Problem Set #4 (Spring 2014) 1/8

Name: _______Cecilia Estlander__________________

(Last name, first name)
SID: ______232 99 363___________________
GSI: ________Felix Miranda_________________


UGBA 101B
Macroeconomic Analysis
Professor Steven Wood

Spring 2014


Problem Set #4
Due: April 1, 2014 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.

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

1. In the short-run, as economic output falls below potential output:

a. Inflation will fall from its current level because of the upward-sloping nature of the Phillips curve.
b. Inflation will rise from its current level because of the upward-sloping nature of the Phillips curve.
c. Inflation will fall from its current level because of the upward-sloping nature of the aggregate
supply curve.
d. Inflation will rise from its current level because of the upward-sloping nature of the aggregate
supply curve.
e. Unemployment will fall below the natural rate because of the upward-sloping nature of both the
Phillips curve and the aggregate supply curve.

2. Suppose that inflation is falling while the quantity demanded and output are rising. The economy is likely
on a point on:

a. The aggregate demand curve above the short-run aggregate supply curve.
b. The aggregate demand curve below the short-run aggregate supply curve.
c. The short-run aggregate supply curve above the aggregate demand curve.
d. The short-run aggregate supply curve below the aggregate demand curve.
e. This situation is not possible.

3. Suppose the economy is in general equilibrium. What would happen if the natural rate of unemployment
were to increase?

a. According to the Phillips curve, the resulting positive unemployment gap would exert inflationary
pressures.
b. According to Okuns law, the resulting positive unemployment gap would be consistent with a
positive output gap.
c. According to the AD/AS framework, the LRAS curve would shift to the left and the resulting
output gap would have to be closed by subsequent downward shifts on the SRAS curve to a lower
equilibrium level of inflation.
d. All of the above.
e. None of the above.

4. By the time Paul Volcker took office as the new Federal Reserve chairman in 1979, both inflation and
unemployment were much higher that during the 1950s, the 1960s, and the early 1970s. The Federal
Reserve implemented an autonomous tightening of monetary policy that resulted in the famous Volcker
Disinflation which was successful in bringing both problems under control. What would have been the
likely short-run result had the Federal Reserve conducted an expansionary monetary policy instead?

a. Both inflation and unemployment would have declined.
b. Both inflation and unemployment would have increased.
c. Inflation would have increased but unemployment would have declined.
d. Inflation would have declined but unemployment would have increased.
e. None of the above.


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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.
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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 Aggregate Demand and Aggregate Supply Model. Suppose that the economy is in general equilibrium and characterized by sticky wages and
prices.

a. Based only on this information, use two aggregate demand and aggregate supply diagrams to clearly and accurately show the economys
initial economic output and inflation. These diagrams should be identical and drawn in BLACK.
































Y Y
SRAS
0
(
e
=
0
)

SRAS
0
(
e
=
0
)

AD
AD
LRAS LRAS

0
Y
P
Y
P
AD
1
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b. In Year 1, the country decides that it wants to substantially reduce unemployment and is trying to
decide between using fiscal policy (i.e., government purchases) or monetary policy. The magnitudes
of these policies would be chosen to have identical Year 1 effects on economic output. Based only on
this additional information, clearly and accurately show the Year 1 effects of a fiscal policy (in your
diagram on the left) and a monetary policy (in your diagram on the right) on (1) economic output and
(2) inflation. These effects should be drawn in RED.


Because the economy is initially in general equilibrium, the economic output will be at potential level,
i.e. Y0=Yp, with inflation at 0. Unemployment will be at the natural rate of unemployment, Yp.
Because prices and wages are sticky the SRAS curve is flatter.
SRAS0 does not shift because we started at equilibrium point, where expected inflation=actual
inflation.(0). So SRAS0=SRAS1

1. Fiscal: The IS curve will shift up and right, with easing of fiscal policy to reduce unemployment
rate, and causes AD curve to shift the same direction. Because the output gap and the unemployment
gap is related by Okuns law, an increase in economic output relative to its potential level, Yp, will
lead to a decrease in unemployment rate, relative to the natural rate of unemployment. The easing of
the policy are increases in government purchases and/or decreases in taxes. Either policy will increase
planned expenditures at any given real interest rate and also increase aggregate demand at any given
inflation rate. This can be represented by a rightward shift of the IS curve and a rightward shift of AD
curve, from AD0 to AD1. Now there is a short-run equilibrium, where AD1=SRAS1.
Inflation rises from 0 to 1, because as economic output goes up, with easing of taxes or higher
government purchases, businesses try to increase production and hire more workers. They also need
to raise wages and their prices, and as prices increase, so does inflation. So, higher output gap (lower
unemployment), leads to an increase in inflation. (Higher inflation, in accordance with Taylor
Principle, results in movements along the MP curve endogenously, which increases the real interest
rate.)

2. Monetary: The country will shift the MP curve, with an easing of monetary policy, to reduce
unemployment rate. They will shift MP curve down, reducing the real interest rate at any given level.
When MP curve shifts, the AD curve shifts in the same direction from AD0 to AD1. When interest
rates go down, the cost of borrowing goes down and there is more borrowing-activity from
businesses. There will be an increase in planned expenditures, economic output will increase from Y0
to Y1, businesses will hire more workers and unemployment will decrease. When businesses need to
raise wages and prices with the increase in economic output, inflation will increase from 0 to 1.



c. Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to (1) economic output, (2) inflation, and (3) unemployment and explain why
these changes take place.

d. In Year 2, there are no further exogenous shocks. On your diagrams above, clearly and accurately
show the Year 2 effects of (1) economic output and (2) inflation. These effects should be drawn in
BLUE.

e. Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to (1) economic output, (2) inflation, and (3) unemployment and explain why
these changes take place.

