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Questions and Answers List

level questions: Level 1

analysis implies that the individual's consumption in a given period is determined not by income that period, but by income over his/her lifetime (Friedman).What does the permanent income hypothesis?
hypothesized that a fraction (lambda) of consumer's spend their current income and the remaining consumers behave according to Hall's Theory. Measured consumption as nondurable and services per person. --> results that consumption appears to increase by about fifty cents in response to an anticipated on dollar increase in income, and the null hypothesis of no effect is strongly rejected. Lambda,however, is far below 1, suggesting that PIH is important to understanding consumption.PIH/RWH - Campbell and Mankiw
Examined alaska oil royalties using panel data. Finds no evidence that consumption reacts to these payments. --> proves PIHHseih (PIH)
slope - B is the relative variation in permanent and transitory income intercept is determined b average incomesHow are slope/intercept estimated for PIH?
Implies a procyclical real wage in the face of demand fluctuation. A rise in demand leads to rise in effective labor demand, and thus to an increase in the real wage as workers move up their labor supply curve.Keynesian Model with rigid nominal prices
Implies a countercyclical wage: a rise in demand leads to an increase in prices, which decreases real wages -> which leads to a decrease in labor supply -> decrease in output.Keynesian Model with rigid nominal wages
Aggregate data is bad to use because it averages everything out and the results are that real wage is cyclical or moderately pro-cyclical. It ignores how lower skilled workers are more cyclical versus high skilled workers. Study done by Solon, Barksy, and Parker use panel data which predicts that real wages are 2 times as pro cyclical on individual level compared to aggregate.Empirical Evidence of cyclical nature of real wages
The destruction of capital does not affect or to shift since neither are dependent on "K". However K and Q move along these curves. K decreases and moves left from to k1/2. This causes q to exceed 1 and therefore increase to point A. Since q is greater than 1, there is more investment in K since additional capital increases present value of firms profits. This continues in which the economy is on the saddle path and returns to equilibrium.Phase Diagram - War destroys half capital
K, the stock of capital, cannot jump at the time of the implementation of the tax. Thus q must jump down so that the economy is on the new saddle path point A< Intuitively, since the government is now taking a fraction of profits, existing capital is less valuable and so the market value of capital falls. The economy then moves up the new saddle path with K falling and q rising. Intuitively, the lower market value of capital discourages investment and so the capital stock begins falling. As it does so, profits begin to rise and thus so does the market value of capital, reaching a new equilibrium.Phase Diagram - Gov Tax
q^. = rq - (lambda)(k(t)) From this equation it can be understood that a permanent decline in the interest rate shifts the q locus up. Since the capital stock cannot adjust instantly, existing capital earns rent, and so its market value rises. The higher market value of capital attracts investment and so the capital stock begins to rise. In addition, since 'r' multiplies q in the equation, for q locus the decline makes the locus steeper.Phase Diagram - Interest Rate declines = f(q(t)) and =rq - Profit(k)Equations of Motions for Q and K (Phase Diagram)
q shows how an additional dollar of capital affects the present value of profits. Increase capital stock if q is high, vice versa. q is also the present discounted value of the future marginal revenue products of unit of capital.Tobin's q
Without the transversality condition then marginally raising investment in period and holding the additional capital forever has a nonzero impact on the firm's profits, which would mean that the firm is not maximizing profit. Transversality condition is therefore necessary for profit maximization. Intuitively this version of the condition states that it cannot be optimal to hold valuable capital forever.transversality condition
Walras's law is a principle in general equilibrium theory asserting that budget constraints imply that the values of excess demand (or, conversely, excess market supplies) must sum to zero regardless of whether the prices are general equilibrium prices.Walras' Law
A Bellman equation, named after Richard E. Bellman, is a necessary condition for optimality associated with the mathematical optimization method known as dynamic programming.It writes the "value" of a decision problem at a certain point in time in terms of the payoff from some initial choices and the "value" of the remaining decision problem that results from those initial choices. This breaks a dynamic optimization problem into a sequence of simpler subproblems, as Bellman's “principle of optimality” prescribesBellman's Equation
people use all available information to form expectations of a variable and don't make systematic errors. Before rational expectations we had adaptive expectations.rational expectation
y = m - p so the factors that determine how much firms will raise output in response to a price change is the money supply and the magnitude of the price change.In Lucas's model, what factors determine how much firms will raise their output in response to a rise in the price of said output?
