1. In the classical model, the assumption of diminishing marginal product of labor implies that the labor demand curve is:
Explanation:
Firms hire labor until the real wage (W/P) equals the marginal product of labor (MPL). The principle of diminishing marginal product states that as more labor is added (holding capital fixed), the additional output from each new unit of labor decreases. Therefore, firms are only willing to hire more workers if the real wage falls. This inverse relationship between the real wage and the quantity of labor demanded results in a downward-sloping labor demand curve.
Source: EC3115 - Ch 8 Classical models and monetary policy-1.pdf, p. 3; McCallum, Monetary Economics, p. 90.
2. What is "superneutrality" of money?
Explanation:
Superneutrality is a stronger condition than neutrality. Neutrality means a change in the *level* of the money supply does not affect real variables. Superneutrality means a change in the *rate of growth* of the money supply (and thus the long-run inflation rate) does not affect real variables like the real interest rate or the level of output. The basic classical model is superneutral, but this property can fail if, for example, a real-balance effect is introduced.
Source: McCallum, Monetary Economics, p. 121.
3. In the political business cycle model described by Hargreaves Heap, why might a government initially pursue a non-inflationary policy even if inflating offers a short-term benefit?
Explanation:
In a repeated game between the government and the private sector, the government may choose to forego the short-run gain from surprise inflation. By doing so, it can build a reputation as an inflation-fighter (a "hard-nosed" type). This reputation leads the public to maintain low inflation expectations, making it possible to achieve the Pareto-superior zero-inflation outcome in subsequent periods. The cycle begins when the incentive to inflate eventually outweighs the benefit of maintaining the reputation.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, pp. 67-69.
4. In the context of the Cagan model of hyperinflation, the adaptive expectations hypothesis \(\Pi_t = \lambda \Delta p_t + (1 - \lambda) \Pi_{t-1}\) implies that the expected inflation rate is:
Explanation:
By repeatedly substituting for the lagged expectation term (\(\Pi_{t-1}\), \(\Pi_{t-2}\), etc.), the adaptive expectations formula can be expressed as an infinite distributed lag of past inflation rates: \(\Pi_t = \lambda \sum_{j=0}^{\infty} (1-\lambda)^j \Delta p_{t-j}\). This shows that the expected inflation rate is a geometrically weighted average of all past inflation rates, with more recent inflation rates receiving more weight.
Source: McCallum, Monetary Economics, p. 137.
5. A central argument of the Plosser (1989) paper is that real business cycle models:
Explanation:
Plosser argues that a key strength of the RBC approach is that it does not treat growth and fluctuations as separate phenomena requiring different theories. The same factors that drive economic growth (e.g., permanent changes in technology) also cause the transitory dynamics and fluctuations we call business cycles. The model provides a single, consistent framework for understanding both.
Source: Plosser, 'Understanding real business cycles', p. 60.
6. In the Long and Plosser (1983) model, the elements of the \(A\) matrix in the equation \(y_{t+1} = Ay_t + k + \eta_{t+1}\) represent:
Explanation:
The matrix \(A\) is the input-output matrix for the economy. Each element \(a_{ij}\) represents the equilibrium cost share of input \(j\) in the production of output \(i\). This matrix is the key propagation mechanism in the model, determining how shocks are transmitted across sectors.
Source: Long and Plosser, 'Real Business Cycles', p. 53.
7. What is a major criticism of the adaptive expectations hypothesis?
Explanation:
The adaptive expectations hypothesis is a backward-looking mechanism. If inflation is consistently rising, for example, an agent using adaptive expectations will consistently under-predict inflation. This is a systematic error. The New Classical critique, which led to the adoption of rational expectations, is that rational agents would notice such systematic errors and adjust their forecasting method to eliminate them.
Source: McCallum, Monetary Economics, p. 143.
