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1. 6 points In November 2021, President Biden signed the Infrastructure Investment and Jobs Act. The bill funds government spending on infrastructure (roads, bridges, etc.). A case can be made that public infrastructure is an input to production. To make this explicit, let G in be government spending on infrastructure. Therefore, we can write the production function as zF K N G ( , , in ). Assume, as seems reasonable, that the marginal products of labor and capital increase with an increase in G in . a. Explain why an increase in G in causes an increase in the current-period output supply curve. An increase in government spending on infrastructure, represented by Gin, can lead to an increase in the current-period output supply curve due to the concept of crowding-in. When the government invests in infrastructure, it enhances the productivity of both labor and capital. Improved roads, bridges, and other infrastructure elements reduce transportation costs and increase the efficiency of production processes. As a result, the marginal products of labor and capital increase, leading to higher overall productivity. This increase in productivity causes the output supply curve to shift outward, reflecting higher levels of output at each price level. b. Within the context of the real intertemporal model, consider, then, an increase in G due to an increase in G in . Determine the equilibrium effects of the increase in G in in the labor market and in the goods market. To make matters concrete, assume that the impact of the increase on Y d is greater than the impact of the increase on Y s . In the real intertemporal model, an increase in government spending on infrastructure, denoted by Gin, has equilibrium effects in both the labor market and the goods market. The increase in Gin raises the marginal products of labor and capital, leading to higher wages and returns on capital. In the labor market, this stimulates an increase in employment and potentially a reduction in unemployment. In the goods market, the higher productivity translates into an increase in output. c. In terms of its conclusions, how does this example differ from the example in Chapter 11 that considers the equilibrium effects of an increase in G ? This example differs from the Chapter 11 example that considers the equilibrium effects of an increase in government spending (G) by specifically focusing on infrastructure investment. The emphasis on infrastructure spending acknowledges the potential for productivity-enhancing effects, which can have a more direct impact on the production function and, consequently, on the equilibrium in both the labor and goods markets. The consideration of the marginal products of labor and capital explicitly connects the increase in government spending on infrastructure to changes in productivity and economic output. This highlights the importance of the type of government spending and its specific impact on the production process in understanding equilibrium effects. 2. 4 points The government decides that the use of credit cards is bad, and introduces a tax on credit card balances. That is, if a consumer or firm holds a credit card balance of X (in real terms), he or she is taxed tX, where t is the tax rate. Determine the effects on the equilibrium price and quantity of credit card balances, the demand for money, and the price level, and explain your results

2 Introducing a tax on credit card balances can have several effects on the economy, influencing the equilibrium price and quantity of credit card balances, the demand for money, and the price level. The tax on credit card balances increases the cost of holding such balances. As a result, consumers and firms may reduce their demand for credit card balances. The quantity of credit card balances in equilibrium is likely to decrease. Higher taxes make it less attractive for consumers and firms to maintain high credit card balances. 3. 6 points As explained in Chapter 11, a sectoral shock causes a reduction in the equilibrium level of the labor input and thus a reduction in output supply. This in turn reduces equilibrium output and raises the equilibrium real interest rate. The latter causes a decline in the equilibrium levels of consumption and investment. Moreover, because there is no shift in the production function, it follows that average labor productivity, Y / N , increases so that in such instances average labor productivity is countercyclical rather being procyclical as usual. a. The following figure, which is similar to Figure 11.32 in that the data is presented as an index with each value measured relative to its level in the first quarter of 2020 (before the recession begins), shows the behavior of real GDP over the 14 quarters following the onset of the Covid recession of 2020. Does the behavior of real GDP appear to be consistent with there being a sectoral shock in the first quarter of 2020? Briefly explain. An increase in the equilibrium real interest rate. A sectoral shock is expected to raise the equilibrium real interest rate, affecting consumption and investment. If there's evidence of declining consumption and investment, it might be consistent with the narrative of a sectoral shock. The behavior of real GDP appear to be consistent with there being a sectoral shock in the first quarter of 2020 since the figure suggest that the shock is not sector-specific or that the effects are not manifested in overall employment figures. A sectoral shock typically involves a reduction in the equilibrium level of labor input, leading to a decline in output supply and employment in the affected sectors.

4 following the onset of the Covid recession of 2020. Does the behavior of average labor productivity appear to be consistent with there being a sectoral shock in the first quarter of 2020? Briefly explain. There is evidence of a simultaneous increase in average labor productivity, it might indicate a departure from the typical pattern associated with a sectoral shock. In a standard sectoral shock, a reduction in the equilibrium level of labor input is expected to lead to a decline in output supply in affected sectors. This reduction in labor input, combined with the absence of a shift in the production function, typically results in an increase in average labor productivity (Y/N) even as overall economic output decreases in the affected sectors. 4. 4 points In the Excel file associated with this problem set, you will find quarterly data on the rate of inflation measured using the Consumer Price Index (CPI) and the Personal Consumption Expenditures Index (PCE). These are the two most commonly used measures of inflation at the household level. a. To get a sense of any differences in these two measures, calculate and report the average rate of inflation for each measure [use = average(array)] and the standard deviation for each measure of inflation [ = stdev.s(array) ]. Which inflation measure is the highest on average and which inflation measure is the most variabile? Average Rate of Inflation: For CPI: =AVERAGE(C2:C104) For PCE: =AVERAGE(B2:B104) Standard Deviation: 98 100 102 104 106 108 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quarters after Onset of Covid Recession Average Labor Productivity Relative to 2020-Q1

5 For CPI: =STDEV.S(C2:C104) For PCE: =STDEV.S(B2:B104) The highest on average and which inflation measure is the most variabile is 2023-01-01 with 5.8% b. In forming monetary policy, the Federal Reserve uses the PCE as its measure of inflation rather than the CPI. The Fed uses the PCE because the CPI does not account for how households substitute away from goods that become more relatively expensive over time. The PCE does so. To understand how this works, we need to consider how each price index is calculated. The CPI is a Paasche index which measures the change in prices between the base year 0 and the current year t of the basket of goods in the base year, Q 0 . We can usefully represent this measure as PQ t 0 . The PCE is a Lasperyes index which measures changes in prices PQ 0 0 between the base year 0 and the current year t of the basket of goods in year t , Q t . We can usefully represent this measure as PQ t t . PQ 0 t Given how these CPI and PCE are calculated, provide an explanation for what you found regarding the average rate of inflation and the volatility of inflation as measured by the CPI when compared to the average rate of inflation and the volatility of inflation as measured by the PCE. Hint: As the Fed does, think about the impact of substitution effects. The Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE) are both measures of inflation, but they have some differences in their calculation methodologies, which can lead to variations in their reported average rates of inflation and volatility. CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It includes a fixed basket of goods and services that represents the spending habits of the average consumer. The CPI is calculated by comparing the current cost of the basket to the cost in a reference base year. On the other hand, considers a broader range of goods and services. It accounts for changes in consumer behavior by allowing the basket of goods to change over time as people adjust their spending patterns. PCE is also adjusted for changes in quality and new products, making it more flexible than the fixed basket used in CPI.