Problem Set #3 (Spring 2014)

1/8
Name: _______Estlander Cecilia__________________
(Last name, first name)
SID: ______23299363___________________
GSI: _____Felix Miranda____________________


UGBA 101B
Macroeconomic Analysis
Professor Steven Wood

Spring 2014


Problem Set #3
Due: March 18, 2013 in class at 9:40 a.m.
(The grace period ends promptly at 9:50:01 a.m.)
Place your completed problem set in the box near the entrance.


Please sign the following oath:

On my honor, the answers on this problem set are entirely my own work. I neither copied from the work of others nor
allowed others to copy from my work.

_______________________________________
Signature

Any problem set turned in without a signature will be assigned a grade of zero.



Problem Set Instructions

1. You MUST complete your problem set on this template.

2. Your answers to the multiple choice questions MUST be computer highlighted.

3. Graphs and equations MAY be drawn by hand. When drawing diagrams, clearly and accurately label all axis,
lines, curves, and equilibrium points.

4. Explanations MUST be word-processed. Your explanations should be succinct and to the point.

Problem Set #3 (Spring 2014)

2/8
A. Multiple Choice Questions (15 points). Computer highlight the best answer (3 points each).

1. If C = 2, I = 3, G = 1.45, T = 1.6, NX = 1, mpc = 0.75, c = 0.05, d = 0.30, and x = 0.15, then the IS curve is:

a. Y = 34.6 - 2r
b. Y = 8.65 - 2r
c. Y = 25 - 2r
d. Y = 8.33 - 0.67r
e. None of the above.

2. The IS curve is Y = 20 - 1.5r, and the aggregate demand curve is Y = 15.5 - 0.3. When the interest rate is 7
percent, the inflation rate is ________ percent.

a. 3.6
b. 9.5
c. 14.6
d. 20.0
e. None of the above.

3. According to liquidity preference theory, an increase in the price level would:

a. Decrease the real interest rate.
b. Increase the demand for real money balances.
c. Decrease the supply of real money balances.
d. All of the above.
e. None of the above.

4. Given the accelerationist Phillips curve = - 0.7 (U - 5) + , suppose that inflation has increased from 8
percent to 10 percent. If the unemployment rate is 4 percent, then the price shock is:

a. 0.6 percent.
b. 1.0 percent.
c. 1.3 percent.
d. 2.7 percent.
e. None of the above.

5. If the output gap is constant at minus 2 and the inflation rate has fallen from 6 percent to 5 percent, then next
period's short-run aggregate supply curve might be:

a. = 5 - 0.5 (13 - 15)
b. = 5 + 0.5 (13 - 15)
c. = 4 + 0.5 (13 - 15)
d. = 5 + 2 (11 - 15)
e. None of the above.

Problem Set #3 (Spring 2014)

3/8
B. Analytical Question (35 points). Answer the following question based on the standard models of analysis
developed in class. The information in the various parts of the question is sequential and cumulative.

1. The ISMPAD/AS Model. This question has two scenarios which are independent of each other.

a. Scenario #1. Suppose that the economy is initially (i.e., in Year 0) in general equilibrium, that
economic output is an inverse function of the real interest rate, that the real interest rate is a positive
function of inflation, and that wages and prices are sticky. Based only on this information use IS (on
the left), MP (on the right), and AD/AS (at the bottom) diagrams to clearly and accurately show the
economys initial (1) economic output, (2) inflation, and (3) real interest rate. These diagrams should
be drawn in BLACK.





































Problem Set #3 (Spring 2014)

4/8
b. Provide an economic explanation of what you have shown in your diagrams above.

General equilibrium means that the AD0 curve, the SRAS0 curve, and the LRAS0 curve are
all at the same intersection. As a result, the economy is producing at natural rate of
unemployment=actual unemployment/potential output i,e Y0=Y, inflation is constant at 0,
and actual inflation is equal to expected inflation, i.e. e= 0.

Because Inflation is at 0, the monetary policy, MP curve, shows that the central bank will
set the real interest rate to r0.

The real interest rate is at r0 and therefore, the IS curve indicates that planned expenditures
and equilibrium economic output are at Y0, which equals potential output: Y0=Yp.

