# ECON 104 HOMEWORK #7 and 8

Part 1: (60 points total)Pretend that you have a lemonade stand and that the demand for lemonade in your neighborhood isestimated to be:Q = 60 – 100 PJust like in the lecture, you get all the materials to make the lemonade for free so we assume that the costsof production are zero. Your goal, your objective, is to maximize profits which is the same asmaximizing total revenue given the zero cost assumption.a) (5 points) What is the profit (revenue) maximizing price and quantity (in cups) of lemonade andthe corresponding maximum profit.Suppose that there was a demand shock so that the new estimated demand function for lemonade in yourneighborhood changes to:Q = 100 – 100 Pb) (5 points) Name and support two reasons why demand would change like this.c) (5 points) Solve for the new profit (revenue) maximizing price and quantity (in cups) of lemonadeand the corresponding profit.d) (5 points) Compare your quantity sold and your profit in part c) to the quantity sold and profit ifyou kept ‘sticky’ lemonade prices – that is, what would be the quantity sold and profit if you didnot change prices?GRAPHICS (30 points total for a correct and completely labeled diagram)Just like in the lecture on the lemonade stand, draw a demand curve in your top diagram and atotal revenue function below making sure that you exploit the fact that the horizontal axis is thesame in the top and bottom diagrams. Label the initial equilibrium points according to youranswer in part a) as points A. Then, label on both diagram as points B, the answer you gave inpart c). We can think of this as the long run since you will increase price in the long run. Then,label as point C, the quantity sold and profit if you did not change price (i.e., your work from partd).e) (5 points) On a separate diagram, draw a supply curve that pertains to your behavior from pointsA to B and another supply curve that pertains to points A and C. Pretending that these are shortrun aggregate supply curves, under which curve would macroeconomic (demand side) policieshave the most effect on output? On prices? In other words, which supply curve is more Keynesianand which is more Classical?1f)(5 points) Suppose that in order to change prices, you need to make a new sign which costs you\$5, these are referred to as menu costs. Is it worth it for you to change prices, why or why not?Explain.Part 2: True/ False Questions (2 points each 40 points total) Answer T for True and F for False1) A fall in the tax rate on capital will cause the aggregate expenditure curve to shift up and theaggregate demand curve to shift to the left, all else constant.2) One reason that the aggregate demand curve slopes downward is that when prices rise, say in theUS, the relative price of imports fall and thus, US citizens substitute away from domesticallyproduced goods toward imported goods and thus, GDP in the US will fall (all else constant).3) Suppose the value of the US dollar changes from \$1 = 1.2 euros to \$1 = 1.30 euros. This beingthe case, imports from the US to Europe, have become more expensive to European citizens, allelse constant.4) One reason the aggregate demand curve slopes downward is due to the fact that if the price levelfalls, real money balances rise, all else constant, interest rates will fall causing an increase inconsumption and investment.5) Assuming that natural gas for firm X is an important input to the production process, an increasein the availability of natural gas that lowers the price of natural gas, will result in a leftward shiftof firm X’s supply curve.6) According to the lecture on the cyclical properties of the aggregate supply curve, I argued thataggregate demand side policy works better, in terms of influencing output, when the economy isoperating at near full employment output relative to when the economy is operating at levels ofoutput well below full employment.7) If labor markets become loose and wages fall, all else constant, the short run aggregate supplycurve will shift to the left.8) The more ‘sticky’ nominal wages and other input costs are, the steeper the slope of the aggregatesupply curve and therefore, the less effective demand side policies in terms of effecting realoutput.9) If the US economy is growing faster that the rest of the world, then we would expect a surge inUS exports.10) Suppose that expected inflation is 5% and thus, nominal wages rise, along with all other inputprices by 5%. Suppose also, that actual inflation over this period was only 2%. In terms of thebehavior of the short-run aggregate supply curve, it would shift up given the expectations ofhigher inflation and then