Economics 102 Introductory Macroeconomics
Spring 2005, Professor J. Wissink
Problem Set 6
ANSWERS
1. Multiple choice:
1.
Growth in potential GDP is usually represented by a.
A shift in the aggregate demand curve up slightly and to the right. b.
A shift in the aggregate demand curve up and slightly to the left. c.
A shift in the aggregate supply curve to the right. d.
A shift in the aggregate supply curve to the left. e.
None of the above.
2.
Monetary policy is most likely to result in high GDP growth when the aggregate supply curve is a.
Vertical and the Fed lowers the discount rate. b.
Vertical and the Fed raises the reserve requirement. c.
Horizontal and the Fed sells securities. d.
Horizontal and the Fed lowers the required reserve ratio.
3.
The money-supply multiplier assumes that: a.
All new money is deposited in checking accounts. b.
Individuals do not retain cash balances. c.
Banks do not hold excess reserves. d.
All of the above. e.
None of the above.
4.
The aggregate supply curve is likely to be fairly flat at low levels of aggregate output because a.
Interest rates are very low and therefore investment will be increasing. b.
Aggregate demand is low. c.
At low levels of output, the additional cost of producing more output is likely to be small. d.
Prices and wages are below their equilibrium levels.
5.
According to the (short-run) Phillips curve, if policy makers want to reduce the unemployment rate, they must accept a.
A lower inflation rate. b.
A higher inflation rate. c.
A reduction in aggregate demand. d.
A reduction in aggregate supply.

6.
Doubts about the nature and the existence of a negatively sloped Phillips Curve arose in the 1970s when the economy experienced a.
Simultaneously high rates of inflation and unemployment. b.
Simultaneously low rates of inflation and unemployment. c.
A high rate of unemployment, along with a low rate of inflation. d.
A high rate of inflation, along with a low rate of unemployment. e.
No inflation at all for several years.
7.
The natural rate of unemployment is usually thought to be the sum of a.
Frictional unemployment and cyclical unemployment. b.
Cyclical unemployment and structural unemployment. c.
Frictional unemployment and structural unemployment. d.
Frictional unemployment and seasonal unemployment. e.
Frictional unemployment, cyclical unemployment and structural unemployment.
2.
You have the following data on the economy: Ypotential = 1,500 and Y* = 1,300.
a)
P LRAS
AS
0
AD
0
1,300 1,500
Y b) In principle, since there is excess capacity and high unemployment, input prices should fall. This would lead to a shift of the Aggregate Supply to the right until Ypotential is reached.
P
LRAS
AS
0
AS
1
1,300 1,500
AD
0
Y

c) Possible fiscal policies include raising government expenditures G and/or lowering taxes T. This raises
Aggregate Expenditure, and hence raises Y at each price level.
An expansionary monetary policy would lead to lower interest rates, higher investment which in turn would raise Aggregate Expenditure and hence Y at each price level. In both cases the Aggregate
Demand curve shifts out.
P LRAS
AS
0
AD
1
AD
0
1,300 1,500
Y
Unlike the previous case, here the rise in Y would come together with an increase in prices.
3.
Disagree. As seen in the graphs below, an increase in the AS, will imply a fall in prices and an increase in output Y. This means lower unemployment and lower prices. While a movement “down along” the Phillips curve implies lower inflation, but higher unemployment.
P LRAS
AS
0
AS
1 inflation
A
AD
0
B
PC
Y
Unemployment rate

4.
a)
If labor productivity is rising, then wage increases need not translate into cost-push inflation. However, if the increases in wages outpace the increases in labor productivity then there will be cost-push inflation. b) With a sudden rise in the price of oil purchased from OPEC nations many goods will become more expensive, since oil is a basic input in the production of many products. In other words there will be an increase in inflation. There will also be higher unemployment in America due to the fact that part of the internal resources are now going abroad to pay for the imported oil.
[Note: Answering by shifting the AS curve to the left is also a valid answer] c) The unemployment rate is the ratio of the number of people unemployed to the total number of people in r the labor force. The non-accelerating inflation rate of unemployment (or NAIRU) is the rate of unemployment at which inflation won’t grow nor decrease. If the unemployment rate is smaller than the
NAIRU inflation will start growing; similarly if the unemployment rate is larger than the NAIRU inflation will fall.
5.
If prices go up the Money Demand will rise, leading to higher interest rates, lower investment, and hence lower aggregate expenditure. This will result in smaller real output. In other words, as prices go up output falls.
M S r r
1 r
0
P
0
<P
1 r
1 r
0
M D (r,Y,P
1
) I
M D (r,Y,P
0
)
M I
1 I
0
I
AE 45˚
AE
0
AE
1
Y
1
Y
0
Y

6.
An increase in inflationary expectations will lead firms to raise their own prices, because they expect the prices for other products to rise as well. Hence, at each level of unemployment the inflation rate will be higher. In other words the Phillips curve will shift upwards. inflation
PC’
PC
Unemployment rate
7.
If the money supply is fixed, the only reason for (demand driven) sustained inflation to happen is an expansion in government expenditure G (holding T constant). This means that the government must borrow funds in order to finance the rising G. This is done by issuing government bonds, and the interest rate on these bonds must increase dramatically in order to make them attractive to the public. Even if the interest rate is rising, eventually the public would be unwilling to buy more of such bonds. At that point the government would be unable to keep expanding G, and therefore inflation should stop. If inflation doesn’t stop it must be because the AD curve is shifting out due to an expansionary monetary policy.