Econ Qual Study Sheet

Micro Question 1 Suppose that X is an inferior good. If px falls, will the gain in consumer
surplus measured under the Marshallian (uncompensated) demand curve exceed that measured
under the Hicksian (income compensated) demand curve, or vice versa?
∂x ∂x
The Slutzky equation takes the form ∂P x
= ∂P x
|U =constant −x ∂x
∂I
. Or, the effect a change in
∂x ∂h
price has on quantity of X demanded is equal to the substitution effect ( ∂P x
|U =constant = ∂P X
)
∂x
plus the income effect (−x ∂I ). For a normal good, the income effect is negative. However,
because the income effect is positive for an inferior good,
∂h ∂x
<
∂Px ∂Px
∂h ∂x
Since for normal goods both effects are negative, ∂P x
is smaller in magnitude than ∂Px
,
but this is reversed for inferior goods so,
   
 ∂h   ∂x 
 ∂Px  >  ∂Px 
   

We can then show that the slopes of the Hicksian and the Marshallian demand curves
are:
1 1
 < 
 ∂h   ∂x 
 ∂Px   ∂Px 
We find that the Hicksian Demand curve is flatter than a standard Marshallian demand
curve for an inferior good. The following graph shows the effects of a change of price of good
x on quantity of x purchased, with both hicksian and marshalian demand curves. In the
graph there are two hicksian demand curves, DH 0 and DH 1 . The reason for this is that, all
else equal, a higher utility level can be achieved when the price of good x is lowered. This
presents an interesting problem for welfare analysis.

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 If we look only at the changes in welfare from the perspective of the Hicksian demand
curve, we have two options. We can take the either the perspective that the new utility level
is the natural level for welfare observations or that the old utility level is more natural. In
the graph above, the first case sees an increase in welfare represented by the red area, the
second case sees an increase in welfare represented by the red, yellow, and green area. Since
utility is held constant in a Hicksian demand curve, we can interpret the red area as amount
of money that the consumer would demand in order for them to be indifferent to consuming
this higher quantity of the inferior good x as opposed to, while at this new, higher utility
level. The red plus yellow plus green area can be interpreted as the amount of money the
consumer would demand in order to consume a greater amount of this inferior good, at its
lower price, and still stay at the same utility level.
The use of the Marshallian demand curve actually provides a middle ground for these
two different analyses, and makes the interpretation of the change in welfare simpler. The
increase in consumer surplus associated with a movement along the Marshalian demand
curve can be seen in the graph above as the sum of the red and yellow areas.

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Micro Question 2
You have been hired to advise a monopolist firm on its price and output policy. An
independent market research firm has estimated its elasticity of demand to be −0.5. Would
you recommend that the monopolist change its output? If so in what direction? Explain your
answer and illustrate it with appropriate graphs.

If the monopolist has an elasticity of demand that is inelastic (eq,p > −1), which is the
case in this question, then they will be producing a quantity associated with a negative
marginal revenue. This can be seen by the equations:
 
1
MR=p 1 +
 eq,p 
1
=p 1 +
−0.5
MR=-1 ·p

This quantity is greater than the quantity the monopolist should be producing to max-
imize profits. A negative marginal revenue can obviously not be equated with a positive
marginal cost. The graph below shows the current quantity being produced Q0 which is
lower than the profit maximizing quantity Q∗. The profit maximizing quantity Q∗.

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Micro Question 3 An author and publisher are deciding how many copies of the author’s
book to print and what price to charge per book. The author receives royalties, calculated as
a percentage of the revenues received from selling books. The publisher wants to maximize
profits and must incur positive marginal cost to print books. If the author is trying to maxi-
mize his or her royalties, will the author and the publisher agree on the number of copies to
print and the price to charge? Explain your answer and illustrate it with appropriate graphs.