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In year two, due to the economys self-correcting mechanism, the economy will start to move back to
the long-run equilibrium. Expected inflation now equals inflation in year 1. We have a positive output
gap, and therefore higher inflation expectations. So now SRAS curve shifts to the left. We shift it
where inflation year one (1) crosses LRAS. This change is the same for both scenarios, and it results
in an increase in inflation from 1 to 2 and a decrease in total economic output form Y1 to Y2. The
economic output gap decreases from Y1 to Y2 because, the central bank responds moving up along
the MP curve causing higher real interest rate, less borrowing, less spending and therefore less
economic output.
Inflation goes up in year 2, expected inflation rises, which causes the SRAS to rise to SRAS2.
However, we still have a positive output gap, which puts upward pressure on inflation. The central
bank, following the Taylor Principle, will increase interest rates, which will reduce borrowing,
spending and economic output as we move back along the IS curve and therefore along the AD curve.
Positive output gap does not mean positive unemployment gap, but Okuns law relates them
(Unemployment - natural rate of unemployment= - 0.5x output gap (Ya-Yp). Whichever way the
output is going the unemployment is going in the opposite direction. Therefore, in year two,
unemployment increased.

(Sticky prices means that we have smaller changes in inflation and if prices arent changing very
much we get a bigger change in economic output, which also means a bigger change in
unemployment rate through Okuns law.)


f. On your diagrams above, clearly and accurately show the economys final general equilibrium for
(1) economic output and (2) inflation. These effects should be drawn in GREEN.

g. For each of the following variables, indicate whether its value has INCREASED, DECREASED, or
stayed THE SAME when comparing the initial and final equilibrium when the government used
fiscal policy. Be sure to explain why.

i. Economic output: The same. In LR there is no change in unemployment or economic output.
As the economy adjust in the LR, economic output goes back to potential output. Since we
assume adaptive inflationary expectations, increased inflation means higher inflationary
expectations. This shifts the SRAS curve to the left until it equals LRAS and AD curve, and
decreases output to Y2. Since Y2 is still greater than Yp, inflation will rise again, and the
cycle will repeat until we reach the potential output level, Yp=YN (or the end point, N).

ii. Inflation: Higher. In the LR we have a permanent change in inflation. Since we assume
adaptive inflationary expectations, increased inflation means higher inflationary
expectations. This shifts the SRAS curve to the left and increases inflation. Output continues
to decrease until Yp=YN, and inflation stops accelerating and increases permanently to N.


iii. The real interest rate: Increased in long run, because real interest rates moves along the MP
curve endogenously.

iv. Consumption: If government purchases was raised then the consumption decreases as saving
decreases. If taxes were cut then people would consume more and consumption would
increase (with lower taxes on goods and services).
v. Investment: Decreases. With higher interest rates people save more and invest less.

vi. Government purchases: Increase if they use government purchases as a policy and stay the
same if taxes stay the same.
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vii. Net exports: Fiscal policy, they decrease. ( NX=Exports-Imports)

viii. Exports: Decreased because of higher permanent inflation. Foreign countries buy less of
domestic goods as inflation rate increased. The rise in interest rates attracts foreign capital
and to get more domestic currency to invest, foreigners bid up the price of the domestic
currency, causing an exchange-rate appreciation in the short run. This appreciation makes
imported goods cheaper in the United States and exports more expensive abroad, leading to a
decline of the goods market trade balance.

ix. Imports: Increase because of higher real interest rates and people invest more in other
countries.

x. Taxes: Same. If government purchases were increased they stayed the same.

h. For each of the following variables, indicate whether its value has INCREASED, DECREASED, or
stayed THE SAME when comparing the initial and final equilibrium when the government used
monetary policy. Be sure to explain why.

i. Economic output: The same. In LR there is no change in unemployment or economic output.
As the economy adjust in the LR, economic output goes back to potential output. Since we
assume adaptive inflationary expectations, increased inflation means higher inflationary
expectations. This shifts the SRAS curve to the left until it equals LRAS and AD curve, and
decreases output to Y2. Since Y2 is still greater than Yp, inflation will rise again, and the
cycle will repeat until we reach the potential output level, Yp=YN (or the end point, N).

ii. Inflation: Higher. In the LR we have a permanent change in inflation. Since we assume
adaptive inflationary expectations, increased inflation means higher inflationary
expectations. This shifts the SRAS curve to the left and decreases output and increases
inflation. Output continues to decrease towards Yp, and inflation stops accelerating and
increases to N.

iii. The real interest rate: Decreases, according Taylor Principle, the central banks decreases
interest rates exogenously.

iv. Consumption: Increases. Planned expenditures increased so consumption goes up.

v. Investment: Increases. With lower real interest rates, the price of investments goes down and
leads to greater investments.


vi. Government purchases: Stays the same, because government purchases are only part of the
fiscal policy.

vii. Net exports: Increases. Export more than import.

viii. Exports: Increase. Because interest rates have fallen, and bond prices rise. Rising domestic
bond prices cause investors to sell those bonds in exchange for other foreign bonds. This in
turn, causes the supply of domestic currency on foreign exchange markets to increase and the
supply of foreign currency on foreign exchange markets to decrease. This causes the
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domestic currency to become less valuable relative to the foreign currency. The lower
exchange rate makes the domestic produced goods cheaper in the foreign country and foreign
goods more expensive, so exports will increase and imports will decrease.

ix. Imports: Decrease. Look previous explanation.

x. Taxes: Same. No changes, again relates to fiscal policy.