Homework 4
Economics 503
Foundations of Economic Analysis
Assigned: Week 4
Due: Week 5
1.
Using aggregate demand, short-run aggregate supply and long-run aggregate
supply curves, explain the process by which each of the following economic events will
move the economy from one long-run macroeconomic equilibrium to another. Illustrate
with diagrams. In each case, what are the short-run and long-run effects on the aggregate
price level and aggregate output?
a. There is a decrease in households’ wealth due to a decline in the stock market.
The model starts at point 1. Household consumption drops as wealth declines. This
decreases spending at any given price level (the AD curve shifts in) and reduces the
prices they are willing to pay for goods. The falling price level along with given
wages raises the costs of hiring workers and output declines in equilibrium.
Equilibrium price and output drop to point 2. The falling price level combined with
fixed wages will raise the relative or real wage as the economy goes into a recession.
The relatively low demand for labor in the recession will put downward pressure on
the nominal wage rate. The falling cost of production reduces the prices that firms
demand for their production (i.e the SRAS curve shifts down). Wages will fall until the
labor market equilibrium return relative wages to their long-term levels. The new
long run equilibrium will be at point 3.
SRAS
LRAS
P
SRAS´
1
2
3
AD
AD´
Y
YP
b. The government lowers taxes, leaving households with more disposable income,
with no corresponding reduction in government purchases.
The economy begins at point 1. When households have more disposable income, they
increase spending. This shifts out demand for goods and increases the prices they are
willing to pay for goods. The higher prices of goods reduce the cost of labor. Falling
real wages induce firms to increase production. The new equilibrium is at point 2.
When firms are producing a lot of output, labor demand is high. Wages feel upward
pressure, raising costs. The costs of production are passed along to customers which
in turn reduces equilibrium demand. Eventually, wages rise far enough that the
excess demand for labor is in equilibrium and real wages return to their equilibrium
level and the economy returns to potential output at point 3.
LRAS
P
SRAS
3
2
SRAS´
1
AD´
AD
Y
YP
2.
Consider again the case (b) from the above problem, when the government lowers
taxes. Focus on how event (b) will change money market interest rates and the forex rate.
a. Draw a graph of the money market and show what would happen to money
market interest rates after event (1b) if the central bank left the money supply
unchanged. (Hint: After event (1b), GDP will change. How will this change affect
money demand?).
Money Market: In the short-run, prices and output increase which increases the money
value of transactions which means people will have to hold more liquidity. Liquidity
tightens and the interest rates that banks must offer to raise liquidity rises.
Money
Supply
i
Y↑
2
1
Money
Demand´
Money
Demand
M
b. Demonstrate the impact of the changes in the interest rate (described in 2.a.)
caused by monetary policy on the foreign exchange market. Would the spot
exchange rate appreciate or depreciate?
Foreign Exchange Rate: The higher interest rate in domestic markets encourages
domestic investors to keep their money at home. The domestic demand for foreign
exchange drops. At the same time, the domestic market attracts funds from overseas
increasing the supply of foreign currency. The excess supply conditions of forex reduces
the price of domestic currency and the domestic currency appreciates.
S
Supply
Supply′
1
Demand
2
Demand′
Forex
3.
In 2005, a hurricane hit New Orleans, Louisiana, an important transportation and
oil refining center in the USA, one of Hong Kong’s key for the petrochemical industry in
that country. Consider the impact of the recent hurricanes that devastated that city as a
temporary supply shock for the USA.
a. Discuss briefly, using one graph, the outcomes that we would have been likely
to see in terms of goods markets in the USA as a result of this negative
business cycle shock.
With the refineries knocked out, the price of oil would rise. With firms energy
costs rising, the price level charged by firms at every level of production would
rise. The rising price levels would dampen consumption and hurt export
competiveness and the equilibrium quantity would fall and prices rise.
SRAS
P
2
SRAS´
1
AD
Y
b. Analysts are also worried that the natural disaster might have had a negative
impact on consumer confidence. Discuss briefly, using one graph, the
differences in outcomes that we would observe if this demand side effect were
stronger from the outcomes that we would observe if the supply side effects
were dominant.
c.
YP
P
SRAS
1
P**
2
AD
´
AD
Y
A decline in consumer confidence would reduce the demand for consumer goods
at any level of prices. This would shrink demand at any price level. If this effect
were dominant the price level would fall.