If we assume a demand curve of the form QB = a − bPb where a and b are constants,
a − Qb
then Pb = Then,
b
πP =(1 − ρ)T R − T C − F C
πA =ρT R − T C

Where ρ is the percent of revenues which go to the author. To maximize π with respect to
Q, it must be that,
∂πP
∂Q
=0, for the publisher
∂πA
∂Q
=0, for the author

For the author,

∂πP
= ρM R
∂Q
as fixed costs do not vary with output.
So to maximize profit, the author produces at the level where

ρM R = 0 → M R = 0
For the publisher,
∂πP
= (1 − ρ)M R − M C
∂Q
so to maximize profit, the publisher produces at the level where
MR
MR =
1−ρ
Graphically, we can represent this as:

lines lines lines lines lines lines.

So clearly, the author wishes to produce at a higher quantity than the publisher.

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5
Micro Question 4 Explain why it is possible for an increase in the price of good X to cause
an individual’s consumption level of good Y to increase, while an increase in the price of
good Y causes the same individual’s consumption level of good X to decrease. (Except for
the specified price change, you should assume that preferences, income, and the price of the
other good remain constant.)

This is possible when Y is a Giffen good. A giffen good is an inferior good who’s income
effect completely dominates the substitution effect. So, the increase in the price of good Y
causes the quantity of good Y consumption to rise and consequently the amount of good X
decreases.
This can be seen in the following image:

In this graph, we start with the ability to purchase good X and good Y in proportions
that get us to indifference curve I0 . If we increase the price of good X, we move to indif-
ference curve I1 , which decreases the amount of X consumed and increases the amount of
Y consumed. If we increase the price of good Y, we move to indifference I2 , which again,
decreases the amount of good X consumed and increases the amount of good Y. In both of
these cases, the income effect causes an increase in the amount of good Y consumed.
A giffen good also has a negative (cross) price elasticity of demand
∂QX PY
EX,Y = · >0
∂PY QX
EY,X < 0

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Micro Question 5 Which of the following describes an externality and which does not?
Explain the difference.
(a) A policy of restricted coffee exports in Brazil causes the U.S. price of coffee to rise, which
in turn also causes the price of tea to increase.
(b) An advertising blimp distracts a motorist who then hits a telephone pole.

An externality is defined as an effect of one economic agent on another that is not taken
into account by normal market behavior.
Example (a) above does not describe an externality. From the U.S. perspective the
restriction on Brazillian exports is simply a restriction of coffee supply. The reduction in
supply causes, through normal market forces, an increase in price. Consequently, since tea is
assumed to be a substitute for coffee, an increase in the price of coffee would, again through
normal market forces, cause an increase in demand for tea, raising its price as well.
Example (b) above does describe an externality. We assume that when an advertiser
purchases the use of the blimp, they do not also purchase distracted motorist insurance, and
that the advertiser will not compensate the motorist for the costs incurred by the crash.
The difference between these two examples is that example (a) has a market that can
respond to the effects of one economic agent, while example (b) does not have a market that
can respond to the effects the economic agents.

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Micro Question 6 Explain how it is possible for an industry supply curve to be perfectly
elastic with respect to price when each firm in the industry has increasing marginal costs.

For this to be possible, we must assume a perfectly competitive market. Under these
assumptions, there is free entry and exit, there are a large number of identical firms and
all of these firms are price takers. The graph below shows the relationship between the
individual firm and the industry in both the short and long run. Since there is free entry,
there is no possibility for economic profit, and all of the firms will be producing at the bottom
of their identical long run average cost curves.
The individual firm’s short run supply curve is bolded in the graph below. However,
they would be better off shutting down in the long run, than producing on the upward
sloping portion of this curve. So, aggregating the firms supply curve gives us a horizontal
(or perfectly elastic) supply curve.
However, in the short run, a price shock can cause temporary profits, creating a less
elastic supply curve. Still, free entry will cause these profits to diminish, and in the long run
return to the perfectly elastic supply curve.

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Micro Question 7 Jane has 8 liters of soft drinks and 2 sandwiches. Bob, on the other
hand, has 2 liters of soft drinks and 4 sandwiches. With these endowments, Jane’s marginal
rate of substitution (MRS) of soft drinks for sandwiches is three, and Bob’s MRS is equal to
one. Draw an Edgeworth box diagram to show whether this allocation of resources is efficient.
If it is, explain why. If it is not, what exchanges will make both parties better off ?

