QUIZ 6: Fall 2015
Name: ______________________
Section Registered (circle one):
Tuesday a.m. Tuesday p.m. Wednesday a.m.
Mail Folder (circle one):
Campus Gleacher Exchange Other
Quiz assumptions (READ!): Use the models developed in class with our standard assumptions.
In particular, assume:







All consumers are non-liquidity constrained, non-Ricardian PIH (as developed in class)
NX = 0
Expected inflation has no effect on money demand
All changes are permanent and unexpected unless told otherwise
The economy is initially in long run equilibrium at Y*
No monetary or fiscal policy takes place unless I tell you otherwise
TFP, taxes, consumer confidence, value of leisure, population, government spending, and the
nominal money supply do not change unless I tell you they change
Question 1 (14 points – 2 point each)
Given the model developed in class, which of the following are unambiguously true about a
permanent increase in oil prices? For simplicity, assume no income effect on labor supply.
Lastly, assume conditions are such that prices rise in the short run.
a. Output will unambiguously fall in both the short run (relative to the initial position) and the
long run (relative to the initial position).
T – Y* will fall as quantity of oil used in production falls and N* falls. Y in the short
run will fall as AD shifts in (as C and I(.) fall) and SRAS shifts in (as oil prices rise).
Both shifts will make Y fall. Where Y in the short run is relative to the new Y* is
ambiguous (see the answer to (b) and (c)).
b. Prices will unambiguously rise in the long run (relative to initial position).
False. The effect on prices in the long run is ambiguous because we do not know where
Y (short run) is relative to the new Y*. You should be able to see this in the labor
market. In the labor market, the labor demand curve shifts in and we will be on a new
labor demand curve. We know unambiguously that W/P will fall in the long run. In
the short run, W is fixed and P increased. So, in the short run, we know that W/P will
fall. By how much will it fall? We do not know. If it falls a little, N (short run) < N*
(new). In this case , Y(short run) will be lower than new Y*. This means that nominal
wages will fall between short run and long run (shifting in the SRAS and putting
downward pressure on wages between short run and long run). In this case, prices in
long run (relative to initial position) would be ambiguous. You would be able to graph
that out.
If real wages fall a lot in the short run (because P increases a lot in the short run), N
(short run) could be HIGHER than new N*. In this case, Y (short run) > new Y*. This
means that nominal wages will increase in the short run. This will further shift out
SRAS and cause Prices to increase further between short run and long run. In this case,
prices in the long run (relative to the initial position) would be unambiguously higher.
You should be able to graph this out.
In this case, with prices increasing in the short run, the effect of prices in the long run
are ambiguous.
c. Output in the short run (relative to the initial position) will be unambiguously lower than
output in the long run (relative to the initial position).
False – see above. Where Y is in the short run relative to the new Y* is ambiguous. It
depends on where N in the short run is relative to the new N*. Given that P increased,
W/P falls in the short run. We just don’t know how far W/P fell.
d. Both the money supply curve and the LM curve will unambiguously shift left in the short run.
True. Both are a function of P. P in the short run increased. This reduces M/P. A fall
in M/P will shift both money supply curve and LM curve to the right.
e. Nominal wages will unambiguously fall between the short run and the long run.
False. See above.
f.
Real wages will unambiguously fall in both the short run (relative to the initial position) and
the long run (relative to the initial position).
True. Given P goes up and W is fixed in the short run, W/P falls in the short run. We
also know from our labor market analysis that W/P falls in the long run (relative to
initial position). We don’t know where W/P (short run) is relative to new W/P (in long
run). But, we know they are both lower than the original W/P. You should be able to
graph this out with your knowledge of the labor market.
g. The IS curve and the AD curve will unambiguously be shifted to the right in both the short
run (relative to their initial position) and the long run (relative to their initial position).
False. Both C(.) and I(.) fall and that shifts both IS and AD left in the short run. They
stay there between short run and long run. All the action to get back to Y* with the self
correcting mechanism is from adjustments to SRAS and LM.
Question 2 (3 points)
Explain how changes in expected inflation can cause changes in actual inflation. Be specific by
referring to our model to the extent possible. Keep your answer to no more than 4 well-constructed
sentences.
Inflation expectations can be self-fulfilling because of the existence of the large amount of
forward looking contracts made within an economy. Wage contracts, loan contracts and
supply contracts between firms all have payouts made in the future. The inflation rate between
now and the future affects the real value of those payouts. If individuals expect inflation in the
future, they will increase nominal wages today, nominal interest rates today, and nominal
supply contracts today to stave off the expected inflation eroding away the value of those
payments. In our model, if input prices increase, the SRAS (short run aggregate supply curve)
will shift to the left actually causing inflation. If the Fed accommodates the inflation (by
increasing M) to keep us out of a recession, it only serves to further fuel our inflation
expectations.
Question 3 (3 points)
Suppose you are the manager of a large firm that operates within the United States. Suppose that I
told you that the U.S. inflation rate unexpectedly increased. Given this information, would you
increase, decrease or keep the same the (nominal) wages of your workers? Explain your answer
(briefly) – no more than 4 well-constructed sentences.
Write down something to this question. This was a real question on a survey of managers in New
Zealand (they were asked about New Zealand inflation). Everyone is going to get full credit for this
question (conditional on providing an answer). I just want to see how people answer this question.
Here is the background on this question. My friend (a Professor at Berkeley) ran a survey of
New Zealand managers to ask them about their expectations of inflation ((1) what was inflation
last year, (2) what do you expect inflation to be next year, (3) if there was inflation, how would
they adjust wages, etc.). He presented the paper at Booth last week. I told him I thought the
last question was crazy in that I am not sure I would have enough information to answer that
question.
In his mind, he was thinking they should respond by saying that nominal wages should increase.
(He didn’t use the word nominal – but, implied it in the exact wording of his question). In our
model, nominal wages should increase if N > N* or if we expect inflation to be high in the future
(raising our input costs). N > N* if there are demand shocks and wages are sticky in the short
run or if there are supply shocks and prices are fixed or rise in the short run.
However, if N < N*, nominal wages may FALL even if inflation is high today – like in periods of
stagflation. So, if people think the high inflation is associated with stagflation (from like an oil
price shock where prices increase in the short run), actual nominal wages could fall in the short
run.
Now, if the expected inflation is large enough – that may overwhelm that effect – but that is not
a given.
I think the answer to this question is more nuanced and there was not enough
information to provide an accurate answer. He thinks I am overacting that that people will
think about the expected inflation effect and that would cause nominal wages to increase.
I told him that I would ask you guys and see what you were thinking. You are likely to be much
closer to the managers that he is sampling than either him or I.