Just Before the Berkeley Graduate Core Macro Exam, 8 AM, May 19, Evans 9

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—-**Economics 202b Final: May 19, 2009, 9 Evans, 8-11 AM**Part I: Answer “true”, “false”, or “uncertain”. Then explain your answer. Your explanation determines your grade.1. The New Keynesian Phillips Curve generates the very persistent inflation that is observed in the data while alternative Phillips curves don’t.2. In sticky price models, monetary shocks are more or less equivalent to countercyclical markup shocks in real business cycle models. 3. The Taylor principle for interest policy rules suggests that the rational expectations equilibrium in the basic New Keynesian model is determinate and unique if the policymaker lowers the real interest rate in response to an inflationary shock. 4. Procyclical productivity proves that supply shocks are the major source of business cycles. Part II: According to Bernanke and Gertler, whenever financial intermediaries have very low levels of capital savers will not lend to them and they will be unable to finance investment projects; the moral hazard that they will invest their creditors’ money in negative NPV projects with a large upper tail is simply too great. U.S. banks today have very low levels of capital. What are the pluses and minuses of recapitalizing the banks through:1. Overpaying for bank assets through a government asset-purchase program.2. Full nationalization of the banks followed by sufficient injection of government money to allow the banks to continue operations until reprivatized.3. Full nationalization of the bans followed by shutting them down while a new, privately-funded banking system grows up alongside the old, failed banks.4. Government loans or preferred stock that are forgiven if the bank is in the end liquidated.Part III: Recall our simplest possible epidemiological model of irrational bubbles—a unit interval [0, 1] of investors who can either own risky or safe assets. Safe assets pay a fixed and certain net rate of return r each period. Risky assets have a price p, and each period pay a serially-uncorrelated stochastic payout— δ with probability π and 0 with probability 1-π. The supply of risky asset is thus that the price of equities p is equal to the fraction p of agents who own stocks. At the start of each period t a value for the payout and a price pt for risky assets is cried out by a Walrasian auctioneer. Investors then calculate the past period’s rates of return. p(1-p) agents talk to others who are following a different portfolio strategy and wonder whether they should switch. A fraction of those agents who talk to others equal to the difference in just-past realized returns times a parameter λ in fact switch to the better-performing last-period strategy. 1. Which of the following equations gives the dynamics of the number of risky-asset investors and the price of risky assets:

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2. How does this model behave when the current price p is close to 1?3. How does this model behave when p is close to πδ/r?4. What are the advantages and disadvantages of a model like this as we try to think about bubbles?Part IV: The quantity theory of money says that: MV = PY. Suppose that we take velocity V to be V(i), an increasing function of the short-term nominal interest rate on Treasury securities.1. What are the arguments for taking V(i) to be a function with a small derivative—a nearly vertical line when plotted on the standard graph—even when i is close to zero?2. What are the arguments for taking V’(i) to be very large—for V to be nearly horizontal—when i is close to zero?3. What are the arguments for thinking that expansionary monetary policy—increases in M—might be ineffective at raising output and employment in depression when i is close to zero? What else do you have to assume about the determination of the interest rate i and other factors in order to make those arguments?4. What are the arguments for thinking that expansionary monetary policy—increases in M—might be very effective at raising output and employment even when i is close to zero? What else do you have to assume to make those arguments?Part V: George Akerlof and Robert Shiller wrote last year:>The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so – and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed…And Australian economist John Quiggin explicates:>The central theme of new Keynesianism was the need to respond to the demand, from monetarist and new classical critics, for the provision of a microeconomic foundation for Keynesian macroeconomics. As Akerlof and Shiller note above, the research task was seen as one of identifying minimal deviations from the standard microeconomic assumptions which yield Keynesian macroeconomic conclusions…. Akerlof’s ‘menu costs’ arguments, showing that under imperfect competition small deviations from rationality generate significant (in welfare terms) price stickiness, are an ideal example of this kind of work. New Keynesian macroeconomics has been tested by the current global financial and macroeconomic crisis and has, broadly speaking, been found wanting. The analysis of those Keynesians who warned of impending crisis combined an ‘old Keynesian’ analysis of mounting economic imbalances with a Minskyan focus on financial instability…. [T]he policy response… has been informed mainly by old-fashioned ‘hydraulic’ Keynesianism, relying on massive economic stimulus to boost demand, combined with large-scale intervention in the financial system. The opponents of Keynesianism have retreated even further into the past, reviving the anti-Keynesian arguments of the 1930s and arguing at length over policy responses to the Great Depression. There is of course, still a need to explain why wages do not adjust rapidly to clear labour markets in the face of an external financial shock. But, in an environment where the workings of sophisticated financial markets display collective irrationality on a massive scale, there is much less reason to be concerned about the fact that such an explanation must involve deviations from rationality, and seeking to minimize those deviations…Ever since Samuelson, Solow, Tobin, Patinkin, Friedman, and company established the “neoclassical synthesis,” the game of macroeconomic theory has focused on taking a full-employment equilibrium benchmark and then analyzing, one at a time, the consequences of each potential macroeconomically-significant market failure for the behavior of the macroeconomy. Now Akerlof and Shiller say that it is time to dynamite that intellectual game and start another. Do you agree? Or do you think that the “neoclassical synthesis” is still a progressive research program?

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