MACROECONOMIC THEORY –ECO 320L

Spring 2018
HW7-Written Part
Due: April 30 in class at 12:30.
Instructor: Anastasia Zervou

NAME:
DATE:
Instructions: This is the written part of HW7. Please print out and complete the written part on this sheet. It will
be collected at the beginning of class on Monday, April 30, 12:30pm. We will solve it in class and no extension
can be offered. I will not be able to accept late homework. If unable to come in class, you can leave the sheet at
the economics department main office in BRB first floor, time stamped, due 11:50am (the office closes at
noon). Don't forget to submit the multiple choice part of HW7 in Canvas, which is due Monday April 30, 9:00
am. 70.5% of your grade on this homework will come from the multiple choice questions, and 29.5% will come
from this written part. The written part adds up to 32 points, so there are 2.5 extra points.
Question 1: Use the intertemporal monetary macroeconomic model to show that monetary policy is neutral. Use
the graphs of the labor, output and money markets to show how an increase in money supply has no real effects.
[8 points]
Now use the New Keynesian model with sticky prices to explain why monetary policy might not be neutral, and
instead, have real effects.

Question 2: Use the graphs of the labor, output and money markets to show how a decrease in the interest rate
target by the monetary authorities produces an expansion in the New Keynesian model. Denote the initial points
with the letter A and the final points with the letter B. [13 points]

Decrease in interest rate target means higher output demanded (off equilibrium). Thus more output is produced,
and more workers are employed. Given the lower interest rate, through the intertemporal substitution of leisure
effect, labor supply decreases. The N2 workers ask for higher wage than before in order to work for the firm.
Also, lower interest rate and higher output means higher money demand, which is met by the central bank.
Overall, output increases, employment increased, real wage increased, consumption and investment increased
(given lower r). Average labor productivity is acyclical. Also, price level is sticky by assumption.
Question 3: What does the model predict for the following variables, after a decrease in the interest rate target?
Are they procyclical, countercyclical, or acyclical? (4 points)
Consumption: Procyclical Employment: Procyclical Investment: Average Labor Productivity:
Procyclical countercyclical

Question 4: What do the data tell us for the following variables, are they procyclical, countercyclical, or
acyclical? (4 points)
Consumption: Procyclical Employment: Procyclical Investment: Average Labor Productivity:
Procyclical Procyclical

Question 5: Are monetary policy shocks likely to be generating the business cycle? Yes/No (Tip: compare
your answers in question 2 & 3). (3 points) NO (note: this is the prediction for our model; the point is more to
see how we compare data-model predictions. Our model, although simple, was able to predict the direction of
most of the variables. It fails in some dimensions and modern Ney Keynesian models add complications in
order to match the rest of the data predictions. Through our model though, Average labor productivity is not
matched, and thus monetary policy shocks were not good predictors or the average US business cycle).