The Edgeworth box below shows the initial allocation of sodas and sandwiches A0 and has
solid lines representing a constant marginal rate of substitution for both Bob and Jane. Under
the assumption of a constant marginal rate of substitution, this allocation is not efficient.
The shaded area represents trades that would be mutually beneficial, pareto prefered.

However, The possibilities for pareto improving trade could be much smaller if we do
not assume linear MRS. If Bob and Jane have indifference curves represented by the dashed
lines, then at the The mutually beneficial trades can be seen to be much smaller. However,
since at the initial allocation, their MRS are not equal, there will necessarily be mutually
beneficial trade.

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Micro Question 8 Consider the following game between two firms that produce automobiles.
Each firm must make its choice without knowing what the other has chosen.
Firm 1
big car small car
big car Π1 = 400 Π1 = 800
Π2 = 400 Π2 = 1000
Firm 2
small car Π1 = 1000 Π1 = 500
Π2 = 800 Π2 = 500

(a) Define dominant strategy. Does either firm have a dominant strategy?
(b)Define Nash equilibrium. Does this game have any Nash equilibria?
(c) Suppose we have the same payoff matrix as above except now firm 1 gets to move first
and knows that firm 2 will see the results of this choice before deciding what type of car to
produce. Draw the game tree fro this sequential game. What is the Nash equilibrium for this
game?

(a) A dominant strategy is the best response to the all strategies of all other players. In
the game above neither Firm 1 nor Firm 2 have a dominant strategy. In the table below the
underlined values are the choices that a firm would make, given the other firm has already
chosen the associated car size.
Firm 1
big car small car
big car Π1 = 400 Π1 = 800
Π2 = 400 Π2 = 1000
Firm 2
small car Π1 = 1000 Π1 = 500
Π2 = 800 Π2 = 500

As can be seen in the table above, each firm would prefer to be producing the opposite
sized car as the other firm.

(b) In a two player game, a Nash Equilibrium is a strategy profile s1 , s2 such that, for
each firm, s1 ∗ is a best response to the other player’s equilibrium strategy s2 ∗. Again,
looking at the underlined choices above, we can see that this game has two pure strategy
Nash Equilibria, namely Firm 1 chooses big car, Firm 2 chooses small car and Firm 1 chooses
small car, Firm 2 chooses big car.
Additionally, since games almost always have an odd number of Nash Equilibria, we
should suspect that there is also a mixed strategy equilibrium. We can find this equilibrium
by calculating the the expected payoff for each firm. Let the strategies for each firm be given
by (B, 1 − B) and (b, 1 − b) for Firm 1 and Firm 2 respectively where B is the probability
that Firm 1 chooses big car and b is the probability that firm 2 chooses big car. Then the
expected payoff for Firm 1 can be written as

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 u1 =B · b · 400 + B(1 − b)1000 + (1 − B)(1 − b)500 + (1 − B)b · 800
=500 + B · 500 + b · 300 − B · b · 900

And the expected payoff for Firm 2 can be written as

u2 =B · b · 400 + B(1 − b)800 + (1 − B)(1 − b)500 + (1 − B)b · 1000

=500 + B · 300 + b · 500 − B · b · 900

We can then use these results to find the mixed equilibrium. If the second firm is playing
the mixed strategy (b, 1 − b) then we can find the utility of Firm one building a big or small
car respectively as:

u1 (big, (b, 1 − b)) = 500 + 500 + b · 300 − b · 900

u1 (small, (b, 1 − b)) = 500 + b · 300
For this strategy to be in equilibrium these two equations must be equal. We then find,
by solving for b that b = 59 . We now do the same for Firm 2.

u2 ((B, 1 − B), big) = 500 + B · 300 + 500 − b · 900

u2 ((B, 1 − B), small) = 500 + B · 300
Again, setting these equal, we find that B = 59 . Then, our mixed Nash Equilibrium is
that both firms build big cars with probability 59 . The following graph shows the three mixed
equilibria, two of which (E1 and E2 ) are the special cases of pure strategy equilibria.

