Solutions to Problems
Chapter 30
1.
Because the events were 'unexpected' in the following examples means that workers and employers, when negotiating wage
contracts, have not incorporated the events into their expectations and have agreed to a money wage that does not allow for
the impacts of these events. In the short run, the money wage is fixed. Assume we begin from a full-employment
equilibrium and an anticipated inflation rate of 4 percent.
1a. With an unexpected increase in the money supply there is unanticipated inflation and above full employment equilibrium
real GDP.
An unexpected increase in the money supply reduces the interest rate and increases interest rate sensitive components of
aggregate demand, particularly investment.
In figure 1 workers and employers were expecting aggregate demand to increase from AD0 to EAD1 and anticipated an
inflation rate of 4%. Because of the unexpected increase in the money supply aggregate demand actually increases from
AD0 to AD1, shifting the AD curve further to the right than expected. The increase in the price level is greater than expected
and real GDP increases. The economy is at short run equilibrium b in figure 1, with inflation at 8% and unemployment
below the natural rate. There is unanticipated inflation and above full employment equilibrium real GDP.
1b. With an unexpected increase in government expenditure there is unanticipated inflation and above full employment
equilibrium real GDP.
An unexpected increase in government expenditure on goods and services adds directly to aggregate demand.
In figure 1 workers and employers were expecting aggregate demand to increase from AD 0 to EAD1 and anticipated an
inflation rate of 4%. Because of the unexpected increase in government expenditure, aggregate demand actually increases
from AD0 to AD1, shifting the AD curve further to the right than expected. The increase in the price level is greater than
expected and real GDP increases. The economy is at short run equilibrium b in figure 1, with inflation at 8% and
unemployment below the natural rate. There is unanticipated inflation and above full employment equilibrium real GDP.
1c. With an unexpected increase in income taxes there is unanticipated disinflation and below full employment equilibrium real
GDP.
An increase in income taxes does not directly affect aggregate demand. But since disposable income falls, the level of
induced consumption falls and aggregate demand decreases.
In figure 2 workers and employers were expecting aggregate demand to increase from AD 0 to EAD1 and anticipated an
inflation rate of 4%. Because of the unexpected increase in income taxes, aggregate demand actually increases from AD 0 to
AD1, shifting the AD curve to the right by less than expected. The increase in the price level is less than expected and real
GDP falls. The economy is at short run equilibrium b in figure 2, with inflation at 3% and unemployment above the natural
rate. There is unanticipated slowdown in the rate of inflation  disinflation and below full employment equilibrium real
GDP.
1d. With an unexpected increase in investment demand there is unanticipated inflation and above full employment equilibrium
real GDP.
An unexpected increase in planned investment expenditure adds directly to aggregate demand.
In figure 1 workers and employers were expecting aggregate demand to increase from AD0 to EAD1 and anticipated an
inflation rate of 4%. Because of the unexpected increase in investment expenditure, aggregate demand actually increases
from AD0 to AD1, shifting the AD curve further to the right than expected. The increase in the price level is greater than
expected and real GDP increases. The economy is at short run equilibrium b in figure 1, with inflation at 8% and
unemployment below the natural rate. There is unanticipated inflation and above full employment equilibrium real GDP.
1e. With an unexpected increase in real wages there is unanticipated disinflation and below full employment equilibrium real
GDP.
Real wages will increase if nominal wages increase more than the price level. This happens if the actual increase in
aggregate demand is less than expected and there is lower than anticipated inflation. Real wages will unexpectedly increase.
In figure 2 workers and employers were expecting aggregate demand to increase from AD0 to EAD1 and anticipated an
inflation rate of 4%. Because employers and workers negotiated wage contracts based on the expected 4% inflation, nominal
wages increases exceeded the increase in the price level and real wages increased. The increase in the price level is less than
expected and real GDP decreases. The economy is at short run equilibrium b in figure 2, with inflation at 3% and
unemployment above the natural rate. There is unanticipated slowdown in the rate of inflation  disinflation and below full
employment equilibrium real GDP.
1f. With an unexpected increase in labour productivity there is unanticipated disinflation and above full employment
equilibrium real GDP.
An unexpected increase in labour productivity shifts the aggregate production function upwards, and shifts the LAS curve to
the right, shifting the SAS curve with it. Initially, the price level falls as aggregate supply and the level of real GDP
increases.