The economy is also following the Taylor principle since the MP curve is upward sloping
and Ad curve is downward sloping.

c. In Year 1, the economy experiences a significant stock market boom that increases business
executives expected future profits. Incorporating only this additional information, clearly and
accurately show in your diagrams above what effects this would have on the economys (1)
economic output, (2) inflation, and (3) real interest rate. These effects should be drawn in RED.


d. Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to the economys (1) economic output, (2) inflation, (3) real interest rate, AND (4)
unemployment rate. Be sure to explain why these changes take place.

An increase in business executives expected future profits means that business
confidence goes up and this leads autonomous investment to increase, exogenously, and in
turn rise planned expenditure at any given level of r. Thus, the IS curve shifts up from IS0 to
IS1a. At a given inflation rate (0), and a real interest rate of r0=r1, equilibrium output rises
from Y0 to Y1a.
The expected future profit also creates an increase in expected future income, which in
turn creates autonomous consumption to go up. This further shifts the IS curve up,
exogenously from IS1a to IS1. At a given inflation rate (0), and a real interest rate of r0=r1,
equilibrium output rises from Y1a to Y1.
When IS curve shifts, the aggregate demand curve shifts by the same amount (as shift
from IS0 to IS1) and in the same direction, AD0 shifts rightward to AD1. By itself, this
causes an increase in economic output from Y0 to Y1, and an increase in real inflation from
0 to 1, endogenously. In year one at point B, actual output has gone up to Y1 and there
is a positive output gap, which leads to an increase in inflation. So at point B we are in
short run equilibrium but not long run equilibrium. In year one this will be true because
wages and prices are sticky, and this will not have an immediate effect on interest rates. The
unemployment rate due to the structure of the market is in short run lower than the natural
unemployment rate (demand for labor increases because the total output goes up and
therefore more labor is demanded).
Problem Set #3 (Spring 2014)

5/8

Expected inflation in first year does not change i.e. e= 0 , due to the assumption of the
one-year adaptive inflation. In year one, SRAS curve is the same as in year zero, because of
this rule.

e. In Year 2, there are no further exogenous shocks. Incorporating only this additional information
clearly and accurately show in your diagrams above what effects this would have on the economys
(1) economic output, (2) inflation, and (3) real interest rate. These effects should be drawn in BLUE.

f. Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to the economys (1) economic output, (2) inflation, (3) real interest rate, AND (4)
unemployment rate. Be sure to explain why these changes take place.
Although there are no further exogenous shocks, there is will be adjustments from year one
taking place.
Because AD shifted in year one, economic output became Y1>Yp, and while the economy is
in short run equilibrium, it is in disequilibrium in the long run. The demand for labor
increased (with higher output) and this will lead to an increase in wages, and therefore a
higher expected inflation. In year two, the expected inflation is no longer 0 (because
inflation is determined by the one-year adaptive process), it has increased to 1. This can be
shown by an upward shift of the SRAS curve from SRAS0 to SRAS1. In year two, expected
inflation changes and SRAS shifts up and it has to shift so it intersects the previous years
inflation rate. Now output goes down from Y1 to Y2 and inflation is even higher so now we
are at point C. There is an endogenous real interest rate increase from r1 to r2. The
unemployment rate is higher than before unemployment rate going back to natural
unemployment. This mechanism occurs on its own, and it is called the economys self
correcting mechanism. This occurs because the expected inflation has to match the actual
inflation of the previous year This will go on until the economy moves back to the natural
unemployment level of output Yp, and as a result the inflation rate will increase as well as
the real interest rate, up until the economy reaches the long-run equilibrium.













Problem Set #3 (Spring 2014)

6/8
g. Scenario #2. Suppose that the economy is initially (i.e., in Year 0) in general equilibrium, that
economic output is an inverse function of the real interest rate, that the real interest rate is a negative
function of inflation, and that wages and prices are sticky. Based only on this information use IS (on
the left), MP (on the right), and AD/AS (at the bottom) diagrams to clearly and accurately show the
economys initial (1) economic output, (2) inflation, and (3) real interest rate. These diagrams should
be drawn in BLACK.





































Problem Set #3 (Spring 2014)

7/8
h. Provide an economic explanation of what you have shown in your diagrams above.

Because real interest rate is a negative function of inflation, the central banks do not follow
the Taylor Principle. This means that a lower interest rate cause a higher inflation rate.
Suppose inflation goes up and interest rate goes down, then planned expenditures go up
(along the IS curve), so demand would increase (price goes up). This causes even higher
inflation. The AD curve is upward sloping without the Taylor Principle.

