Detailed solutions to multiple choices of PS #2
Hongfei Sun / Halina Kalita
1. A rise in the real rate of interest increases the price of capital, and hence causes a decrease in
investment. Real money demand is determined by the equation:
L=k*Y – h*i, where i = r+ expected inflation rate.
Hence, the increase of real rate of interest when the expected inflation rate stays constant raises the
nominal interest rate and hence will reduce the money demand.
2. The currency-to-deposit ratio affects the monetary base multiplier. If it increases, the currency drain
increases i.e. the multiplier falls. Money supply that is determined by the product of high-powered
money (monetary base) and the monetary base multiplier will fall accordingly. The LM curve shifts to
the left, and so does the aggregate demand curve.
3. An autonomous increase in savings implies an autonomous decrease in consumption. This will shift
the IS to the left, and so will shift the aggregate demand to the left. With the longer-term contracts, the
New Keynesian aggregate supply curve doesn’t respond during this period. So, only aggregate
demand curve shifts to the left and results in a lower output level.
4. This question deals with the classical model (“long run”).
The question implies that the labor demand curve shifts to the left, causing a decrease in the real wage
and long-term employment. Accordingly, the long-term output also decreases. (Note: the production
function shifts inward, reinforcing the reduction in output). There is no shift in labour supply.
Now go to the IS-LM and AS-AD graphs. The vertical AS shifted to the left. The price level goes up.
The real money supply shrinks, causing a leftward shift in the LM curve (the IS curve does not move).
As a result, the real interest rate goes up. And, because the aggregate price level is now higher, the real
money balances in the economy (=M/P) is now lower.
5. Expected price level is not high enough.
Draw the AD and a positively-sloped New Classical AS curve (EAS curve or Lucas’ supply curve).
The expected price level is determined by the intersection of this NCAS curve with the vertical longrun supply curve. The actual price level is higher, i.e. the AD intersects the short-term NCAS above
the expected price level (to the right of it). The level of output is higher than its long-term equilibrium:
( c ) is true. By assumption number 1 of our AS theories, the level of employment is higher: ( b ) is
true as well. Finally, since employment is higher, by assumption #2 of our AS theories, the MPL is
lower. And by assumption #3 of our AS theories, at all times firms keep MPL = W/P, i.e. the level of
real wages is lower: ( a ) is true as well. So the answer is ( D ).
6. Unanticipated changes in aggregate demand (such as government spending and production effect
from drought) will always make a difference because agents can’t take those into consideration. (you
can refer to questions in part II.) An anticipated technological improvement will shift up the
production function. Labor becomes more productive, shifting the labour demand to the right. As a
result, we’ll have higher levels of employment and output. An unanticipated drought is a real shock,
i.e. it will presumably affect labour market and hence employment and output. Only B, that is, an
anticipated increase in autonomous investment, will not make output to change because of the perfect
flexibility of prices and wages. Agents realize that this increase will shift the IS to the right, the AD
also shifts, putting upward pressure on prices. They will demand higher nominal wages to protect their
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cost of living, and firms will grant this request as they know they can charge higher nominal prices for
their output. There will be no change in output and employment.
7. By the Lucas Critique, agents have rational expectations. The reason why agents can’t make the
correct decisions is that they don’t have the relevant information available. That is, information is
imperfect. Hence the only reason agents cannot predict whether there will be a recession in the next
year, is that economic situations now and later are independent. Otherwise, if recession now is related
to recession tomorrow, agents can also predict/expect that because of the rational expectations.
In other words, under rational expectations agents do not make systematic mistakes. The only reason
for which there will be a recession is that there was a random shock that they could not foresee.
Whether they will be in recession next year or not, depends on another random shock and its direction.
Such random shocks are uncorrelated. As a result, there is no relationship between the state of the
economy this year and next year.
8. The unexpected rise in the money supply shifts the LM curve to the right and hence, aggregate
demand curve shifts to the right, too. Since the increase is “unexpected”, the EAS curve (New
Classical AS, Lucas’ supply curve) does not shift. This results in a higher short-run output, and hence,
higher level of employment (assumption #1 behind our models of AS). Marginal product of labor goes
down (assumption #2 behind our models of AS) and so do real wages, which are equal the MPL at all
times (assumption #3 behind our models of AS).
9. Since it turns out that government spending and hence aggregate demand don’t change at all, yet
firms are restrained by the high-wage contracts (resulting from the expectation of higher prices at the
time of negotiation), the aggregate supply curve shifts to the left. With AD curve unchanged, this will
give a lower output and a higher price.