shift downward to adjust for the actual rate of inflation.11) The more sensitive consumption is to real wealth, the steeper the aggregate demand curve.12) During the Great Recession, we argued that the aggregate expenditure curve shifted downwardand the short-run aggregate supply curve and the aggregate demand both shifted to the left.13) Anything that shifts the investment demand curve to the right will also shift the aggregatedemand curve to the right.14) The Obama administration in 2013 let a tax holiday expire which effectively increases incometaxes for all workers who pay into social security. The effect of this increase in taxes, all elseconstant, would shift the consumption function down, the aggregate expenditure curve down, andthe short-run aggregate supply curve to the left.15) Given that the working age population is shrinking in Japan, our discussion about thedeterminants of the potential growth rate of the economy suggests that this demographic realitywould lower the potential growth rate of the economy for Japan, all else constant.16) One reason the short-run aggregate supply curve slopes upward is due to the ‘stickiness’ of inputprices relative to output prices. We saw this in the plastering example when we let output pricesrise and kept nominal wages constant. This being the case, the firm’s profit maximizing outputrises with the rise in prices, all else constant.17) According to our discussion about the cyclicality of the aggregate supply curve, the closer theeconomy is to potential output, the more Keynesian the world and thus, the more effectiveaggregate demand side policies are in terms of effecting real GDP.18) If output prices rise without the nominal wage rising, then real wages rise and workers are willingto work more. This is one of the main reasons that the short-run aggregate supply curve slopesupward.19) When we discussed the stagflation of the 1970s, we argued that policymakers should have actedmore aggressively with expansionary policies the fight the recession that occurred during thattime.20) The more flexible wages and prices, the steeper the short-run aggregate supply curve. In fact, ifprices and wages (and other inputs costs) are perfectly flexible then we are in a ‘classical’ world,where the short-run aggregate supply curve is vertical.*************************************ECON104HOMEWORK#8(100pointstotal)Part 1: (60 points total)Money Supply ProblemYou are hired by the Chair of the Federal Reserve to manage the trading desk at the New York Fed andthe Chair tells you that he wants you to increase the money supply (M1) by 33 percent. He/she warnsyou to be careful because in these uncertain times, the money multiplier tends to become very unstable.He/she suggests that you stay closely connected with the banking sector and he gives you a list ofphone numbers to do so. Note that in this problem we are targeting the growth rate of M1.Reserve MarketInitial Conditionsrr/D= .10C = 400 bD = 2000 bER = 00 (not a typo)M=C+Da) (6 points) Show your work!i.Calculate the MB.ii.Calculate the money multiplier.iii.What is the money supply (use mm x MB to calculate this)?So you decide to inject \$100 billion in reserves via open market purchases with phone in hand. Recall, theChair said to watch that multiplier and so you start making some calls. Just as you suspected, the banksarent making any loans, that is, they are sitting on all \$100 billion in excess reserves.b) (6 points) Given these new conditions, redo part a).c) (6 points) Now the Chair calls an
d asks you how things are going and you tell him/her that youinjected \$100 billion in the system but it didnt work. In the space below, write down what youwould say to the chair (i.e., explain why the injection did not work).1Now you get some calls from bankers and you learn that there has been some internal substitution withinthe M1 money supply. In particular, households prefer to hold more currency relative to deposits, i.e., thecurrency to deposit ratio rises. The numbers are as follows:rr/D= .10C = 800 bD = 1600 bER =100 bd) (6 points) redo part a)e) (6 points) Now the Chair is not pleased with your work, and calls again. Assuming that themoney multiplier is now stable (i.e., the value in part d), what must you do, in terms of openmarket operations, to hit the 33 percent money growth rate desired by the chair and the FOMC?Please show all work!f)(10 points) Calculate the total percent change in the monetary base, the money multiplier, and themoney supply (from part a) to part e)) and compare to the actual real world percent changessince this crisis began in August of 2007 to the end of 2010. Please