ECON-501
FS-05
Dr. Kelton

1. Graphically and verbally explain how output, employment, real wages, prices, interest rates, nominal wages, saving and investment are determined in the Pre-Keynesian (or "Old Classical") model.

1. Explain why the equilibrium level of employment must be at full employment.
2. Show and explain the results of an increase in "thriftiness".
3. Show and explain the results of a rise in the money supply.
4. Show and explain the results of a rise in productivity.
   

2. According to the Old Classical model, a fall in nominal wages will move the economy to full employment. Keynes agreed that this was theoretically possible (the "Keynes effect"), but he cautioned against the use of deflation in order to stimulate activity. Explain the Old Classical argument as well as Keynes’ view of the limitations of such a policy.

3. Derive the IS-LM model and use it to answer the following questions.

1. Does the equilibrium level of income have to be at full employment in the simple IS-LM model? Explain.
2. Explain the "Keynes" effect and the "Pigou" effect. If these effects are operable, how will your response in part (a.) be affected?
3. How is policymaking complicated if investment is not a function of the interest rate?
4. What are the effects of an increase in government spending? Is there crowding out?
5. How is stabilization policy complicated if money demand is not a function of the interest rate?
6. What is a liquidity trap, and what should policymakers do if the economy is in one?
7. Does treating consumption as a function of wealth make fiscal policy more powerful? Explain.
8. What happens if the monetary authorities increase the money supply? Explain and show. What happens if there is deflation? Explain and show.
   

4. Orthodox Monetarists relied on the expectations-augmented Phillips Curve to analyze the effects of changes in the rate of monetary expansion, while New Classical (Mark I) theorists relied on the rational expectations hypothesis. Answer the following questions about each model:

1. Which school emphasizes "fooling" and which emphasizes "surprises"? Explain the role played by each.
2. Is there a short-run tradeoff between unemployment and inflation following announced/anticipated monetary expansion? Explain.
3. How would your answers in part (b) change if the policy is unanticipated?
4. Can money be neutral in the short-run? Can it be neutral in the long-run? Explain.
5. Suppose policymakers want to reduce the rate of inflation. Would a Monetarist recommend a "cold turkey" approach or a "gradual" approach? What about a New Classical? Explain.
6. Do Monetarists believe that it would be possible to maintain unemployment below its natural rate? What about New Classicals? Explain.
   

5. Compare and contrast the Monetarist explanation of the Great Depression with that of a "Keynesian". Why did economists turn against the "New Economics" (or textbook Keynesian approach) in the past few decades?

6. Keynes said:

"If we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip".

Carefully explain what he meant by this. Be sure to explain how these "slips" might occur? Would Milton Friedman agree with the above quote? Why/why not?
 

7. Phillips said:

"If, as is sometimes recommended, demand were kept at a value which would maintain stable wage rates the associated level of unemployment would be about 5 ½ per cent".

Did Friedman believe that the monetary authority should choose the "natural" rate of unemployment as its target? Carefully explain.
 

8. What did Friedman refer to as the "fundamental defect" in Phillips analysis of the relation between nominal wage growth and unemployment? Carefully explain his criticism.
 

9. Discuss the "Old View" and the "New View". Why does Brunner argue that the New View is unpersuasive? Carefully explain his empirical work, discussing his finding that actual changes in the monetary base are "meaningful and appropriate measures of actual behavior of monetary authorities".

10. Orthodox Monetarists relied on the expectations-augmented Phillips Curve to analyze the effects of changes in the rate of monetary expansion, while New Classical (Mark I) theorists relied on the rational expectations hypothesis. Answer the following questions about each model:

    a. Which school emphasizes "fooling" and which emphasizes "surprises"? Explain the role played by each.
    b. Is there a short-run tradeoff between unemployment and inflation following announced/anticipated monetary
    expansion? Explain.
    c. How would your answers in part (b) change if the policy is unanticipated?
    d. Can money be neutral in the short-run? Can it be neutral in the long-run? Explain.
    e. Suppose policymakers want to reduce the rate of inflation. Would a Monetarist recommend a "cold turkey"
    approach or a "gradual" approach?; What about a New Classical? Explain.
    f.  Do Monetarists believe that it would be possible to maintain unemployment below its natural rate? What about    
    New Classicals? Explain.

11. The New Classical approach treats unemployment entirely as a voluntary phenomenon. As a result, equilibrium in the labor market implies full employment (i.e. the absence of involuntary unemployment). New Keynesians, in contrast, argue that given efficiency wage considerations, the existence of involuntary unemployment can be considered an equilibrium phenomenon. Carefully explain both arguments.

12. Compare and contrast the monetary surprise explanation of the business cycle with the real business cycle (RBC) explanation. How did RBC combine both "cycle" and "trend"? What drives the fluctuations, according to each theory? What role does money play in each? What policy implications follow from each?

13. Outline the RBC approach and contrast it with both the Friedman and the Lucas "monetarist" approaches. What drives the fluctuations, according to RBC? Explain. What role does money play in RBC? Explain. What policy implications does RBC have? How did RBC combine both "cycle" and "trend"? Does the concept "involuntary unemployment" make any sense from the perspective of RBC? Explain.

14. Outline the RBC approach and contrast it with the Friedman-type Monetarist approach. How did Lucas provide for temporary non-neutrality of money, even as all markets clear? What role does rational expectations theory play in the NC approach? What is the "Lucas Critique", and why was it important in providing criticism of the "income-expenditure" models used in the 1960s? Explain the notion of "dynamic time inconsistency" and its implication for policy formation.

15. Explain the three central, theoretical propositions that underlie NC (Mark I) models. Which one is most controversial? Why? Which proposition did RBC (Mark II) theorists drop? Did dropping this proposition affect the policy implications of New Classical (Mark II) models? Explain.

16. According to RBC theory, instability is as desirable as it is inevitable. Explain.

17. Consider the graph of real GDP for a modern, capitalist economy like the United States (the one I always draw on the board). How would the observed fluctuations in output (especially the deviations away from the long-run trend) be explained by:

    a. Keynes
    b. an IS-LM theorist
    c. an orthodox Monetarist
    d. a New Classicist
    e. a Real Business Cycle theorist