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 (c)In the sequential game where Firm 1 gets to move first, Firm 1 will choose to produce
a big car. Firm 2 will then choose to produce a small car. The following diagram shows this
sequential game. The dashed line is the Nash Equilibrium. The bold line shows the path
Firm 2 would take if Firm one chose the (sub-optimal) path of producing a small car.

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Macro Question 1 Until the recent financial crisis, the Federal Reserve has implemented
monetary policy by targeting the federal-funds interest rate. Starting in 2008, there has been
considerable attention paid to “quantitative easing” as a complement to low interest rates.
Explain the rationale behind the need for a policy of quantitative easing. Why are some
models pessimistic that it will have beneficial effects?

“Quantitative easing” is technically a central bank policy designed to increase the money
supply, instead of targeting interest rates or reserve requirements. (On a very basic level,
then, quantitative easing will not be effective if money is neutral.) Colloquially, however, and
especially when related to the recent financial crisis or Japan around 2000, quantitative easing
has come to mean targeting the monetary base by unconventional means i.e. buying up
long-term bonds or other assets (such as mortgages) instead of short-term treasury securities,
which are the normal avenue for Federal Reserve policy to enact monetary policy during a
liquidity trap.
To see how this is supposed to work, lets first examine a liquidity trap situation in the
IS-LM model. Hicks first observed that, since nominal interest rates cannot fall below zero,
there must be some kind of lower bound on the LM curve, such that the Fed could never
push the interest rate into a negative region. This suggested to him that instead of the
standard linear LM curve, what the Fed faced was something more as follows:

Essentially, as the interest rate nears zero, treasury securities and cash become perfect
substitutes, so if the federal reserve tries to buy securities with cash, it is exchanging two
goods of equal value, and therefore cannot effect output. Because of this Keynesians saw
the only way out of a liquidity trap to be fiscal policy, raising the IS curve. However, the
monetarists proposed a different solution. Even though the nominal interest rate may be

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near zero, they suggested, the real interest rate could still be lowered. If other assets, such
as long term bonds, are not perfect substitutes for short-term bonds, then the federal reserve
could instead buy up these assets with newly printed money (if not, the Fed will face the
same problem it does with treasury securities). While this would not change the nominal
interest rate, it could drive the real interest rate down below zero by increasing expectations
of inflation, in effect overcoming the zero bound rule which is so fundamental to liquidity
traps. However, there are several problems with this plan. First of all, the market in long
term bonds and other assets is a lot deeper than that in treasury securities, and to effect any
kind of change, the federal reserve will have to make massive purchases. Second, if banks
or companies are cash-hoarding, the money that the fed is putting into them by buying up
their assets will not be released into the general economy. Therefore, consumer spending
decisions will not change, as they will not see any inflation to adjust to.

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Macro Question 2 In the New Keynesian theory of business cycles, “nominal rigidities”
are elements such as menu costs that make firms want to keep nominal prices unchanged,
whereas “real rigidities” cause firms to want to keep their relative prices in relation to their
rivals) unchanged. Explain why real rigidities alone cannot explain why firms would fail to
adjust prices in response to a correctly perceived change in the money supply. Explain how
the presence of real rigidities can increase the amount of price stickiness caused by a given
degree of nominal rigidity in response to a monetary shock.

According to Keynes, nominal wages and prices are rigid, so nominal disturbances have
real effects. Many of the most common real life-life examples including efficiency wages,
implicit contracts, and differences in markets are nominal explanations, not explanations of
real rigidities. Menu costs are one of the few good examples of real rigidities.
The way in which nominal rigidities cause price stickiness in the face of monetary shocks
is they cause firms to have to decide whether changing their prices to the profit-maximizing
price will improve profit enough to make up for the costs of the nominal rigidities (such as
menu costs); if this is the case, and only nominal rigidities apply, then the firm will change
price. Real rigidities refer to the way in which being the first firm to move decreases the
profit function associated with the new profit-maximizing price without any other firms in
the industry also changing their prices. If real rigidities are the only rigidities, however,
and there are no nominal rigidities, then the firm will always want to change price if the
profit-maximizing price has changed as a result of the monetary shock, because the increase
in profit will always be greater than the (nonexistent) costs. Thus, every firm will change
price, so there will be no costs associated with being the first to change price. Real rigidities,
however, do increase the stickiness caused by nominal rigidities, because they do decrease
the profits from changing to the new profit-maximizing price. This makes it less likely that
a firm will find that the increase in profits will be greater than the costs associated with the
nominal rigidities, because the increase in profits will be lower in the face of real rigidities.