Inflation rate
Price level
Unexpected economic impacts – Problems 1&2
LAS
SAS1
•
108
•a
104
SAS0
b
/
AD1
8
•a
100
LRPC
•b
•a
4
EAD1
SRPC
AD0
Yf
Ye
Real GDP
Ue
Unemployment
U
Figure 1
LAS
SAS1
Inflation rate
Price level
Unexpected economic impacts – Problems 1&2
LRPC
SAS0
104
b
•
•a
/
•a
100
EAD1
4
•a
3
AD1
AD0
Yf
Ye
Real GDP
U
•b
SRPC
Ue Unemployment
Figure 2
with no change in the level of employment or real GDP
An increase in the money supply reduces the interest rate and increases interest rate sensitive components of aggregate
demand, particularly investment.
In figure 3 workers and employers were expecting aggregate demand to increase from AD 0 to EAD1 and anticipated an
inflation rate of 10%. Because aggregate demand increases from AD0 to AD1, as expected, the increase in the price level has
been anticipated and the economy stays at potential real GDP and full employment. The economy is at long run equilibrium
b in figure 3, with inflation at 10% and unemployment at the natural rate.
3b. With an expected increase in government expenditure there is anticipated inflation; prices rise with no change in the level of
employment or real GDP.
An increase in government expenditure on goods and services adds directly to aggregate demand.
In figure 3 workers and employers were expecting aggregate demand to increase from AD 0 to EAD1 and anticipated an
inflation rate of 10%. Because of the increase in government expenditure, aggregate demand increases from AD0 to AD1 as
expected, the increase in the price level has been anticipated and the economy stays at potential real GDP and full
employment. The economy is at long run equilibrium b in figure 3, with inflation at 10% and unemployment at the natural
rate.
3c. With an expected increase in income taxes there is anticipated disinflation; inflation slows with no change in the level of
employment or real GDP.
An increase in income taxes does not directly affect aggregate demand. But since disposable income falls, the level of
induced consumption falls and aggregate demand decreases.
In figure 4 workers and employers were expecting aggregate demand to increase from AD 0 to EAD1 and anticipated an
inflation rate of 1%. Because of the increase in income taxes, aggregate demand increases only to AD1 as expected; the
lower increase in the price level has been anticipated and the economy stays at potential real GDP and full employment. The
economy is at long run equilibrium b in figure 4, with inflation at 1% and unemployment at the natural rate.
3d. With an expected increase in investment demand there is anticipated inflation; prices rise with no change in the level of
employment or real GDP.
An expected increase in planned investment expenditure adds directly to aggregate demand.
In figure 3 workers and employers were expecting aggregate demand to increase from AD 0 to EAD1 and anticipated an
inflation rate of 10%. Because of the increase in investment expenditure, aggregate demand increases from AD0 to AD1 as
expected, the increase in the price level has been anticipated and the economy stays at potential real GDP and full
employment. The economy is at long run equilibrium b in figure 3, with inflation at 10% and unemployment at the natural
rate.
3e. If we are to assume that rational workers will not deliberately put themselves out of work an anticipated increase in the real
wage can only mean there was a correctly anticipated increase in productivity. The answer is the same as 3f below.
3f. With an expected increase in labour productivity there is an increase in real GDP, a fall in the natural rate of unemployment
and an no unexpected change in the price level.
In figure 5 workers and employers were expecting productivity increases and with the expected growth in aggregate demand
an anticipated inflation rate of 4%. The increase in labour productivity shifts the aggregate production function upwards, and
shifts the LAS curve to the right, from LAS0 to LAS1 in figure 5, shifting the SAS curve with it. Because there have been no
surprises, the supply and demand changes were as expected, the economy moves to the new higher potential real GDP and
the new lower natural rate of employment without adding to inflation. The economy is at long run equilibrium b in figure 5,
with inflation at the anticipated 4% and unemployment at the natural rate.
Inflation rate
Price level
Expected economic impacts – Problems 3&4
LAS
SAS1
110
•b
104
a/
SAS0
AD1=EAD1
100
LRPC
10
•b
SRPC0
•a
4
•a
SRPC0
AD0
Yf
Figure 3
Real GDP
U
Unemployment
LAS
SAS1
Inflation rate
Price level
Expected economic impacts – Problems 3&4
LRPC
SAS0
104
a/
101
100
• ba
•
4
•a
1
•b
AD1= EAD1
AD0
Real GDP
Yf
U
SRPC0
SRPC1
Unemployment
Figure 4
LAS0
Inflation rate
Price level
Expected economic impacts – Problems 3&4
LAS1
SAS1
LRPC1
LRPC0
SAS1
104
a/
100
•a
•b
AD1
4
•b
•a
SRPC1
SRPC0
AD0
Yf
/
Yf
Real GDP
U/
U
Unemployment
Figure 5
5a. The expected price level is 100 and expected real GDP is $600 billion.