use the following links andclick view data on the upper left to obtain the actual real world values. For the monetary basestart in August 2007 (this is monthly data), for the money multiplier start 8/15/07 (bi-weekly data)and for M1 start at 8/13/2007 (also weekly data)).g) (20 points) Graphing exercise: In the space below, draw two diagrams with a graph of theMonetary Base on the left and the Money Supply on the right. Locate as point A, the conditions thatprevailed in part a), locate as point B, the conditions that prevailed in part b), locate as point C, theconditions that prevailed in part d) and finally, locate as point D, the conditions that prevailed in parte). Helpful hints: don’t worry about labeling interest rates, the variable on the vertical axis, since thereare none in this problem. Simply draw vertical lines (as we did in the lecture) labeling the value of theMB and MS on the horizontal axis with the appropriate points (A, B, C, D). If the curve doesn’tchange (hint, this happens with MS but not MB), simply label it with the appropriate A = B orwhichever applies.Part 2: True/ False 40 points total (2 points each)1) If the excess to reserve deposit ratio goes up along with the currency to deposit ratio, all elseconstant, then we are unsure what happens to the money multiplier since the money multiplier isnegatively related to the excess reserve to deposit ratio but positively related to the currency todeposit ratio.2) During each FOMC meeting policymakers discuss the current state of economic affairs in each ofthe 12 regional districts that make up the US. In fact, the Presidents of all the regional FederalReserve Banks attend all FOMC meetings and discuss the conditions in their respective districts.3) If the Fed was worried about overheating (GDP growing too fast, inflationary pressures building),then the appropriate open market operation would be for the Fed to conduct open market sales.24) The FOMC meets in Washington DC but the action, in terms of conducting open marketoperations takes place at the New York Fed (FRBNY).5) During the Great Depression, the excess reserve to deposit ratio rose for a variety of reasons.The impact on the money multiplier was negative. That is, all else constant, a higher excessreserve to deposit ratio lowers the money multiplier.6) In the lectures, we argued that the money (M1) multiplier (since October 2008) has been risinggiven that banks have been hoarding money (due in part to the fact that the Fed is payinginterest on excess reserves) resulting in a rise in their respective reserve to deposit ratios.7) If the money multiplier is 3 and the Fed conducts \$100 billion of open market sales, then themoney supply will increase by \$300 billion.8) If the money multiplier falls by 50%, then the Fed, to keep the money supply constant, wouldhave to double the monetary base.9) Prior to October 2008, the M1 money multiplier was trending downward since the requiredreserve ratio administered by the Fed was trending upward.10) According to the quantity theory of money in percent change form, then if velocity falls so that itsgrowth rate is negative then the Fed, to keep inflation and output growth stable, should match thedecrease in velocity with an equivalent increase in the percent growth of the money stock.11) According to Milton Friedman, inflation is always and everywhere, caused by excessiveeconomic growth.12) The reason that the existence of money increases efficiency in the economy is that it allowssociety avoid the double coincidence of wants and therefore, allows people to specialize in whatthey do best.13) Assuming that the nominal return on money is equal to zero, the real return to holding money isthe inflation rate.14) The largest component of household sector wealth is wealth in the stock market.15) M2 is more liquid than M1 since M2 includes traveler’s checks where M1 does not.16) The FOMC meets every month unless conditions warrant more frequent meetings.17) The Philadelphia Federal Reserve Bank is responsible for monitoring economic activity in theirdistrict which includes the economic activity in State College, PA.18) According to the lecture discussing the October 2012 FOMC statement, the Fed plans on buying\$85 billion per month in longer term securities in hopes of lowering long term interest rates.19) According to the lecture discussing the October 2012 FOMC statement, they plan on keepingtheir target for the federal funds rate in the range of 0 – .25% at least through mid 2015.20) All regional bank presidents of the Federal Reserve system vote at all FOMC meetings.
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