1. An article in the December 22, 2022 issue of The Wall Street Journal was entitled ‘Spending Bill at Odds With Fed on Inflation’. That article begins with the following: “Inflation is the economy’s No. 1 problem. The Federal Reserve understands this and has adapted accordingly. Congress and President Biden still haven’t.” Later in the article author Greg Ip writes, “Yet, the bill still raises nondefense, non-emergency spending by 8% and defense spending by 10% next year – above the current inflation of about 7% - according to the Committee for a responsible Federal Budget. So at the margin the bill adds to, rather subtracts from, demand and inflation pressure.”

a) Within the context of the full Classical model developed in class, what is the relevance of Mr. Ip comparing the increases in spending of 8% and 10% to the current inflation rate of 7%? (10 points)

b) Within the context of the complete closed-economy Classical model developed in class, is Mr. Ip’s conjecture that this budget will add to inflation justified? Use graphs and words to explain your answer. (15 points) For the purposes of this question assume the “spending” Mr. Ip refers to is real government purchases of goods and services and this spending is increased. Please limit your analysis and discussion of the prediction of other endogenous variables to those that are relevant to your analysis of inflation.

c) How would your answer to part b) change if the “spending” Mr. Ip refers to is not an increase in real government purchases of goods and services but rather an increase in real transfer payments made by the government to domestic residents? Make sure to include an analysis, if possible, of whether the magnitude of inflation predicted by the Classical model varies with the definition of “spending”. Again, use both graphs and words to explain your answer.

d) Analyze the two types of spending discussed in parts b) and c), i.e. an increase in real government purchases of goods and services and an increase in real transfer payments by the government to domestic residents, within the context of the complete small open economy Classical model developed in class. Specially, use graphs and words to explain if these two policies would create inflation or not, and, if possible, compare the levels of inflation predicted by the model. Please limit your analysis and discussion of the prediction of other endogenous variables to those that are relevant to your analysis of inflation.

e) Pick one of the two possible definitions of spending used above and use the complete small open-economy Classical model developed in class to analyze what the spending policy described by Mr. Ip would do the U.S. current account, net exports, terms of trade, the nominal exchange rate and the nominal wage. Use both graphs and words to explain your answer.

f) Which model, the closed-economy model or the small open-economy model, would be more appropriate for analyzing the U.S.? Explain. (10 points)

g) Turning now to the Fed, Mr. Ip does not elaborate on what he means about the “the Fed understands”. Suppose he means that the Fed understands that inflation is the economic problem most in need of attention of appropriate action through monetary policy. Use the complete closed-economy Classical model developed in class to identify what a central bank can do to lower inflation. If there is a single possible action, then identify that action and describe how taking that action will lead to lower inflation. Use both graphs and words to explain your answer. If there are multiple actions, then provide the complete list of actions and for only a single action describe how taking that action will lead to lower inflation. Use words and graphs to explain your answer.

h) Suppose the Fed undertakes the action you analyzed in part g). Are there any actions that the non-bank private sector (the households and firms that hold the U.S. money supply) could take that would have a direct impact on the money supply and thereby (presumably inadvertently) work against the Fed’s attempt to lower inflation? If yes, provide a single example of such an action and explain how this action has a direct impact on the money supply.i) Should you change your answers to parts g) or h) if the model was the complete small open-economy Classical model developed in class? Use just words, not graphs

j) Return to your answer to part g). What does the Keynesian model developed in class predict will be the short-run effects on the economy of the Fed taking the action you select? In particular, what will the effect be on output, consumption, investment, the budget deficit, and the expected real interest rate? Use graphs and words to explain your answer.

k) Leave this first sentence aside and focus on the second. Using either the complete closed economy Classical model or the complete small open-economy model developed in class, identify a policy the government could take to expand aggregate supply. For the purposes of this question assume “aggregate supply” means real GDP. You may allow the policy you select to involve changing one or more exogenous variables under the control of the government, although, if possible, select a single exogenous variable. Use both graphs and words to explain your answer and explain whether it matters which of the two models you chose.

l) Finally, returning to the first sentence, briefly describe in words how you could, based on the complete Classical model developed in class, improve Mr. Ip’s statement about aggregate supply being what matters for inflation. If possible, answer for a closed economy and small open-economy

2. On the midterm you were asked to analyze the effects of an increase in the corporate profits tax rate in the closed-economy Classical model that included a labor market and a goods market. The correct analysis showed that the effects of this policy action would be to increase output, lower consumption, increase investment, lower the expected real interest rate, and lower the real user cost of capital.

a.) Compare these “long-run” results to the “short-run” results that come from the Keynesian model developed in class.

b.) Return to the closed-economy Classical model developed in class. Now that money market has been added to the model that was available at the time of the midterm, the model makes predictions about the effect of an increase in the corporate profits tax rate on inflation. What is that prediction? Explain. (You may use graphs if you wish, but that is not necessary. Explaining in words is sufficient.)

3. A common question that arises in macroeconomic models is whether expectations can become self-fulfilling. That is, if households or firms expect something to increase in the future then do the actions they take in response to that expectation cause what they expect to happen actually happen, even though it would not have happened had their expectations not changed.

a.) Evaluate this issue in the small open-economy Classical model by using that model to analyze what happens if households and firms for some reason increase their expected depreciation of the domestic currency. Use both graphs and words to explain your answer.

For the purposes of this question assume that expectations of the inflation rates for domestically produced goods and foreign produced goods remain unchanged. And likewise for expectations of the future real wage, future government tax and transfer policy, future total factor productivity, and future output.

b.) How should your answer to part a) change if the increase in expected depreciation of the domestic currency is accompanied by an equal decrease in the expected inflation rate for foreign produced goods?

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