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Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2013
Problem Set #4 ANSWERS
Due: April 2, 2013 in class at 2:10 p.m.
(The grace period ends promptly at 2:20:01 p.m.)
Place your completed problem set in the box near the entrance.
Please sign the following oath:
The answers on this problem set are entirely my own work. I neither copied from the work of others nor allowed
others to copy from my work.
_______________________________________
Signature
Any problem set turned in without a signature will be assigned a grade of zero.
Problem Set Instructions
1.
You MUST complete your problem set on this template.
2.
Your answers to the multiple choice questions MUST be computer highlighted.
3.
Graphs and equations MAY be drawn by hand. When drawing diagrams, clearly and accurately label all axis,
lines, curves, and equilibrium points.
4.
Explanations MUST be word-processed. Your explanations should be succinct and to the point.
Problem Set #4 (Spring 2013)
1/5
A. Multiple Choice Questions (15 points). Computer highlight the best answer (3 points each).
1.
Rising inflation causes economic output to decline because:
a.
b.
c.
d.
e.
2.
If the inflation rate is fixed and autonomous net exports decrease, then:
a.
b.
c.
d.
e.
3.
d.
e.
Planned expenditures are greater than actual economic output so inflation will rise.
Planned expenditures are less than actual economic output so economic output will decline.
Planned expenditures equal actual economic output but inflation will decline and actual economic
output will rise.
The AD curve will shift to the right until planned expenditures are equal to actual economic
output.
The AD curve will shift to the left until planned expenditures are equal to actual economic output.
Suppose a new technology is developed that leads to an increase in total factor productivity. Then,
a.
b.
c.
d.
e.
5.
Investment spending would increase.
Government purchases would also decrease.
Consumption spending would also decrease.
All of the above.
None of the above.
Suppose the economy is in short-run equilibrium but the unemployment rate is above the natural rate of
unemployment. Then:
a.
b.
c.
4.
Rising inflation reduces real income, leading to a decline in consumption.
Rising inflation causes households and businesses to become more reluctant to spend.
Rising inflation prompts the central bank to increase the nominal interest rate by more than the
increase in expected inflation.
All of the above.
None of the above.
Inflation would immediately decline.
Inflation would be permanently lower.
Economic output would immediately increase.
Economic output would be permanently higher.
All of the above.
Suppose the aggregate demand curve is given by Y = 29.25 – 0.5π and the short-run aggregate supply
curve is given by π = 2.5 + 2(Y – 22). If current economic output is 25 and inflation expectations are
adaptive, then inflation in the next period will be:
a.
b.
c.
d.
e.
2.5
8.5
11.5
14.5
None of the above.
Problem Set #4 (Spring 2013)
2/5
B. Analytical Question (35 points). Answer the following question based on the standard models of analysis developed in class. The information in the various
parts of the question is sequential and cumulative.
1.
The Aggregate Demand and Aggregate Supply Model. Suppose that the economy is characterized by sticky wages and prices and there is a positive
unemployment gap.
a.
π
Based only on this information, use two aggregate demand and aggregate supply diagrams to clearly and accurately show the economy’s
initial economic output and inflation. These diagrams should be identical and drawn in BLACK.
π
Scenario #1: Fiscal Policy
Scenario #2: Monetary Policy
LRAS
LRAS
SRAS0(πe = π-1)
SRAS1(πe = π0)
SRAS0(πe = π-1)
SRAS1(πe = π0)
SRAS2(πe = π1)
SRAS2(πe = π1)
π0
π0
π1
π2
SRASN(πe = πN)
π1
π2
SRASN(πe = πN)
πN
πN
AD1
Y1 Y2 Y0
Problem Set #4 (Spring 2013)
YP = YN
AD0
AD0
Y
AD1
Y1 Y2 Y0
YP = YN
Y
3/5
b. Now suppose that in Year 1, the country decides that it wants to substantially reduce inflation and is
trying to decide between using fiscal policy or monetary policy. The magnitudes of these policies
would be chosen to have identical Year 1 effects on economic output. Based only on this additional
information, clearly and accurately show the Year 1 effects of a fiscal policy (in your diagram on
the left) and a monetary policy (in your diagram on the right) on (1) economic output and (2)
inflation. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to (1) economic output and (2) inflation and explain why these changes take
place.