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Macro Question 3 Suppose that capital is perfectly mobile internationally and that prices
of goods can be assumed to be fixed in the short run. Climatopia follows a policy of fixing
its exchange rate against the U.S. dollar. Use the Mundell-Fleming model to show what
will happen to domestic output, interest rates, the exchange rate, and the money supply if
global warming causes a large decline in Climatopia’s lucrative tourist trade. Will the fixed
exchange rate be more or less helpful (relative to a floating rate) in stabilizing domestic
output in the face of this shock? Suppose that doubts begin to emerge about the ability of
Climatopia’s central bank (Sunny Money United Reserve Fund, or SMURF) to maintain the
exchange-rate peg. Use the model to show how this can lead to an exchange-rate crisis.

Since we assume perfect capital mobility, the domestic interest rate must always equal
the foreign interest rat (r = r∗). For this reason, the MP curve must be horizontal in (Y, r)
space. This must be true, because targeting an interest rate other than r∗ would cause
immediate capital inflows or outflows. The first part of our analysis on the effects of global
warming comes in noting that a decrease in the tourist trade is a decrease in net exports.
This causes a leftward shift of the IS curve, as can be seen in the graph below.

It is notable that domestic output decreases to Y1 while interest rates remain at r∗.
At this point we can move our analysis to looking at the effect of this shock on the
exchange rate. We define the nominal exchange rate e as the price of a unit of foreign
currency, in terms of a unit of domestic currency. The real exchange rate is then defined as
 = ePP ∗ . Note that since prices are fixed in the short run, δ = δe. Also, note that a fall in
 is the same as an appreciation of the domestic currency.
In (, Y ) space, the MP curve is vertial, since output for a given inflation rate is deter-
mined entirely by monetary policy, as the interest rate is fixed at r∗. It can be seen in the
graph below, that a fall in net exports caused by global warming will shift the IS curve left.
Under a floating exchange rate, this would cause a depreciation of the domestic currency.

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However, money supply must decrease, to offset the effect of decreased demand for money,
pulling the exchange rate back up to its fixed level 0 .

It is easy to see from the graph above, that Climatopia would have been better off under a
floating exchange rate. Rather than decrease the money supply to keep the exchange rate
fixed at 0 , with the adverse effect of decreasing output. They could have let their currency
depreciate to 1 and kept domestic output at Y0 , a simpler and less detrimental way of
stabilzing the economy.
We have seen above that keeping the fixed exchange rate is difficult for Climatopia when
net exports are decreasing. If people begin to doubt the ability of Climatopia to hold
its exchange rate fixed, they would expect that Climatopia would have to depreciate their
currency. This expectation is essentially a risk premium associated with holding Climatopia’s
currency, which would further decrease net exports. This cycle is self re-enforcing, leading
to an exchange-rate crisis.

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Macro Question 4 Relative to those of the United States, the labor markets of many Eu-
ropean countries tend to have greater participation in collective bargaining, more generous
government unemployment and disability insurance programs, and more regulations restrict-
ing the ability of employers to fire employees. What effects would you predict that these poli-
cies would have on the long-term natural unemployment rate and why? What effects would
you predict that they would have on the response of unemployment to an adverse aggregate-
demand shock and why? Are these predictions consistent with the relative performance of
these economies from 1980-2010?