General equilibrium means that the AD0 curve, the SRAS0 curve, and the LRAS0 curve are
all at the same intersection. As a result, the economy is producing at natural rate of
unemployment=actual unemployment/potential output i,e Y0=Y, inflation is constant at 0,
and actual inflation is equal to expected inflation, i.e. e= 0.

Because Inflation is at 0, the monetary policy, MP curve, shows that the central bank will
set the real interest rate to r0.

The real interest rate is at r0 and therefore, the IS curve indicates that planned expenditures
and equilibrium economic output are at Y0, which equals potential output: Y0=Yp

i. In Year 1, the economy experiences a significant stock market boom that increases business
executives expected future profits. Incorporating only this additional information, clearly and
accurately show in your diagrams above what effects this would have on the economys (1)
economic output, (2) inflation, and (3) real interest rate. These effects should be drawn in RED.


j. Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to the economys (1) economic output, (2) inflation, (3) real interest rate, AND (4)
unemployment rate. Be sure to explain why these changes take place.
An increase in business executives expected future profits means that business confidence
goes up and this leads autonomous investment to increase, exogenously, and in turn rise
planned expenditure at any given level of r. Thus, the IS curve shifts up from IS0 to IS1a. At
a given inflation rate (0), and a real interest rate of r0=r1, equilibrium output rises from Y0
to Y1a.
The expected future profit also creates an increase in expected future income, which in turn
creates autonomous consumption to go up. This further shifts the IS curve up, exogenously
from IS1a to IS1. At a given inflation rate (0), and a real interest rate of r0=r1, equilibrium
output rises from Y1a to Y1.
When IS curve shifts, the aggregate demand curve shifts by the same amount (as shift from
IS0 to IS1) and in the same direction, AD0 shifts right and down to AD1. By itself, this
causes an increase in economic output from Y0 to Y1 in the short run, and an increase in
real inflation from 0 to 1, endogenously. In year one at point B, actual output has gone
up to Y1 and there is a positive output gap, which leads to an increase in inflation. So at
point B we are in short run equilibrium but not long run equilibrium. In year one this will
Problem Set #3 (Spring 2014)

8/8
be true because wages and prices are sticky (there is less responsiveness due to change in
inflation rates), and this will not have an immediate effect on interest rates.
Due to the structure of the market, the unemployment rate is in short run lower than the
natural unemployment rate (demand for labor increases because the total output goes up and
therefore more labor is demanded).
Expected inflation in first year does not change i.e. e= 0 , due to the assumption of the
one-year adaptive inflation. In year one, SRAS curve is the same as in year zero, because of this
rule.

k. In Year 2, there are no further exogenous shocks. Incorporating only this additional information
clearly and accurately show in your diagrams above what effects this would have on the economys
(1) economic output, (2) inflation, and (3) real interest rate. These effects should be drawn in BLUE.

l. Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to the econoomys (1) economic output, (2) inflation, (3) real interest rate, AND (4)
unemployment rate. Be sure to explain why these changes take place.

Although there are no further exogenous shocks, there is will be adjustments from year one
taking place.
When AD curve shifted in year one, Y1>Yp, and the economy is only in short run
equilibrium at 1 and Y1. However, we are still in long run disequilibrium.
Because demand increased, there will be an increase in wages and therefore a higher
expected inflation.

In year two, the expected inflation is no longer 0 (because inflation is determined by the
one-year adaptive process), it has increased to 1. Now the economy starts to move even
further away from the long run equilibrium point (Yp) and as a result, there is an upward
shift of the SRAS curve from SRAS0 to SRAS1. In year two, expected inflation changes and
SRAS shifts up and it has to shift so it intersects the previous years inflation rate. Now
output goes up from Y1 to Y2 and inflation is even higher, at 2, so now we are at point
C. There is an endogenous real interest rate decrease from r1 to r2. The unemployment
rate is even lower than before unemployment rate going away from natural
unemployment. SRAS1 will intersect LRAS0 at 1. This mechanism occurs on its own, and
it is called the economys self correcting mechanism. This occurs because the expected
inflation has to match the actual inflation of the previous year. Because the central banks are
not following the Taylor principle, when inflation goes up, interest rate goes down, higher
aggregate activity (along IS curve) and even higher inflation rates. This continues on and on
and results in higher and higher inflation.
The economy keeps going away from the natural unemployment level of output Yp. It will
move further and further away from the long run equilibrium. It is important to note that the
MP curve is not following the Taylor principle; this process can be repetitive thus causing
high inflation in the economy.