U6301 Macroeconomics for International and Public Affairs Martsella Davitaya

Columbia University | SIPA

Recitation #7
Suggested Solutions
Problem 1. Discuss the effects of global warming (a permanent negative productivity shock) on GDP,
consumption, saving, investment and the current account balance of the U.S. assuming that
a) U.S. is a small open economy running a current account deficit.

S
r

rWorld I’ I

S I' I’ S,I

Global warming causes a drop in total factor productivity which causes GDP to fall for any level of employment.
Because of the drop in labor productivity, labor demand decreases and employment falls. The drop in productivity
and in employment causes GDP to fall permanently.

Because GDP falls permanently, consumption falls by the same amount of the drop in GDP. Hence, national
saving does not change. However, because the shock is permanent, future capital becomes less productive as well.
Hence, firms reduce current investment. Because saving does not change and investment falls, the CA balance of
the U.S. increases. Hence, the CA deficit decreases.

b) U.S. is a large open economy and that all countries in the world are negatively affected. Can you
predict the effects on the international real interest rate and the current account balances?

Due to the lower domestic demand for funds by the U.S., the current account would increase but, the current
account for the R.O.W. would increase as well as R.O.W.’s demand for funds would decrease too. As R.O.W.
cannot lend more while the U.S. is borrowing less, the real interest rate will drop such that one’s current account
surplus equals the other’s current account deficit, but it is ambiguous if there will be greater or small current
account surpluses/deficits.

Problem 2. Laffer Curve

Derive and illustrate the Laffer curve in a labor market, where the labor demand is perfectly elastic at
𝑤 = 10 and the equation of the labor supply is given by 𝑁! = 𝑤. What is the proportional tax rate that
maximizes tax revenue?

The equilibrium employment in this economy is equal to 𝑁 ∗ = 10(1 − 𝑡) because the labor demand is perfectly
elastic. With a proportional tax, the labor demand firms are facing is given by 𝑤 #$%& = 10, and the wages that
workers are receiving is given by 𝑤 '(%)*% = 𝑤 #$%& (1 − 𝑡). Therefore, the amount that government collects on
each hour of employment is given by 𝑤 #$%& − 𝑤 '(%)*% = 𝑤 #$%& 𝑡 = 10𝑡. The total tax revenue is given by 𝑇 =
10𝑡 × 𝑁 ∗ = 100𝑡(1 − 𝑡) = 100𝑡 − 100𝑡 + .
𝑇 is a quadratic function, the proportional tax rate that maximizes 𝑇 is t=50%.

Problem 3. Money Supply

For all parts of this question assume that we are in the long run. Suppose that during the fourth quarter
of 2010 GDP in the U.S. is at full employment. In addition, because of the revitalization of the banking
system, commercial banks increase their deposits. Hence, the money multiplier increases.

a) How does the resulting change in nominal money supply affect prices in the long run (assume
that expected inflation does not change)?

MS = μ MB. If μ increases, holding monetary base constant, money supply increases. Because money is
neutral in the long run, a one-shot increase in money supply increases prices in the long run. (Prices are
flexible in the long run). More money chasing a given amount of goods will cause the price of goods to
increase.

b) Explain in words what nominal money demand and real money demand are.

Nominal Money Demand is the amount of monetary assets (in dollars or any national currency) that
people hold (in their pockets or in a bank deposit).

Real Money Demand is how may goods and services the nominal amount of money can purchase; the
purchasing power of the amount of money that people hold (in their pockets or in bank deposits). It is not
a function of prices.

c) How does the change in nominal money supply affect real money demand in equilibrium in the
long run (holding expected inflation constant)?

Real Money demand does not change.

d) How does the change in nominal money supply affect nominal money demand in equilibrium
in the long run (holding expected inflation constant)?

Nominal Money demand increases p * L.

In answering question e)-h), keep in mind that during the crisis the Fed acquired several assets linked
to the real estate sector (mortgage-backed securities) that had low credit quality.

e) If the Fed wants to contain the long-run effect on output prices caused by the increase in
deposits should the Fed conduct purchases or sales of Treasury bonds? Explain why.

The increase the money multiplier will cause an increase in nominal money supply. An increase in
nominal money supply would cause an increase in prices. Therefore, to offset the increase in money supply
caused by the increase in the money multiplier, the Fed should look to decrease the monetary base. It should
sell Treasury bonds. The sale of T-bonds will reduce the amount of monetary base and withdraw liquidity
from the system.

f) Explain why these operations on Treasury bonds could hurt the credit quality of the assets
owned by the Fed.

If the Fed sells the Treasury bonds, the composition of the Fed assets will have a greater weight of low
credit-quality assets. It will be more biased towards toxic assets. Hence, the overall credit quality will
deteriorate.

g) If the Fed does not want to hurt the credit quality of its assets, should it buy or sell its mortgage-
backed securities?

It should sell the mortgage-backed securities instead.

Problem 4. Temporary Shocks and Asset Markets

Discuss the long-run effects on output prices of a temporary beneficial productivity shock.
Illustrate your answer on the asset markets graph.
What should the Central Bank do to prevent prices from changing in the long run?

In open economies:
• Temporary beneficial productivity shock causes Y to increase.
• Since real money demand is a positive function of Y, real money demand increases, and the L curve shifts
to the right.
• In open economies, r does not change. Nominal money supply (MS) remains constant. Therefore, P must
decrease so that MS/P increases and shifts to the right.
• Intuitively, P falls because there are more goods and the same amount of nominal money.
 r A: Old Equilibrium
r
C: New
S(Yold) Equilibrium
S(Ynew) L(Ynew)
rworld L(Yold)
A C
I
rworld C
A C

S*old S*new I* S,I

In closed economies:
• An increase in Y causes an increase in both consumption and saving to increase.
• S curve shifts to the right and the interest rate decreases (set by S = I)
• Since real money demand is a positive function of Y, real money demand increases, and the L curve shifts
to the right.
• MS/P must increase and shift to the right. Since nominal MS remains constant (set by the Central Bank),
P must decrease.
• However, P falls more than in open economies because of the decrease in r.
• Intuitively, the decrease in r causes more demand for real money holdings, therefore less is spent on goods
& services, therefore the decrease in price is more than in open economies.

r r
S(Yold) A: Old Equilibrium
rold S(Ynew) rold C: New
rnew A rnew Equilibrium
C A
C
L(Ynew)
I L(Yold)
L(Y*)

S = I S’ = I’ S, I

• The Central Bank can offset the decrease in prices by increasing MS by the same proportion.
• Mathematically, rather than allowing P (the denominator) to adjust, the Central Bank could increase MS
(the numerator). This is important – changes in real money supply are affected by both MS and P.

Y up è S right è r down
In asset markets: increase in Y and decrease in r è L up. So, L increases for 2 reasons here.