8. In the classical model, if the labor supply becomes more elastic (more responsive to the real wage), the vertical aggregate supply curve will:
Explanation:
The position of the vertical AS curve is determined by the equilibrium level of employment \(l^*\). A change in the elasticity (slope) of the labor supply curve does not change the initial equilibrium point, assuming the labor demand curve is unchanged. Therefore, \(l^*\) and \(y^*\) do not change, and the AS curve does not shift. However, a more elastic labor supply curve means that any shift in the labor demand curve (e.g., from a technology shock) would lead to a larger change in employment and a smaller change in the real wage.
Source: General application of the classical labor market model, e.g., McCallum, Monetary Economics, pp. 91-92.
9. The idea of "trading at false prices" as described by Hargreaves Heap is meant to provide a microfoundation for:
Explanation:
The concept of trading at "false" (i.e., non-Walrasian, non-market-clearing) prices arises in a world without a Walrasian auctioneer, where prices are set for discrete periods. If prices are set incorrectly, markets will not clear. Trades will occur at these non-clearing prices, and agents will be quantity-constrained (e.g., firms cannot sell all they want, workers cannot sell all the labor they want). This quantity adjustment is the hallmark of Keynesian analysis.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, pp. 31-32.
10. According to RBC theory, why might a social planner's attempt to smooth out business cycles be welfare-reducing?
Explanation:
A core tenet of RBC theory is that the observed fluctuations are not market failures. They are the efficient, optimal responses of rational agents to changes in the economic environment (e.g., technology). Forcing the economy onto a smoother path would prevent agents from making these optimal adjustments (e.g., investing more during a temporary productivity boom), thereby making them worse off. The equilibrium is Pareto-efficient, so no one can be made better off without making someone else worse off.
Source: Plosser, 'Understanding real business cycles', p. 56.
11. In the classical model, what is the role of the real interest rate?
Explanation:
The real interest rate is the price that clears the goods market (or loanable funds market). It adjusts to ensure that the amount of output households choose to save is equal to the amount firms choose to invest, plus any government borrowing. This equilibrium is represented by the IS curve.
Source: McCallum, Monetary Economics, pp. 78-83.
12. The Fisher equation relates the nominal interest rate (R), the real interest rate (r), and the expected inflation rate (\(\pi^e\)) as:
Explanation:
The Fisher equation states that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation. Lenders need to be compensated for the loss of purchasing power due to inflation, in addition to earning a real return on their loan.
Source: McCallum, Monetary Economics, p. 113.
13. In the RBC model presented by Plosser (1989), what is the primary reason investment is more volatile than consumption?
Explanation:
A fundamental principle of intertemporal choice is consumption smoothing. When faced with a temporary positive shock to income (from a productivity increase), rational, risk-averse agents will choose not to consume all the extra income at once. Instead, they save/invest a large portion of it to support higher consumption in future periods as well. This makes investment highly responsive to income shocks (volatile) while consumption follows a smoother path.
Source: Plosser, 'Understanding real business cycles', p. 56.
14. What is a key assumption of the basic classical model that is relaxed in the Lucas misperceptions model?
Explanation:
The standard classical model assumes all agents have perfect information about all prices in the economy. The Lucas model relaxes this by introducing an information asymmetry: producers know the price of their own good but do not know the current aggregate price level. This imperfect information is what allows them to be "surprised" by monetary policy and misperceive price changes.
Source: EC3115 - Ch 8 Classical models and monetary policy-1.pdf, p. 7.
15. In the repeated game version of the time-inconsistency problem, a government might be able to establish a reputation for being non-inflationary if:
Explanation:
In a repeated game, the government weighs the one-time gain from creating surprise inflation against the future losses from having a bad reputation (which leads to permanently higher expected inflation). If the government is sufficiently patient (has a low discount rate), the present value of the future losses will exceed the immediate gain, making it optimal to maintain the non-inflationary reputation.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, pp. 67-68.
16. The term "procyclical" means that a variable tends to:
Explanation:
A procyclical variable is one that is positively correlated with overall economic activity. For example, consumption and investment are procyclical because they tend to rise during expansions and fall during recessions. A variable that moves in the opposite direction (like unemployment) is called countercyclical.
Source: EC3115 - Ch 8 Classical models and monetary policy-1.pdf, p. 6.
