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Questions for Final Exam
Subject to Revision
ECON 309 -- Graduate Macroeconomics
Fall 2005
Consumption Theory
In 1942 and 1946, Simon Kuznets tested his new data on consumption and income against the Keynesian consumption theory. Explain his findings and explain their implications.
Smithies (1945) attempted to reconcile the Kuznets secular consumption function with the short-run Keynesian consumption function by arguing that the short-run curve was shifting. Discuss in detail Smithies’ theory. What was Modigliani’s reaction to Smithies’ theory?
How do Deusenberry and Modigliani use “habit persistence” to reconcile the apparent contradictions in Keynesian consumption theory, the Kuznets findings, and the data? Algebraically derive the Kuznets result from the saving function.
Explain the Life Cycle Hypothesis (LCH) of Franco Modigliani. What are its assumptions, mathematical expression, and logic? What are the criticisms of the LCH? What are its policy implications?
Explain the Permanent Income Hypothesis (PIH) of Milton Friedman. What are its assumptions, mathematical expression and logic? What are the criticisms of the PIH? What are its policy implications?
Explain the Permanent Income Hypothesis (PIH) of Friedman and the Life Cycle Hypothesis (LCH) of Modigliani. What are the differences and similarities in the two theories? In what ways is the PIH distinctly neoclassical? What do these theories imply about the sensitivity of (current) consumption to changes in (current) income? Why?
Explain the logic behind Friedman’s Permanent Income Hypothesis (PIH), and discuss its relationship to the earlier work of Hamburger (1951, 1954, 1955). Is there any evidence from the last 30 years or so of experience in the U.S. that the PIH has any validity? Explain.
What elements of the Lucas Critique relate to the consumption function? What problems does Lucas see with the traditional concept of a consumption function? Haavelmo (1943) and Friedman and Becker (1957) make similar arguments.
Robert Hall (1978) has caused a resurgence of interest in what he calls the Life-Cycle/Permanent Income Hypothesis by adding the consideration of rational expectations. What are his theoretical arguments? What does his theory imply about the nature of the Consumption time series, and how does that lead to a test of his hypothesis? Show his derivation of a testable hypothesis.
Hall’s (1978) paper fueled much debate over excess sensitivity and under-sensitivity to income changes. What are the sides of this debate, and what reasons have been offered for the empirical discrepancies from his theory?
Marjorie Flavin (1981) revisits Halls hypothesis. In what ways does her model differ from his? What are her conclusions?
Others have challenged Flavin's result. Discuss the criticisms of Goodfriend (1986), Mankiw and Shapiro (1985), Stock and West (1987) and others. What other arguments have been made to explain the discrepancies between Hall's results and Flavin's results?
What explanations have been offered to explain the apparent excess sensitivity of consumption to current income?
How important are wealth effects to consumption behavior? Specifically, discuss the relationship of stock market performance to aggregate consumption.
Investment Theory
Derive the basic accelerator model. How does the logic of the model relate to Keynesian investment theory?
Derive the flexible accelerator model and explain its logic. What is "partial adjustment" and why do we often assume it? Explain the cost of capital approach to investment and use it to provide a more complete investment model.
Show how to incorporate modern concepts of cost of capital and depreciation into the investment function. How does an investment function incorporating cost of capital and an accelerator relate to Keynes' investment theory.
Early Phillips Curve
The Phillips curve has been one of the most influential developments in macroeconomics. Discuss the contents of the Phillips (1958) paper. What were the specific findings of the paper. What was the contribution of Phillips? Why was this an important Keynesian result?
Discuss the Lipsey (1960) version of the Phillips curve. What is the contribution of Lipsey? Explain the theoretical basis offered by Lipsey for the curve. Why is this an important Keynesian result?
What are the major contributions of the Samuelson-Solow (1960) paper on the Phillips curve? Algebraically explain the development of their theory, and show its reliance on markup pricing. Does wage inflation always lead to consumer price inflation? What does this suggest as a “cause” for inflation?