If everybody anticipates G to go up, they anticipate the IS to shift rightward, and with it – a rightward
shift in AD. Accordingly, they anticipate upward pressures on prices, and negotiate their wage
contracts incorporating higher price expectations. The New Keynesian AS shifts to the left reflecting
higher nominal wages that are contracted.
However, the AD does not shift. The short-run (New Keynesian) equilibrium is thus to the left of the
long-run output.
The relevant comparison is between the initial observable equilibrium: the intersection of NKAS,
original AD and long-run AS and this new short-run equilibrium. Note that the “anticipated” AD shift
was never observed and as such – it never was the actual equilibrium. That’s why the answer is ( D ).
10. Higher marginal tax rate results in a lower product-market multiplier, hence, the IS curve is steeper
for economy 1 than 2. This results in a steeper AD curve in 1 than in 2. Rumors about the price level
will shift the aggregate supply curve. Since economy 1’s aggregate demand curve is steeper, the
resulting output changes are less but prices changes are more in 1 than in 2.
Hint: to see these effects, draw the original equilibrium: two differently sloped AD curves intersecting
at the same point with one EAS curve (New Classical AS, positively sloped). Shift now upward the
EAS curve to reflect higher price expectations, without shifting the AD curves (since the rumours are
false) – you can thus see graphically the resulting impacts on output and prices.
11. With lower unemployment insurance and welfare benefits, it is more costly for a person to be
unemployed. Hence, when the contracts are being negotiated, the labour supply shifts to the right at
any given real wage. The natural level of employment and output increases, i.e. the long-run AS shifts
to the right, putting downward pressures on prices. Workers are therefore less demanding in terms of
the nominal wage rate. (Actually, since firms are fully aware of the effect of the new tax reform, they
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know workers will be less picky and hence they offer a lower wage contract in the first place. And
indeed, workers are willing to settle for the less. In addition, firms now that prices are going down and
hence cannot pay workers the same as before.) These effects are reflected in the downward shift (to
the right) in the New Keynesian Aggregate Supply curve.
Now go to the IS-LM and AD-AS frameworks: When AS shifts to the right, and P go down, the real
money supply in the economy M/P goes up (as do real money balances), and that shifts the LM curve
to the right. So the real rate of interest is lower.
12. The same argument from the previous question carried through here. Due to the new legislation,
we’re having higher output and lower prices.
13. Here the increase in money supply is anticipated, this reduces to a classical model where the
aggregate supply curve is vertical. The increase in money supply shifts to the right the LM curve
(since it increases real money supply in the economy). It therefore shifts the AD curve, to the right,
resulting in a higher price level. Yet output and employment level are not affected because the price
increase is anticipated and offset by an increase in nominal wages, leaving the real wage unchanged
(there is no mention of real shocks). EAS (New Classical AS, Lucas’s AS) shifts up, and all three
curves (shifted AD, shifted EAS, unchanged vertical AS) intersect again at the same level of output
but higher prices.
14. If AD shifts up, it will always put upward pressures on prices, regardless whether the AD shift is
known or unknown. The only difference is that if it is known, the EAS (New Classical AS, Lucas’ AS)
moves up as well, and the price increase is greater than if the shift comes as a surprise. But (a) is true
always.
Answer (b) does not make sense: if anything, nominal wages rise right away in the New Classical
framework, regardless of whether the AD shift is known or not. Again, they rise by more if the shift is
known.
Real wages either fall (if the shock comes as a surprise) or stay unchanged (if there is perfect
information) – ( c ) is always false.
(d) is only true if the shock was not anticipated. If it is known, the increase in prices is washed away
by the increase in nominal wages, keeping real wages and MPL unchanged.
Accordingly, answer ( a ) is the best answer since it is true regardless of whether the AD shock was
known or not. For ( d ) to be the right answer, you need to make one more assumption that is not given
to you in the question.
15. A is New classical and B is New Keynesian, so the AS curve of A is steeper than that of B. With
lower exogenous consumption, IS curve shifts to the left, and AD curve shifts to the left. However,
since the short-run aggregate supply curves are differently sloped in the two countries, the decrease of
output is larger in B than in A. So the resulting level of employment is lower in B than in A. Therefore,
the rise in MPL is less in A than in B. (because MPL is negatively related to the level of employment.)
16. The main point here is that in economy A agents are not free to act for 3 years on this shock
whereas in economy B agents whose contracts expire can act, demanding higher nominal wages when
they are negotiating new wage contracts. As a result, in (B), the New Keynesian AS shifts upward (not
all the way up though during the 2-year period) whereas in (A) the curve stays in the same position.
So in A, output will be higher than in B.
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