PROBLEM SET 7

Problems for Chapter 7

1.

Concisely explain why the AS curve is upward-sloping.

2.

Concisely explain why the AD curve is downward-sloping.

3.
Explain what effect each of the following events has on the IS curve, LM curve,
and the AD curve:
a.
increase in G
b.
decrease in G
c.
increase in M
d.
decrease in M
e.
rise in consumer confidence
f.
drop in consumer confidence
g.
increase in T
h.
decrease in T
i.
increase in P
j.
decrease in P
4.

Suppose Y > Yn.

a.
In this case, compare U and Un with P and P e.
b.
What will happen to Pe for next year?
c.
What happens to nominal wages (W) for next year?
d.
What happens to the AS curve for next year?

5.

Suppose Y < Yn.

a.
In this case, compare U and Un with P and P e.
b.
What will happen to Pe for next year?
c.
What happens to nominal wages (W) for next year?
d.
What happens to the AS curve for next year?

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6.
Suppose the economy is initially operating at Yn. Now suppose that government
spending (G) increases.
a.
What happens to the level of output (Y), the price level (P), and the interest
rate (i) in the short-run? Use the diagrams below to illustrate.
P
AS (Pe = P0 = 100)

100=P0

MR

AD
Y
LM(P0)

Yn

i0

MR

IS

Yn
Y
b.
Redraw your short-run equilibrium on the graphs below and also draw the
final medium-run equilibrium. Clearly show what happens to Y, P, and i in the medium-run.
AS (Pe = P0 = 100)

100=P0

MR

AD
Y
LM(P0)

Yn

i0

MR

IS

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Yn

c.
Explain HOW THE ECONOMY MOVES FROM SHORT-RUN TO MEDIUM RUN
EQUILIBRIUM, i.e. explain THE DYNAMIC ADJUSTMENT PROCESS IN THIS
PARTICULAR SITUATION.
d.
In what direction and by how much did P and Pe change in the medium-run. Explain
briefly. Did the increase in G have any medium-run effect on real variables (i, Y)? Explain
briefly.
TEXTBOOK, p. 159: #2, 3, 4
SELECTED ANSWERS
1.

An increase in Y corresponds to an increase in employment and reduction in U.

As U falls, bargaining power increases causing W to increase. As W increases,
firms increase P. Therefore, an increase in Y corresponds to an increase in P.
The AS curve is upward-sloping.

2.

A reduction in P causes an increase in M/P. The increase in M/P causes the LM

curve to shift down. This shift in the LM curve causes i to fall. As i falls, I
increases and Y increases (we move along the IS curve). Therefore, a reduction
in P causes an increase in Y in the goods market; the AD curve is downwardsloping.

3.

NOTE: If the curve is not listed, it does not shift.

4.

a.
b.
c.
d.
e.
f.
g.
h.
i.
j.

Is to right and AD to right.

IS to left and AD to left.
LM down and AD to right.
LM up and AD to left.
Is to right and AD to right.
IS to left and AD to left.
IS to left and AD to left.
Is to right and AD to right.
LM up and AD curve does NOT shift (move along it).
LM down and AD curve does NOT shift (move along it).

a.
b.
c.
d.

U is below Un, N is above Nn, and P is above Pe.

The expected price level will increase (adaptive expectations).
The nominal wage will increase (because of b).
The AS curve will shift up.

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5.

6.

a.
b.
c.
d.

U is above Un, N is below Nn, and P is below P e.

The expected price level will fall (adaptive expectations).
The nominal wage will fall (because of b).
The AS curve will shift down.

a. IS shifts right; AD shifts right. This increase P decreases the real money
supply, shifting the LM up. Short-run equilibrium: Y increases, i increases, P
increases.
b. Increase in P in short-run increases expected P (P e), shifting AS up, which
increases actual P. The increase in the actual P shifts LM up. Medium-run
equilibrium: Y returns to Yn, i increases, P increases.
c. In the short-run, P rises above Pe and therefore Y rises above Yn. In
subsequent periods, adaptive expectations means that P e will begin to increases
(AS shifts up). This will push up nominal wages and actual prices
proportionately. The increase in actual prices shifts LM up, pushing up interest
rates. As prices and interest rates increase buyers buy less (move along AD
curve) and production falls back to Yn.
d. In the medium-run, P and Pe increase in the same proportion. The reason is
because the WS relation says that an increase in P e increases W proportionately
and the PS relation says that an increase in W increases P proportionately.
The increase in government spending had no impact on Y in the medium-run, but
did increase i.

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SELECTED ANSWERS PROBLEMS FROM TEXTBOOK
2.

a.
b.

3.

IS right, AD right, AS up, LM up.

Y same, i up, P up; Consumption up because taxes decrease; Investment
down because interest rate (i) increases.
An increase in unemployment benefits affects the aggregate labor market first.
It thus shifts the aggregate supply curve first. Specifically, it shifts the
aggregate supply curve UP. The reason, using the bargaining model, is that an
increase in unemployment benefits makes workers less fearful of losing their
jobs and thus gives them more bargaining power. This increases nominal wages
and thus increases prices for any given level of output.
P

AS
AS

Y
The rest of the curves and variables shift as follows:

SR
MR

WS
up
up

PS
same
same

AS
up
up

AD
same
same

LM
up
up

IS
same
same

Y
i
decrease increase
decrease increase

P
increase
increase

4.
a.
After an increase in the level of the money supply, output and the interest
rate eventually (in the medium-run) return to the same levels. Only prices (and nominal
wages) increase, not real variables. In this sense, money is neutral. However, monetary
policy is useful because it can accelerate the return of output to its natural level if it
deviates in the short-run.
b.
Fiscal policy is not neutral because investment and the interest rate (real
variables) change with fiscal policy.
c.
The natural level of output is independent of (not affected by) fiscal and
monetary policy in the medium-run. However, the natural level of output is not
independent of all government policies. Changes in unemployment compensation, the
minimum wage, policies that affect competition in product markets, etc. affect the natural
level of output because they shift the AS curve.