17. In the classical model, a higher capital stock (k) would:
Explanation:
A higher capital stock generally makes labor more productive (the cross-partial derivative \(f_{12}\) is positive). This increases the marginal product of labor at all employment levels, shifting the labor demand curve to the right. The new equilibrium will feature higher employment and a higher real wage. The combination of more capital and more labor increases the full-employment level of output, shifting the vertical AS curve to the right.
Source: EC3115 - Ch 8 Classical models and monetary policy-1.pdf, p. 3.
18. The "signal extraction" problem in the Lucas model refers to producers trying to distinguish between:
Explanation:
In the Lucas islands model, a producer observes a change in the price of their own good but does not know if it is because of a general increase in all prices (an aggregate shock) or an increase in the specific demand for their good (a relative shock). They must "extract the signal" about the relative price change from the "noise" of the aggregate price change. Their output decision depends on this inference.
Source: Hoover, The New Classical Macroeconomics, pp. 31-32.
19. In the basic RBC framework, what is the effect of a permanent positive technology shock on the real interest rate?
Explanation:
A permanent technology shock raises the marginal productivity of capital, creating an incentive for higher investment to build up the capital stock to a new, higher steady-state level. This increased demand for investment (and loanable funds) temporarily drives up the real interest rate. As the capital stock increases, the marginal product of capital begins to fall back, and the real interest rate returns to its original steady-state level, which is determined by preferences (the rate of time preference).
Source: Plosser, 'Understanding real business cycles', p. 60.
20. The Quantity Theory of Money states that the price level is proportional to the money supply. This holds as a long-run proposition in the classical model because:
Explanation:
In the quantity equation \(MV = PY\), if velocity (V) is treated as constant and real output (Y) is fixed at the full-employment level \(y^*\) (determined by real factors), then any change in the money supply (M) must be met by a proportional change in the price level (P). The classical dichotomy, which separates the determination of real and nominal variables, is the key to this result.
Source: McCallum, Monetary Economics, Chapter 5.
21. In the Long and Plosser (1983) model, the assumption of a multi-sector economy with an input-output structure is primarily used to explain:
Explanation:
The input-output matrix is the key propagation mechanism that creates comovement. When one sector experiences a positive shock, its output increases. Since this output is used as an input by other sectors, it stimulates their production as well. This creates a positive correlation in output movements across sectors, which is a key feature of business cycles.
Source: Long and Plosser, 'Real Business Cycles', p. 57.
22. In a model with a cash-in-advance constraint, why does higher inflation reduce output?
Explanation:
The cash-in-advance constraint \(P_t C_t \le M_{t-1}\) means that the purchasing power of cash is eroded by inflation. Higher inflation (a higher \(P_t\) for a given \(P_{t-1}\)) reduces the amount of real goods \(C_t\) that can be bought with a given nominal cash balance \(M_{t-1}\). This makes consumption more expensive relative to leisure. Households respond by consuming less and taking more leisure, which means they supply less labor, leading to a fall in equilibrium output.
Source: EC3115 - Ch 8 Classical models and monetary policy-1.pdf, p. 8.
23. The "Kydland-Prescott puzzle" in RBC literature often refers to the difficulty of:
Explanation:
A major challenge for early RBC models was matching the observed volatility of hours worked. Microeconomic studies suggest a low elasticity of labor supply, meaning people don't change their work hours much in response to wage changes. However, RBC models needed a high elasticity (high intertemporal substitution) to generate realistic fluctuations in employment. This discrepancy between micro data and macro model requirements is a key puzzle that led to further research (e.g., indivisible labor models).
Source: Plosser, 'Understanding real business cycles', p. 68.
24. In the classical model, the LM curve represents combinations of \(y\) and \(r\) where:
Explanation:
The LM curve is derived from the money market equilibrium condition, \(M/P = L(y, r)\). It shows all combinations of real income (y) and the interest rate (r) for which the demand for real money balances equals the supply of real money balances.
Source: McCallum, Monetary Economics, p. 84.