Explain the dynamics and logic of the expectations-augmented Phillips curve of Friedman and Phelps, and the impact of various expectations formation schemes on policy effectiveness. What is the natural rate of unemployment of Friedman? Is this different from the NAIRU of Phelps?
In his Nobel lecture, what arguments does Friedman offer in support of a short-run, positively-sloped Phillips curve?
Discuss the expectations-augmented Phillips curve relationship in terms of the aggregate demand/aggregate supply model. Relate the natural rate of output to the natural rate of unemployment. Does this imply that aggregate supply and aggregate demand are somehow linked to one another?
Expectations
What does it mean to say the expectations are formed adaptively? Using different mathematical formulations of adaptive expectations, explain the way that the theory supposes that agents use past information and learn from their past mistakes to develop expectations about the future. What does it mean to say that a society has a “long” or “short” memory? What are the shortcomings of adaptive expectations?
What does it mean to say that expectations are formed rationally? What are the assumptions involved? Do rational expectations imply that the public makes no mistakes in forming their expectations; that is, are they always right? Why is the rational expectations hypothesis (REH) so attractive to the modeler trying to make his or her models internally consistent? What are the shortcomings of rational expectations?
Compare static, adaptive, and rational expectations. Discuss their mathematical formulations, the ways in which they apply current and past information, the ways that they argue agents learn from their mistakes, and their impacts on the Phillips curve analysis of policy tradeoffs. What empirical evidence can you provide to support any of these expectations-formation schemes?
Compare expectations formed according to the rational expectations hypothesis and according to Keynesian “animal spirits.” Is the “uncertainty” implied by the two theories the same? Explain. How do other elements of these two theories compare?
Money Demand and Supply, Interest Rates, Monetary Policy Rules
How does Poole define monetary policy rules? What are the different kinds of rules that he discusses. Explain each.
Poole argues that there is a general consensus about what monetary policy can do and should do. What is this consensus view? On what is it based? What are the limits of monetary policy according to Poole?
What does Poole argue is the most important development in modern macroeconomics? Why?
In some detail, discuss the Taylor rule for the conduct of monetary policy. Discuss its form, logic, and give an example.
Monetarism
What key characteristics does David Laidler offer as providing definition to Monetarism? Discuss each.
What is the relationship of Friedman’s Permanent Income Hypothesis (PIH) to Monetarism and his theories regarding monetary policy? Explicitly demonstrate the relationship of the PIH to Friedman’s restatement of the Quantity Theory.
What philosophical basis underlies Friedman’s antipathy toward activist monetary policy? Explain the Austrian notion of money as an institution, and explain how it this approach supports this antipathy. Explain this approach in some detail.
Derive and explain Friedman’s “restatement” of the Quantity Theory. Given that it leads to a functional relation for the income velocity of money, how does the restatement support the notion of stable money demand?
Derive and explain Friedman’s restatement of the Quantity Theory. How does it really differ from the traditional Quantity Theory? How does it differ from the Keynesian Liquidity Preference Theory? According to Friedman’s restatement of the Quantity Theory, the demand for money is stable. Why? What are the differences in terms of the implications for policy?
Friedman argues that “inflation is everywhere at all times a monetary phenomenon.” Explain his position.
Derive the constant growth rate rule (CGRR), and offer at least three arguments supporting its implementation. In what ways would the CGRR be stabilizing?
Explain the “long and variable lags” argument for a constant growth rate rule (CGRR). What is the stable velocity/money demand argument for a CGRR?
How do Monetarists respond to the attack that velocity has become too volatile since 1981 to apply a constant growth rate rule?
Milton Friedman has said, “We are all Keynesians now,” and Franco Modigliani (a leading Keynesian) has said, “We are all monetarists.” Explain and make sense of these somewhat surprising statements. How could something as “radically revolutionary” as Monetarism is to Keynesianism be absorbed by Keynesianism? What could be the possible motivations for such a synthesis?