We would expect that more collective bargaining, more generous government unemploy-
ment and disability insurance programs, and more regulations restricting the ability of em-
ployers to fire employees would all tend to raise the natural unemployment rate in the long
run. Collective bargaining would tend to create upward pressure on wages, reducing the
number of employees that firms would hire. More generous government unemployment and
disability insurance programs would reduce the opportunity cost of being unemployed, caus-
ing people to spend longer in a state of frictional unemployment thereby increasing the
natural rate of unemployment. Finally, restrictions on the ability to fire employees would
increase the opportunity cost to hiring sub par employees. This could have the effect in times
of economic difficulty, of increasing unemployment, as employers would be wary of higher
workers whose marginal product they cannot ascertain. However, during economic booms,
this could serve a ratcheting effect, as employers simply hire more employees without firing
their unproductive workers.
These policies, while increasing the natural rate of unemployment, could have benefits
during an adverse aggregate-demand shock. Restrictions on firing will keep people in their
jobs, and unemployment insurance will allow people some disposable income even after losing
work. These policies will either keep unemployment from sinking too low, or at least should
have a stimulatory effect on the economy, as unemployment won’t further drive aggregate
demand down. However, the stickiness of wages could prevent firms from adjusting their
prices downward in response to the aggregate demand shift.

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Macro Question 5 The Solow model assumes diminishing returns to capital, which means
that the f (k) function giving output per effective labor unit as a function of capital per
effective labor unit increases at a decreasing rate. Describe the equilibrium behavior of the
model if we suspend diminishing returns and allow f (k) = Bk, where B is a positive constant.
(Assume that sB is larger than n + g + δ where n is the growth rate of the labor force and
g is the growth rate of technology and explain why this assumption is important.) Show that
this model generates positive “endogenous growth” if n + g = 0. Does the growth rate depend
on the savings rate? If two countries have identical parameters but differ in their levels of
capital per effective labor unit, will they eventually converge to the same growth path as in
the Solow model? Explain.

As in the standard model, our growth rate of k is still:

γk =sf (k)/k − (n + g + δ)
=sBk/k − (n + g + δ)
=sB − (n + g + δ)

This growth rate is greater than 0 for all k, as sB > (n + g + δ), which was given to us
at the outset. This can be shown graphically as follows:
And since Y /L = y = f (k) = Bk, we know that γy = γk . Since sB > (n + g + δ) ∀
n, g, even when n = g = 0 we still have positive growth. This makes this ’Bk’ model an
endogenous growth model. Clearly, since s enters into our growth rate equation, and in fact:
∂γ
=B>0
∂s
our growth rate is (positively) dependent on savings. Intuitively, in this model, capital builds
directly on the capital you already have:

k̇ = sBk − (n + g + δ) → k̇[(sB − (n + g + δ)]k, sB − (n + g + δ) > 0

The more you save, the more the rate of capital growth grows, the faster your economy
grows.
However, starting out with a different amount of capital per worker will not change your
economy’s growth rate, as γy is not dependent on k. There are also no convergence dynamics.
Countries with the same s, B, n, g, and δ will have exactly the same growth rates independent
of their initial values of k or y, though they will never converge in levels if their k’s or y’s
are not equal at the beginning, as there are no decreasing returns to scale.

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Macro Question 6 Short-term nominal interest rates on Treasury bills are very low. Are
rates on longer-term Treasury bonds equally low? How do rates on corporate bonds compare
to those of Treasury bonds of comparable maturities? Are real interest rates on corporate
bonds high or low right now in historical context? From a cost standpoint, is this a good time
for a firm to invest in new capital? Is your answer different if the firm is using accumulated
cash reserves vs. issuing bonds to finance its investment?