25. The idea that business cycles are Pareto optimal is a feature of which class of models?
Explanation:
In RBC models that do not include pre-existing distortions like taxes, the business cycle fluctuations are the result of optimal choices by rational agents in response to real shocks. The resulting competitive equilibrium is Pareto optimal, meaning no one can be made better off without making someone else worse off. This implies that government intervention to "stabilize" the economy would be welfare-reducing.
Source: Plosser, 'Understanding real business cycles', p. 67.
26. In the classical model, a decrease in taxes (\(\tau\)) on households, holding government spending constant, will:
Explanation:
A decrease in taxes increases disposable income (\(y - \tau\)), which stimulates consumption demand. This increase in aggregate demand shifts the IS curve to the right. Since output is fixed at \(y^*\) by the vertical AS curve, the real interest rate must rise to crowd out an equivalent amount of investment to restore goods market equilibrium.
Source: McCallum, Monetary Economics, p. 95 (Fig 5-15 shows the opposite case of a tax increase).
27. The "indivisible labor" model of Hansen (1985) was developed to address which issue in RBC theory?
Explanation:
The indivisible labor model assumes people can either work a fixed number of hours or not at all. This setup generates a much higher aggregate elasticity of labor supply than is implied by microeconomic estimates for individual workers. It helps RBC models generate the large fluctuations in total hours worked that are observed in reality, without having to assume that individual preferences show a high willingness to substitute leisure over time.
Source: Plosser, 'Understanding real business cycles', p. 69.
28. In the classical model, the price level is determined by:
Explanation:
In the classical model's sequential logic, the real side of the economy (labor and goods markets) determines all real variables, including output (\(y^*\)) and the real interest rate (\(r^*\)). With \(y\) and \(r\) determined, the money market equilibrium condition \(M/P = L(y, r)\) then determines the price level \(P\) for a given money supply \(M\).
Source: McCallum, Monetary Economics, p. 95.
29. A major finding from the empirical work of Nelson and Plosser (1982), which influenced RBC theory, is that:
Explanation:
Nelson and Plosser found that they could not reject the hypothesis that many key macroeconomic series (like real GNP) contain a unit root, meaning they have a stochastic trend (random walk) rather than fluctuating around a deterministic trend. This implies that shocks have permanent effects on the level of output, a finding that is more consistent with RBC models driven by permanent technology shocks than with traditional models where output reverts to a fixed trend line.
Source: Plosser, 'Understanding real business cycles', p. 59.
30. In the game-theoretic model of monetary policy, what is the Nash Equilibrium strategy pair?
Explanation:
The Nash Equilibrium is the outcome where neither party has an incentive to deviate, given the other's action. If the private sector expects inflation, the government's best response is to inflate (as there is no gain from a surprise, and not inflating would cause a recession). If the government is expected to inflate, the private sector's best response is to expect inflation. This (inflate, expect inflation) outcome is the unique Nash Equilibrium, even though it is Pareto-inferior to the (zero inflation, zero inflation) outcome.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, p. 66.
31. The IS curve is downward sloping in \((y, r)\) space because a lower real interest rate:
Explanation:
The IS curve represents goods market equilibrium. A lower real interest rate makes borrowing cheaper for firms, which stimulates investment spending (i). This increase in investment, a component of aggregate demand (y = c + i + g), leads to a higher equilibrium level of output (y). Thus, there is a negative relationship between r and y along the IS curve.
Source: McCallum, Monetary Economics, pp. 81-82.
32. In the context of RBC models, what is the primary mechanism through which a temporary technology shock has persistent effects on output?
Explanation:
A temporary positive technology shock makes investment more attractive. The resulting increase in investment leads to a higher capital stock in subsequent periods. Since the capital stock is a productive input, having more of it allows the economy to produce more output in the future, even after the initial technology shock has dissipated. This process of capital accumulation propagates the shock forward in time.
Source: Plosser, 'Understanding real business cycles', p. 56.