In Year 0, both scenarios have the same starting point with economic output at Y0 and inflation
at π0. Because there is a positive unemployment gap in Year 0, actual economic output is below
potential economic output, i.e., Y0 < YP, while actual inflation, π0, is below expected inflation,
i.e., π0 < πe0 = π-1.
In Year 1, because expected inflation adjusts through a one-period adaptive process, expected
inflation declines to π0, i.e., πe1 = π0. This can be represented by downward shifts in the SRAS
curves from SRAS0(πe = π-1) to SRAS1(πe = π0) in both scenarios.
Each scenario needs to be considered separately
FISCAL POLICY: If the country decides to use fiscal policy to substantially reduce
inflation, it must adopt a contractionary fiscal policy, reducing government purchases
and/or increases taxes. Either policy will reduce planned expenditures at any given real
interest rate and also reduce aggregate demand at any given inflation rate. This can be
represented by a leftward shift of the IS curve and a leftward shift of the aggregate demand
curve from AD0 to AD1.
MONETARY POLICY: If the country decides to use monetary policy to substantially
reduce inflation, it must adopt a contractionary monetary policy, increasing the real
interest rate at any given inflation rate. This can be represented by an upward shift of the
MP curve and a leftward shift of the aggregate demand curve from AD0 to AD1.
[The leftward shift of the AD curve from the contractionary monetary policy is of
exactly the same magnitude as the leftward shift of the AD curve from the
contractionary fiscal policy.]
For both scenarios the leftward shifts of the aggregate demand curves from AD0 to AD1,
combined with the downward shifts of the SRAS curve from SRAS0(πe = π-1) to SRAS1(πe = π0),
actual inflation declines from π0 to π1. With lower inflation, the central bank reduces the real
interest rate according to the Taylor Principle. A lower real interest rate will increase planned
expenditures and aggregate demand endogenously so that the net effect is that economic output
declines from Y0 to Y1.
Once the Year 1 effects are complete, inflation has declined from π0 to π1 and economic output
has declined from Y0 to Y1 in both scenarios.
[It is possible for Y1 to be greater than Y0 but only if the effect of economic output is
greater from the shifts of the SRAS curves than from the shifts of the AD curves.]
Problem Set #4 (Spring 2013)
4/5
d. On your diagrams above, clearly and accurately show the Year 2 effects of (1) economic output and
(2) inflation. These effects should be drawn in BLUE.
e.
Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to (1) economic output and (2) inflation and explain why these changes take
place.
In both scenarios, at the end of Year 1, there is a negative output gap (and a positive
unemployment gap). As a consequence, actual inflation in Year 1, π1, is below expected inflation
in Year 1, πe1 = π0. Because there is a negative output gap (and a positive unemployment gap),
actual economic output in Year 1 is below potential economic output, i.e., Y1 < YP, while actual
inflation, π1, is below expected inflation, i.e., π1 < πe1 = π0.
In Year 2, because expected inflation adjusts through a one-period adaptive process, expected
inflation declines to π1, i.e., πe2 = π1. This can be represented by downward shifts in the SRAS
curves from SRAS1(πe = π0) to SRAS2(πe = π1) in both scenarios. Actual inflation declines from
π1 to π2, the result of both the changes in expected inflation and the negative output gaps.
With lower inflation, the central bank reduces the real interest rate according to the Taylor
Principle. A lower real interest rate will increase planned expenditures and aggregate demand
endogenously so that the net effect is that economic output increases from Y1 to Y2.
Once the Year 2 effects are complete, inflation has declined from π1 to π2 while economic output
has increased from Y1 to Y2 in both scenarios.
f.
On your diagrams above, clearly and accurately show the economy’s final general equilibrium for
(1) economic output and (2) inflation. These effects should be drawn in GREEN.
g.
For each of the following variables, indicate whether its value is higher with FISCAL POLICY,
with MONETARY POLICY, or it is THE SAME.
i. Economic output: THE SAME
ii. Inflation: THE SAME
iii. The real interest rate: MONETARY POLICY
iv. Consumption: FISCAL POLICY (if G was reduced); MONETARY POLICY (if T was
increased)
v. Investment: FISCAL POLICY
vi. Government purchases: THE SAME (if T was increased); MONETARY POLICY (if G
was reduced)
vii. Net exports: FISCAL POLICY
viii. Taxes: THE SAME (if G was reduced); FISCAL POLICY (if T was increased).
Problem Set #4 (Spring 2013)
5/5