Long-term treasury bonds have interest rates higher than those of short-term bonds,
however this is typical of most bonds - the longer until they mature, the higher the interest
rate necessary to induce investment.
Rates of AAA rated 30 year corporate bonds are slightly higher than those of 30 year
treasury bonds. While AAA rated bonds are probably a very safe investment (having a
very low risk of default), treasury securities are still the standard for safety. Therefore this
difference may be cause by a risk premium on corporate bonds.
Nominal rates on AA rated 30 year corporate bonds were increasing over the period from
approximately the end of World War 2 to 1982. However, this corresponds quite well to
inflation, which started increasing in the 50’s and ended around 1982 with Paul Volcker’s
Federal Reserve actions. In the 90’s, with inflation (in a historical context) pretty stable,
returns on corporate bonds stayed relatively stable as well. So real returns were probably
pretty constant during this period, even though the nominal returns varied quite a bit.
If a firm has a good deal of cash, it will decide between putting money in capital and
putting it in the next best investment available. Since, in this case, the best investment avail-
able (assuming no risk premium) is corporate bonds, the firm will decide between investment
in corporate bonds and in capital. The firm will invest in capital if:

rK > rcorporate

i.e. if the return on capital investments is higher than the return on a corporate bond. If
the firm has no cash, it will need to borrow, so it will have to issue bonds. The interest rate
it has to pay on those bonds is equal to rcorporate . So once again, firms will invest in capital
if rK > rcorporate , and will continue to invest until:

rK = rcorporate

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Macro Question 7 Evaluate the following argument: “Deflation is stimulating because it
acts as a tax cut for the economy in two ways. First, people are not losing seigniorage to the
government through real depreciation of their currency. Second, much of the real interest on
their bonds is not taxed because current tax laws levy taxes on nominal interest earnings.”

Deflation is defined as a general decline in prices, or periods of falling prices. There are a
few arguments stating reasons that deflation is stimulating, the first is that “it acts as a tax
cut for the economy in two ways: first people are not losing seignorage to the government
through real depreciation of their currency.” Seignorage is defined as the revenue raised
from printing money. It can also be thought of as an inflation tax, where people holding
money get taxed. This is because printing money increases the money supply, which in turn
causes inflation. This increase in money supply does decrease the real value of money held
in pockets, and hence your purchasing power. The equation for seignorage is as follows:
 
M
R= (pi )
P
where R is seignorage, M P
is the real value of money, and pi is the rate of inflation.
During deflation, the rate of inflation is obviously negative, increaseing real interest rates
over nominal interest rates. This does not necessarily have a stimulating effect though.
People do not hold much of their assest in cash, and high interest rates do not traditionally
have a stimulating effect.
Again, most assests are not held in bonds, so a tax cut on their interest rates is not very
stimulating in relation to the depressive effects of deflation.

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Macro Question 8 According to preliminary estimates by the Bureau of Labor Statistics,
total employment has fallen from a peak of 137.951m in December 2007 to 129.527m in
January 2010. Use labor demand and labor supply curves to explain: (a) How the new
Keynesian model would explain this reduction in employment.
(b) How the real business cycle model would explain it.
(c) Which explanation seems more consistent with the observations of the real world?

a) In the New Keynesian model, recessionary unemployment is caused by low wage rates
that should increase employment, but can not as aggregate demand is too low and firms hire
less employees. Furthermore, wages in the model are sticky and take time to adjust and thus
the wage and employment do not reach equilibrium.

The graph above shows how, because of wage stickiness, after a fall in labor demand,
the market does not clear. Labor demand has fallen, bringing employment from point A to
point B. However, employers cannot lower wages to bring the market to equilibrium at point
C.

b)In the real business cycle model, however, involuntary employment does not exist, and
the labor market clears. In this model, changes in labor are due to exogenous real (not
nominal) shocks, for example, unavoidable technological changes. In the graph above, with
a fall in labor demand, the market would clear to point C.

c) The RBC model is not very consistent with real-world observations. While the model
does a good job creating cycles and modeling the cyclicality of the economy, its explanations
behind this are not very solid. According to Jeff, The RBC model associates marginal

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productivity with real wages (which are only barely procyclical) and assumes that workers
are always on their labour supply curves (there is no involuntary unemployment). Thus,
if employment is strongly cyclical but productivity does not move as strongly with output,
then labor supply must be extremely sensitive to real wage movements. (not true in real
life!)

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Extra Credit Represent, as concisely as possible, the entire Macroeconomy. Make sure that
you’re model is based on firm micro-economic intuition.

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