? Question 3 For each scenario below, draw the appropriate money market and goods market diagrams to illustrate the scenario. Explain the short-run effects on the interest rate and real GDP. a) The Bank of Canada purchases a large number of federal government bonds from Canadian commercial banks. b) A new type of robot is invented, resulting in increased productivity across all industries. c) The U.S. Federal Reserve increases its money supply. What happens to the U.S. economy and the Canadian economy? d) New mobile technology lets people convert bonds to cash (and cash to bonds) easier than ever before. e) The U.S. economy enters a recession caused by a negative aggregate supply shock that has no direct influence on Canada. What happens to the Canadian economy? 3 Question 4 The Prudential Bank of Canada (PBC) currently has $2000 in cash reserves, $53,000 in loans, $50,000 in deposits, and $5,000 in shareholder equity. It is currently satisfying its target reserve ratio. a) Show the PBC balance sheet. What is PBC’s target reserve ratio? b) How much “bank capital” does PBC currently have? Explain. c) Suppose a new customer opens an account at PBC and deposits $2000 into that account. Show PBC’s balance sheet immediately after this deposit, and compute PBC’s new reserve ratio. d) Based on part (c), what do you now expect PBC to do, and why? Show the balance sheet after these actions are taken. e) Starting from the endpoint of your answer to part (d), assume that one of PBC’s existing customers withdraws $3000 from their account. What do you expect PBC to do, and why? Show the balance sheet after these actions are taken. Question 5 The following question will examine what happens in the money market when the interest rate approaches zero. a) Which interest rate represents the opportunity cost of holding money – the real or the nominal interest rate? Explain. b) Argue intuitively why the nominal interest rate (eg, the yield on a riskless bond) cannot fall below zero. c) Can the real interest rate fall below zero? Explain. d) Modify Figure 28-2 in the textbook to take into account this “zero lower bound” for the nominal interest rate. You need to show graphically the slope of the MD curve as the nominal interest rate approaches 0. Explain the shape of the MD curve. e) Using your graph in part (d), explain what happens following a monetary expansion when the nominal interest rate is already close to 0. Question 6 Provide brief but coherent responses to the following short questions. a) Since identifying the ?! curve is difficult, the overnight interest rate is often used as the primary method of implementing monetary policy, whereas the money supply is kept fixed. Explain whether this statement is correct or incorrect, and why. 4 b) For a central bank that implements a credible policy of inflation targeting, this policy acts as an automatic fiscal stabilizer. Explain whether this statement is correct or incorrect, and why. c) Assuming the Bank of Canada targets inflation of 1-3% per year, if the CPI were to rise by 5% suddenly, the Bank would surely tighten its monetary policy. Explain whether this statement is correct or incorrect, and why. d) Because individuals base their expectations of inflation partly on its past values, even individuals with rational expectations are unable to predict large deviations in inflation. Explain whether this statement is correct or incorrect, and why. e) Suppose rising prices of raw materials results in one region of a country experiencing a boom while another region experiences a recession. The central bank should respond by lowering the overnight rate in an attempt to stimulate the economy of the suffering region. Explain whether this policy recommendation is sensible or not, and why. f) Suppose an economy in a severe recessionary gap is unable to lower its nominal interest rate (because it is already at the zero lower bound). In this case, a central bank should induce a higher than normal level of inflation as a method of stimulating the economy. Explain whether this policy recommendation is sensible or not, and why. Question 7 Consider the following simple macro model: ??: ? = ?! + ?? ??: ? = ? - ?? Where ?!, ?, ?, ? > 0 and ?! < ?. a) Calculate the equilibrium values of output and the price level, ? and ?. Now suppose that a negative aggregate supply shock occurs, shifting the AS curve to, ??: ? = ?! + ?? where 0 < ?! < ?!. b) Compute the new macro equilibrium under the assumption that the central bank does not respond to this shock. c) Explain how the central bank could choose to validate this shock. Alter the AD curve to build this “validation” into the model and compute the new macro equilibrium. d) Describe the benefits and risks of validating a negative supply shock.