33. The term "Classical Unemployment" in the context of "trading at false prices" refers to a situation where:
Explanation:
In the generalized model of trading at non-market-clearing prices, different regions of disequilibrium can exist. "Classical Unemployment" occurs when there is an excess supply of labor (unemployment) but an excess demand for goods. In this situation, the real wage is too high. Firms cannot hire all the workers they want at a lower wage, and the only way to increase employment is for the real wage to fall. This contrasts with "Keynesian Unemployment," where there is excess supply in both the goods and labor markets.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, pp. 43-44.
34. In the basic classical model, an increase in the desire to save by households (a downward shift in the consumption function) will lead to:
Explanation:
An increased desire to save for any given income level is equivalent to a decrease in consumption. This shifts the IS curve to the left. Since output (Y) is fixed at the full-employment level, the real interest rate (r) must fall to stimulate investment (I) enough to offset the fall in consumption (C), thereby keeping the goods market in equilibrium (Y = C + I + G).
Source: Application of the IS-LM-AS framework from McCallum, Monetary Economics, Chapter 5.
35. The assumption of a representative agent in RBC models is used to:
Explanation:
The representative agent is a powerful simplification. Based on theorems by Debreu, Prescott, and Lucas, it is possible to model the per-capita quantities of a competitive equilibrium with many identical agents as the solution to a single agent's (Robinson Crusoe's) utility maximization problem. This makes the otherwise intractable problem of analyzing a full general equilibrium system manageable.
Source: Plosser, 'Understanding real business cycles', p. 55.
36. In the classical model, the aggregate demand curve is downward sloping because a lower price level:
Explanation:
The AD curve is derived from the IS-LM model. For a given nominal money supply (M), a lower price level (P) increases the real money supply (M/P). This shifts the LM curve to the right. The new equilibrium intersection with the IS curve occurs at a lower real interest rate and a higher level of output (aggregate demand). This inverse relationship between P and y defines the downward-sloping AD curve.
Source: McCallum, Monetary Economics, pp. 85-86.
37. A key difference between the models of Lucas (1975) and Long & Plosser (1983) is:
Explanation:
The models represent two different branches of New Classical thought. The Lucas (1975) model is a monetary theory of the business cycle, where fluctuations are caused by agents misperceiving monetary shocks due to imperfect information. The Long and Plosser (1983) model is a real business cycle theory, where fluctuations are caused by real technology shocks in a world with perfect information and no money.
Source: Hoover, The New Classical Macroeconomics, pp. 40, 54.
38. In the classical model, if the production function is \(y = f(k, l)\), the marginal product of labor is given by:
Explanation:
The marginal product of an input is defined as the additional output produced from one additional unit of that input, holding all other inputs constant. Mathematically, this is the first partial derivative of the production function with respect to the input in question. For labor (the second argument in \(f(k,l)\)), this is \(f_2\) or \(\partial y / \partial l\).
Source: EC3115 - Ch 8 Classical models and monetary policy-1.pdf, p. 3.
39. The assumption of "constant returns to scale" in a production function \(Y = F(K, N)\) means that if you double both capital and labor inputs, output will:
Explanation:
Constant returns to scale is a property of a production function such that if all inputs are increased by a certain proportion, output increases by that same proportion. Mathematically, \(F(\lambda K, \lambda N) = \lambda F(K, N)\) for any \(\lambda > 0\). If \(\lambda = 2\), output exactly doubles.
Source: Plosser, 'Understanding real business cycles', Appendix.
40. In the context of the time inconsistency game, a government that values non-inflation above all else is referred to as:
Explanation:
In the reputation-building extension of the time inconsistency model, a distinction is made between two types of government. A "wet" government has the standard objective function and is tempted to inflate. A "hard-nosed" (or "dry") government has a different objective function where the commitment to zero inflation is paramount; it will not inflate under any circumstances. The private sector's uncertainty about which type of government is in power drives the reputation-building dynamics.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, p. 69.
41. The "real balance effect" refers to the idea that:
Explanation:
The real balance effect (or Pigou effect) is another reason for a downward-sloping AD curve. When the price level (P) falls, the real value of money holdings (M/P) increases. If households consider these real balances as part of their wealth, they will feel wealthier and increase their consumption spending. This boosts aggregate demand at a lower price level.