If Monetarists are Keynesians and Keynesians are Monetarists, why would Modigliani bother to discuss the “debate” between the two schools in his American Economic Associations Presidential Address?
On the face of it, it might seem that Friedman’s support for a short-run Phillips curve tradeoff would weaken the Monetarist case against Keynesian interventionist policy, when apparently it strengthens the Monetarists’ case. How does it strengthen the Monetarists’ case? How does Friedman’s specification imply that stabilization policies are not really need? How is the Monetarist case against stabilization reshaped by the addition of rational expectations in the sense of Lucas?
What is the Monetarist “accelerationist hypothesis?” Explain and give its implications for policymakers.
Monetarists argue that unaccommodated by monetary policy, Keynesian demand management policy is impotent. Explain this argument and demonstrate this diagrammatically.
Supply-Side Economics
Write a short essay discussing the similarities and differences among the neoclassical, the Supply-Side, Monetarist, and New Classical Economics in terms of theory, method, and policy recommendations.
How does Feldstein explain the late emergence of Supply-Side Economics as a doctrine? How does he distinguish between the “new” and the “old” supply-siders?
What do Supply-Siders mean when they say that the “burden” of a tax is different from the “incidence” of a tax? What are the implications of this distinction for policymakers?
Explain the Laffer Curve and the logic behind it. According to the theory of the Laffer Curve, do tax cuts always result in increases in tax revenues? What is the optimal tax rate in terms of maximizing tax revenue? Is this the rate that Supply-Siders recommend? What are the empirical difficulties with the Laffer Curve?
Supply-Siders like to say “If you tax something you get more of it; if you subsidize something you get less of it.” In what ways, do they argue, have we perverted the economic system by changing incentives through our present system of taxes and subsidies?
Using the AD-AS apparatus, discuss the Supply-Side explanation for stagflation, and show how tax structure changes and increased labor productivity can dispel inflation and restore growth.
Some economists have argued that the real value of the supply-side movement is that it helped restored the “balance” in our thinking regarding the relative importance of aggregate supply and aggregate demand in macroeconomics. Do you think that this position would be acceptable to Supply-Side advocates? Why or why not?
Despite all of their talk about the Laffer Curve, Supply-Siders sometimes appear to be really advocating no taxes.
a. Explain the reasons why Supply-Siders view progressive taxes as detrimental to growth and the cause of much trouble in the macroeconomy.
b. If taxes on earned income have unacceptable disincentive effects, why not tax interest, dividend, and capital gains income
c. What is the “tax wedge” and what is its importance in explaining the disincentive effects of taxes?
d. Governments do incur expenses that must be offset (at least partly) by taxes. According to the Supply-Siders, what is the appropriate way to tax?
According to the Supply-Siders, how do taxes on personal income, stock dividends, and bond interest negatively affect capital formation and employment in firms.
New Classical Economics
Present the policy ineffectiveness proposition of Sargent and Wallace (1976), explaining the result in terms of the Phillips curve diagram. How do they “prove” this result? What assumptions are critical to the result? What do Sargent and Wallace think they have demonstrated?
Give the equations and solution of the Sargent and Wallace (1976) model, and explain the result. What is the meaning and significance of their paper?
What is the “Lucas critique” of macroeconometric policy evaluation? What are the implications and consequences of the “critique”?
Robert Barro’s version of the “Ricardian Equivalence Theorem” supports the New Classical case against policy activism, particularly in the form of deficit spending programs. The “theorem” is not new, but the form of the supporting argument given by Barro is new. Explain Barro’s argument, the “Theorem”, and its significance.
Robert Lucas uses the islands paradigm of Phelps to argue that short-run Phillips curve trade-offs do exist, even in the face of rational expectations. How does he do this? Explain his model, its structure, and the nature of his arguments. What is the “signal extraction problem?” How does this result in an upward-sloping supply function? Show and discuss the Lucas supply function.