:How did lucas test the predictions of his model?
refers to the tendency for people to increasingly choose a smaller-sooner reward over a larger-later reward as the delay occurs sooner rather than later in time.Hyperbolic Discounting
The central prediction of the consumption CAPM is that premiums that assets offer are proportional to their consumption betas. If, for example, an asset's payoff is highly correlated with consumption, its price must be driven down to the point where its expected return is high for individuals to hold it. Equation 8.5 states that the higher the co variance of an asset's payoff with consumption, the higher its expected return.CAPM - Asset A has variance of 5, returns are uncorrelated with income. Asset B has a variance of .5, and positively correlated with income. According to CAPM, which asset would an investor prefer?
They use a set of real and financial variables for the manufacturing sector to analyse the response of small and large firms to monetary policy. They find that small firms contracts substantially relative to large firms after tightening money and they account for a significantly disproportionate share of the manufacturing decline. These results support the importance of imperfect financial markets as large firm's borrowing increases after monetary tightening, where the small firm's borrowing declines sharply. Due to the fact small firms are likely to face larger barriers to outside finance than larger firms do.Financial Imperfection - Gentler & Gilchrist
The theory of financial market imperfections predicts that the association between cash flow and investment will be stronger for firms that face greater barriers to external finance. Unless the association between current cash flow and future profitability is stronger for forms with less access to external finance. The difference in the cash flow - investment relationship between the two groups can be used to test the importance of financial market imperfections to investment.Financial Market Imperfection Theory
Using panel data on individual manufacturing firms, we compare the investment behavior of rapidly growing firms that exhaust all of their internal finance with that of mature firms paying dividends. We find that q values remain very high for significant periods of time for firms paying no dividends, relative to those for mature firms. We also find that investment is more sensitive to cash flow for the group of firms that our model implies is most likely to face external finance constraints Supports Financial Market Imperfection Theory.Financial Imperfection - Fazzari, Hubbard, and Peterson
The model states that economic output is a function of money or price "surprise". The model accounts for the empirically based trade off between output and prices represented by the Phillips curve, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money (the absence of a price or money supply relationship with output and employment) in the long-run. The policy ineffectiveness proposition extends the model by arguing that, since people with rational expectations cannot be systematically surprised by monetary policy, monetary policy cannot be used to systematically influence the economy.Lucas Model
refers to the inability of an important class of economic models to explain the average premium of the returns on a well-diversified U.S. equity portfolio over U.S. Treasury Bills observed for more than 100 years. the investor returns on equities have been on average so much higher than returns on U.S. Treasury Bonds, that it is hard to explain why investors buy bonds, even after allowing for a reasonable amount of risk aversion. The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation of the observation that the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics.Equity-Premium Puzzle
an economic hypothesis holding that consumers are forward looking and so internalize the government's budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing that spending does not affect agents' consumption decisions, and thus, it does not change aggregate demand. Suppose that the government finances some extra spending through deficits; i.e. it chooses to tax later. According to the hypothesis, taxpayers will anticipate that they will have to pay higher taxes in future. As a result, they will save, rather than spend, the extra disposable income from the initial tax cut, leaving demand and output unchanged.barro ricardian equivalence
Hall's extension of PIH, in contrast, predicts that when output declines uneexpectedly, consumption declines only by the amount of the fall in permanent income; as a result, it is not expected to recover. RWH implies that change in consumption is unpredictable. Could not reject hypothesis that either lagged values of income or consumption could not predict the change in consumption.Random Walk Hypothesis (Hall)