Source: McCallum, Monetary Economics, p. 120.
42. In the Long and Plosser (1983) model, what is the source of the initial shocks?
Explanation:
The model is driven by real shocks that are specific to individual production sectors. The paper gives the example of the harvest for an agricultural good like wheat being randomly high or low, even with the same inputs. These sector-specific output shocks are the "impulses" that are then propagated through the economy.
Source: Long and Plosser, 'Real Business Cycles', p. 55.
43. If money is "neutral," what is the effect of a 10% increase in the money supply on the real money supply (M/P)?
Explanation:
Monetary neutrality implies that a 10% increase in the nominal money supply (M) will lead to a 10% increase in the price level (P). Since both the numerator and the denominator of the real money supply (M/P) increase by the same proportion, the ratio itself remains unchanged in the new long-run equilibrium.
Source: McCallum, Monetary Economics, p. 95.
44. The "marginal propensity to consume" (MPC) is defined as:
Explanation:
The MPC, represented as \(C'(y-\tau)\) in the consumption function \(c = C(y-\tau)\), measures how much consumption changes in response to a one-unit change in disposable income. It is a crucial parameter for determining the slope of the IS curve and the size of the Keynesian multiplier.
Source: McCallum, Monetary Economics, p. 79.
45. In the classical model, an increase in the real wage above its equilibrium level leads to:
Explanation:
If the real wage is above the equilibrium level, the quantity of labor supplied by workers will be greater than the quantity of labor demanded by firms. This gap between supply and demand is an excess supply of labor, which corresponds to unemployment.
Source: Hargreaves Heap, The New Keynesian Macroeconomics, p. 19.
46. The solution method for rational expectations models that involves repeatedly substituting for future expected variables is often called:
Explanation:
One way to solve a rational expectations model is to express the current variable (e.g., \(p_t\)) in terms of its future expected value (\(E_t p_{t+1}\)). One then solves for \(E_t p_{t+1}\) in terms of \(E_t p_{t+2}\), and so on. By substituting these expressions back into the original equation, one can express the current variable as a function of the entire future path of expected exogenous variables. This method is known as forward iteration or recursive substitution.
Source: McCallum, Monetary Economics, p. 150.
47. In the Long and Plosser (1983) model, the assumption that all goods are "normal goods" is important because it implies that:
Explanation:
The assumption that all goods are normal means that an increase in wealth (income) leads to an increase in demand for all goods. In their model, a random positive shock to the output of one good represents a windfall increase in wealth. This wealth effect causes demand for all commodities to rise, which is a key part of the propagation mechanism that creates comovement.
Source: Long and Plosser, 'Real Business Cycles', p. 55.
48. The "natural rate hypothesis" was first proposed as a critique of:
Explanation:
In the 1960s, the Phillips curve was interpreted as offering a stable, long-run menu of policy choices between inflation and unemployment. Friedman and Phelps independently critiqued this idea, arguing that such a tradeoff could only exist in the short run, as long as inflation expectations were wrong. In the long run, they argued, unemployment would return to its "natural rate" regardless of the rate of inflation, making the long-run Phillips curve vertical.
Source: Hoover, The New Classical Macroeconomics, pp. 23-26.
49. In the classical model, if the labor force grows due to population growth, what is the long-run effect on the natural rate of output?
Explanation:
An increase in the labor force shifts the labor supply curve to the right. This leads to a higher equilibrium level of employment. According to the production function \(y = f(k, l)\), a higher level of labor input leads to a higher level of output. Therefore, the natural rate of output increases.
Source: Application of the classical model from McCallum, Monetary Economics, Chapter 5.
50. The "method of undetermined coefficients" is a solution technique used in which type of models?
Explanation:
This method is widely used to solve linear rational expectations models. It involves conjecturing a linear solution form for the endogenous variable as a function of the model's state variables and shocks. This conjectured solution is then substituted into the model, and the "undetermined coefficients" of the conjectured solution are solved for by requiring the equation to hold for all possible values of the state variables and shocks.
Source: McCallum, Monetary Economics, pp. 151-153.