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 ∂Px = ∂Px |U =constant −x ∂x . Or, the effect a change in ∂I ∂x ∂h price has on quantity of X demanded is equal to the substitution effect ( ∂Px |U =constant = ∂PX ) plus the income effect (−x ∂x ). For a normal good, the income effect is negative. However, ∂I because the income effect is positive for an inferior good,

∂h ∂x < ∂Px ∂Px Since for normal goods both effects are negative, 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
∂h ∂Px ∂h ∂Px

is smaller in magnitude than

∂x , ∂Px


∂x ∂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.


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.


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 eq,p 1 =p 1 + −0.5 MR=-1 ·p MR=p 1 + This quantity is greater than the quantity the monopolist should be producing to maximize 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∗.


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 maximize 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, then Pb = 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 =0, ∂Q ∂πA =0, ∂Q

for the publisher 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 = 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. 4 MR 1−ρ


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 indifference 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 EX,Y = ∂QX PY · >0 ∂PY QX

EY,X < 0


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.


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.


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.


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 Firm 2 small car Π1 = 1000 Π2 = 800 Π1 = 500 Π2 = 500 big car Π1 = 400 Π2 = 400 small car Π1 = 800 Π2 = 1000

(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 Firm 2 small car Π1 = 1000 Π2 = 800 Π1 = 500 Π2 = 500 big car Π1 = 400 Π2 = 400 small car Π1 = 800 Π2 = 1000

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 10

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 = 5 . We now do the same for Firm 2. 9 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 = 5 . Then, our mixed Nash Equilibrium is 9 that both firms build big cars with probability 5 . The following graph shows the three mixed 9 equilibria, two of which (E1 and E2 ) are the special cases of pure strategy equilibria.


(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.


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 13

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.


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.



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 = eP ∗ . Note that since prices are fixed in the short run, δ = δe. Also, note that a fall in P 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 determined 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. 17

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.


Macro Question 4 Relative to those of the United States, the labor markets of many European countries tend to have greater participation in collective bargaining, more generous government unemployment and disability insurance programs, and more regulations restricting the ability of employers to fire employees. What effects would you predict that these policies 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 aggregatedemand 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 unemployment and disability insurance programs, and more regulations restricting the ability of employers 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, causing 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.


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: ˙ ˙ k = sBk − (n + g + δ) → k[(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.


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 available (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


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: R= M P (pi )

where R is seignorage, M is the real value of money, and pi is the rate of inflation. P 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.


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 23

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!)


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