According to Lucas, how does the variance of prices across markets affect the Phillips curve trade-off? How does this compare with the conventional Phillips curve? What is the theoretical basis of Lucas’ proposition?
Barro (1978) offers empirical evidence that only unanticipated changes in the money supply can affect the real sector (output and unemployment). This stands in contrast with the Marshallian short-run/long-run dichotomy. How does Barro go about testing his hypothesis? What criticisms can you offer for his approach?
What is “time inconsistency” and why is it another attack on discretionary policy? Define the term “consistent policy”. Ultimately, what is the policy recommendation of Kydland and Prescott?
Compare and contrast the New Classical Economics and Monetarism in terms of their approach, vision, models, assumptions, and policy recommendations.
Real Business Cycle Theory
According to the “Real Business Cycle” (RBC) theory of the New Classicals, by what mechanism are business cycles generated? In what ways do simulated RBCs resemble observed real-world business cycles? How is persistence in output changes (serial correlation) achieved in the face of isolated (serially uncorrelated) shocks?
Discuss the time series approach to business cycles and growth introduced by the New Classical Economists. What does this approach reveal about the relationship between business cycles and growth?
What are some stylized facts regarding business cycles that are generally embraced by macroeconomists?
List and discuss the elements of RBC models. What are the major contributions of RBC theory? What are its shortcomings? How do RBC theorists account for persistence?
List and discuss the general problems and major criticisms of the RBC theory.
New Keynesian Economics
What is the basis of the New Keynesian Economics? How does it compare with traditional Keynesian, Neoclassical Synthesis Keynesian, and New Classical Economics?
New Keynesian economics may be considered a response to the New Classical “attack” of the 1970s. In this spirit, the New Keynesians offer a series of responses to the New Classicals, all based on reconsiderations of the microfoundations of employment and price-setting. Briefly outline three of these arguments. Which of these arguments, if any, require deviations from competitive market assumptions?
What is the “insider-outsider” model? How does it suggest that wages will not adjust (downward) to restore full employment?
What is the efficiency wage hypothesis? (There are two forms to this argument which you should identify.) Why would firms deliberately pay more than the marginal product of labor in wages? Why is this a “market-failure” model?
Discuss the effect of transactions costs on the instantaneous adjustment of prices to equilibrium usually found in rational expectations models. How do transactions costs relate to the slope of the Phillips Curve?
Discuss the effect of overlapping contracts on the policy effectiveness results of the general equilibrium rational expectations models.
What are the two basic types of New Keynesian Models? Explain. How do New Keynesians generate policy effectiveness without price or wage stickiness? Discuss this and give examples.
According to Gordon, what is the implication of sticky prices? What are the implications of this for macro models? In what ways might stickiness emerge from the underlying microeconomics of the economy?
How might risk-aversiveness on the part of firms affect macroeconomic outcomes? Explain. How might this affect a firm's financing choices? Its sensitivity to shocks?
Budget Deficits, National Debt, Crowding Out and In
Empirical tests of crowding effects have yielded a confusing array of contradictory results. Discuss the literature and identify some of the factors to which the results seem sensitive. What “truths” can you sort out from these results?
Following closely the work by Benjamin Friedman (1978), explain the different kinds of crowding effects. According to Benjamin Friedman, is the crowding effect 100%?
Discuss the issues of budget deficits, rising federal debt, and crowding. What is the nature of the problems? How threatening is the situation? What is the effect of debt and deficits on economic performance?
Benjamin Friedman (1978) argues that, at least in theory, portfolio crowding may be “out” or “in.” According to Friedman, what determines the direction of crowding?
What are the major assumptions of the Ricardian Equivalence Theorem as given by Barro? What is his basic argument? In what ways has Barro since softened his view?