Christina Romer and Jared Bernstein in "The Job Impact of the American Recovery and Reinvestment Plan" calibrated the impact of proposed expansionary fiscal policy (we know it as an increase in G and/or a lower T) on jobs and GDP growth In order to do so, they make assumptions about size of Government spending and tax multipliers. One significant assumption is contained in paragraph below about the level of federal funds rate:
" For the output effects of the recovery package, we started by averaging the multipliers for increasing government spending and tax cuts from the leading private forecasting firm and the Federal
Reserve’s FRB/US model. Two sets of multipliers are similar and are broadly in line with other estimates. We considered multipliers for the case where federal funds rate remains constant, rather than usual case where the Federal Reserve raises the funds rate in response to fiscal expansion, on the grounds that funds rate is likely to be at or near its lower bound of zero for a foreseeable future."
problem1) So in this problem, employ some of the tools that we have acquired to understand how this assumption, "that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future," effects the government spending and tax multipliers.
a) In this problem, compare the size of the Government spending multiplier under two different assumptions: i) the Fed sits on their hands so that when G rises, r rises with it (the standard case), and ii) the Fed accommodates the (real) shock to money demand so that real interest rates remain constant.
Draw 4 diagrams (label them 1 through 4) with 1) a closed economy desired saving; desired investment diagram, followed by 2) an IS – LM diagram followed by 3) a money market diagram followed by 4) an aggregate supply ; aggregate demand diagram.
We begin at our initial point A which is at the output well below potential GDP (that is there is a significant 'output' gap). We let G rise and with an assumption that Fed sits on their hands (assumption i) above) we move to point B, that corresponds to an output closer to potential GDP, but still not quite there. We then assume assumption ii) above so that Fed accommodates the real shock to money demand to keep rates constant. This assumption takes us to point C, which is at potential GDP (i.e., the output gap is gone!).
Start at an initial equilibrium and label as point A in all diagrams, with all associated market clearing variables denoted by subscript A. Like, in your IS – LM diagram, the interest rate that clears the goods and money market is labelled as rA with the associated output at YA. Note importantly that we are assuming fixed prices throughout this exercise. Now let G rise to G' and show how all your graphs are affected. In particular, locate point B in all graphs making sure you refer to each graph separately describeing the intuition of the movement from point A to point B.
b) We now apply assumption ii), one Romer and Bernstein use "that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future." In terms of our analysis, the Fed is going to make sure that real rates remain at their initial level (i.e., they totally accommodate real shock to money demand) Show this accommodation as point C on all of your diagrams. Recall that we are at full employment/potential GDP at point(s) C. Again, make sure you refer to each graph separately describeing the intuition of the movement from point B to point C.
c) Now compare the government spending multiplier under assumption i) no Fed accommodation and ii) the Fed accommodates the real shock to money demand. Be specific with regard to the multiplier as well as the intuition. To support your intuition, draw two diagrams: the user cost = MPKf and the two period consumption model clearly locating points A, B, and C. Referring to your 2 graphs, describe the intuition as to why we move from point A to point B as well as why we move from points B to C. Be sure to label your graphs completely or points will be taken off. Make sure you relate your discussion of your two graphs to the difference in the multiplier depending on what the Fed does or doesn't do.
d) The real business cycle economists (RBC theory) came up with a story that describes exactly why money is a leading and pro-cyclical variable. In the space below, draw a money market diagram on the left, and IS/LM diagram on the right (label completely) and an aggregate demand / aggregate supply diagram below IS/LM diagram. Discuss how real business cycle economists (RBC) addressed this empirical reality (describe using your diagrams). Starting at initial equilibrium, point A, let shock that the RBC theorists utilize to describe this money - output correlation occur and assuming Fed doesn't react, locate new equilibrium as point B (assume prices are fixed in the short-run). Now discuss what would happen in the long-run commenting (again, the Fed does nothing) on the desirability of this long-run adjustment. Now consider a case where the Fed does their job so that these undesirable results don't occur and label as points C. Is money leading and pro-cyclical given the Fed's behavior? Why is this model referred to as reverse causation? Is money neutral or not? describe. Finish your essay describeing how RBC economists describe business cycle (recurrent fluctuations in output)as well as their thoughts on whether or not policymakers should conduct active counter-cyclical policy.
e) New-Keynesians came up with their own story as to why we observe this positive money – output correlation. Begin with discussing why New Keynesians believe that prices are sticky in as much detail as possible. Then use effective wage theory/model to buttress (support) the argument (i.e., why does the efficiency wage theory play critical role in describeing why firms are willing to produce more output at the similar price?). Draw two graphs, one showing the effort curve and the efficiency wage (be sure to describe how firms pick the efficiency wage) and the other being a labor supply labor demand diagram with the assumption that the efficiency wage (w*) is above the market clearing (classical) wage (wclass). Why is this model so attractive in dealing with the empirical reality in labor markets that the classical school has such a hard time with? Now draw another diagram depicting what is happening in the product markets (demand, marginal revenue, marginal cost and a profit function) and why firms are willing to change output at the given price level (short run) given the change in the money stock. Be clear as to why exactly firms are willing to act like a 'vending machine' in the short run (increase output at the similar price). Is this firm behavior, being willing to increase the output at the simialr price, consistent with the firm’s profit maximizing objective? Why or why not?