The expected price level is determined when expected quantity demanded equals the expected quantity supplied point a in
figure 6. In this case, the expected price level is 100 and expected output is $600 billion.
5b. Actual price level is 110 and equilibrium real GDP is $650 billion.
The actual price level is determined when actual quantity demanded equals the quantity supplied, point b in figure 6. In this
case, when the price level is 110 and output is $650 billion.
5c. Nominal wages are sticky, because the economy is at an above full employment equilibrium.
If nominal wages are sticky the real wage can take time to adjust to the labour market equilibrium real wage. In this case the
real wage is below the equilibrium real wage and there is over full employment; the unemployment rate is below the natural
rate.
Price level
Price level
LAS
160
SAS0
140
120
Unanticipated inflation – Problem 6
LAS
160
•c
140
•a
120
•
•a
100
SAS1
SAS0
b
100
ADactual
ADexpected
ADactual
80
60
ADexpected
60
500
SAS1/
b
80
400
•
Unanticipated inflation – Problem 5
600
700
800
400
500
600
700
real GDP ($ billions)
800
real GDP ($ billions)
Figure 6
Figure 7
7a. If wages are fixed until 2003, the rational expectation of the price level for 2003 will be121.
The expected price level is determined when expected quantity demanded equals the expected quantity supplied, point a in
figure 8. When the quantity supplied is expected to be $590 billion the expected price level is 122. If nominal wages are
fixed the real wage will fall as the price level increases. In this case the real wage will be below the equilibrium real wage
and there is over full employment; the unemployment rate is below the natural rate.
7b. If wages will be renegotiated before 2003, the rational expectation of the price level will be 122.
If wages will be renegotiated before 2003, workers will account for the expected increase in prices and the SAS curve will
shift up to SAS03/ in figure 8.
Rational expectations – Problem 8
Price level
Price level
Rational expectations – Problem 7
LAS02/03
124
•
124
SAS03
123
•
122
b
c
/
SAS03
•
121
SAS04
LAS
125
a
SAS03
123
•
122
b
AD04
121
120
120
AD03
EAD03
119
570
580
590
570
600
580
590
Figure 8
600
610
real GDP ($ billions)
real GDP ($ billions)
Figure 9
9a. The LRPC and SRPC are shown in figure 10.
If the natural unemployment rate and the expected inflation rate have remained constant over this period the SRPC is linear
and passes through the data points listed in the table provided. The LRPC is vertical at the natural rate of unemployment rate
of 4 percent.
9b. The unemployment rate falls from 4 per cent to 3 per cent.
Since actual inflation rises by more than expected, real wages fall and the firm employs along its labour demand curve.
Employment and real GDP rise above the natural levels, and the unemployment rate falls. The economy will be at point b on
its short run Phillips curve.
9c. If actual and expected inflation are the same the rate of unemployment will be 5 per cent.
If the natural rate of unemployment rises to 5 per cent, the long-run Phillips curve shifts to the right to 5 per cent
unemployment and the short run Phillips curve shifts with it (see figure 10). If the actual level of inflation is equal to the
expected rate of inflation then the economy will be on its long run Phillips curve at point c and unemployment will be 5 per
cent, the natural rate.
For given inflationary expectations, changes in the natural rate of unemployment occur because of:
 A fall in labour productivity and a decrease in the demand for labour.
 A decrease in the supply of labour
9d. If actual and expected inflation are the same the rate of unemployment will be 4 per cent.
If the expected rate of inflation falls to 4 per cent the short run Phillips curve moves down to cross the long run Phillips
curve at 4 per cent inflation (see figure 10). If the actual level of inflation is equal to the expected rate of inflation then the
economy will be on its long run Phillips curve at point d and unemployment will be 4 per cent, the natural rate.
Inflation rate
Philips Curve – Problem 9
LRPC0
12
LRPC1
10
•b
8
6
•a
4
•d
•c
SRPC1
2
SRPC0
SRPC2
0
2
3
4
5
6
Unemployment rate
Figure 10