Name: _________________________
(Last name, first name)
SID: _________________________
GSI: _________________________
Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2012
Problem Set #2 ANSWERS
Due: February 14, 2012 (in class before 3:50:01 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.
Graphs and equations MAY be drawn by hand. When drawing diagrams, clearly and accurately label all axis,
lines, curves, and equilibrium points.
3.
Explanations MUST be word-processed. Your explanations should be succinct and to the point.
Problem Set #2 (Spring 2012)
1/6
A. Multiple Choice Questions (15 points). Circle the letter corresponding to the best answer (3 points each).
1.
In the second half of the 1990’s, the U.S. experienced a stock market boom. As a result, we would expect that:
a.
b.
c.
d.
e.
2.
Suppose that the central bank decides to increase the parameter λ in the MP curve. This is an example of:
a.
b.
c.
d.
3.
0.2 percent.
1 percent.
3 percent.
5 percent.
According to the "self-correcting mechanism" within the AD-AS model framework:
a.
b.
c.
d.
e.
5.
Autonomous monetary policy easing.
Autonomous monetary policy tightening.
Leftward movement along the MP curve.
Rightward movement along the MP curve.
Given the accelerationist Phillips curve, ∆π = -0.3(U - 6) + ρ, if inflation in the preceding period was 3 percent,
unemployment is 6 percent, and there is a price shock of 2 percent then the current inflation rate is:
a.
b.
c.
d.
4.
Autonomous consumption would increase because stockholders would feel wealthier.
Autonomous investment would increase because firms would find it less expensive to raise additional
funds for investment purposes.
Inflation would increase.
All of the above.
None of the above.
The aggregate demand curve shifts as needed to bring the economy to full employment.
Inflation changes as needed to move the economy along the short-run aggregate supply curve until
potential output is achieved.
The long-run aggregate supply curve shifts until it intersects both the aggregate demand and short-run
aggregate supply curves in general equilibrium.
All of the above.
None of the above.
Suppose that the economy is initially in general equilibrium. What would happen if there was some event that
caused the natural rate of unemployment to increase?
a.
b.
c.
d.
e.
According to the Phillips curve, the ensuing negative unemployment gap would exert inflationary
pressures.
According to Okun's Law, the ensuing negative unemployment gap would be consistent with a
positive output gap.
According to the AD-AS framework, the LRAS curve would shift to the left and the ensuing positive
output gap would be closed by subsequent leftward shifts in the SRAS curve, leading to higher
equilibrium inflation.
All of the above.
None of the above.
Problem Set #2 (Spring 2012)
2/6
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 IS, MP, and AD-AS Models. In 2007 the U.S. economy was at its full-employment level of output with
moderate inflation. The U.S. economy is characterized by sticky wages and prices.
a.
r
IS1
Based only on this information, use an IS diagram (on the left), a MP diagram (on the right), and an
AD-AS diagram (on the bottom) to clearly and accurately show the economy’s initial levels of
economic output, inflation, and the real interest rate. These diagrams should be drawn in BLACK.
r
IS0
IS2
MP0
r0
r1
r2
r0
r1
r2
rX
rX
Y2 Y1
π
Y0
Y
πX
π
π2 π1 π0
LRAS0
SRAS0 (πe = π0); SRAS1 (πe = π0)
SRAS2 (πe = π1)
π0
π1
π2
SRASx (πe = πx)
πx
AD2
Y2 Y1 Y0 = YP
YX = YP
Problem Set #2 (Spring 2012)
AD1
AD0
Y
3/6
b. Provide an economic explanation of what you have shown in your diagrams above.
Because the economy was initially at is full-employment level of output, the economy is in
general equilibrium with economic output at Y0 = YP and with inflation at π0. With inflation at
π0 implies that the real interest rate is at r0.
c.
In 2008, the bursting of the housing bubble caused housing construction to collapse. Incorporating
only this additional information, clearly and accurately show in your diagrams above what effects
this would have on economic output, inflation, and the real interest rate. These effects should be
drawn in RED.
d. Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to economic output, inflation, and the real interest rate. Be sure to explain why this takes
place.
The bursting of the housing bubble in 2008 that caused housing construction to collapse is a
decline in autonomous investment. This is the exogenous shock to the economy and can be
represented by a leftward shift of the IS curve from IS0 to IS1 (in the IS diagram) and a leftward
shift of the AD curve from AD0 to AD1 (in the AD – AS diagram).
In the AD – AS diagram, the decline in aggregate demand causes economic output to
fall from Y0 to Y1. Because inflation expectations are based on a simple, one-period
adaptive formula, there has been no change in inflation expectations and, therefore, no
shift in the SRAS curve, i.e., SRAS0(πe = π0) = SRAS1(πe = π0). Because wages and prices
are sticky, inflation declines from π0 to π1 along the SRAS curve.
As a result of the decline in inflation from π0 to π1, the real interest rate has declined
from r0 to r1 along the MP curve, i.e., the central bank has reduced the real interest rate
endogenously because of lower inflation.
Finally, the leftward shift in the IS curve from IS0 to IS1 results in a decline in economic
output from Y0 to Y1 although this reduction is tempered by the decline in the real
interest rate from r0 to r1. Economic output of Y2 in the IS diagram is consistent with
economic output of Y2 in the AD – AS diagram.
The net result in 2008 from the collapse in housing construction is that economic output has
fallen from Y0 to Y1, inflation has declined from π0 to π1, and the real interest rate has dropped
from r0 to r1. The economy is now in a short-term equilibrium but is not in general equilibrium.
Problem Set #2 (Spring 2012)
4/6
e.
In 2009, in response to the bursting of the housing bubble, financial institutions sharply tightened their
credit standards, requiring potential borrowers to provide much more loan collateral and to have
significantly higher income-to-loan ratios than before. As a result, bank lending fell sharply.
Incorporating only this additional information, clearly and accurately show in your diagrams above
what effects this would have on economic output, inflation, and the real interest rate. These effects
should be drawn in BLUE.
f.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to economic output, inflation, and the real interest rate. Be sure to explain why this takes
place.
The bursting of the housing bubble that caused financial institutions to sharply tighten their
credit standards in 2009 would result in a decline in autonomous consumption and autonomous
investment. If financial institutions sharply reduce their lending, then the private sector will
have to sharply reduce their borrowing and spending. This is the exogenous shock to the
economy and can be represented by a leftward shift of the IS curve from IS1 to IS2 (in the IS
diagram) and a leftward shift of the AD curve from AD1 to AD2 (in the AD – AS diagram).
[The central bank has not changed the real interest rate; therefore, this is not represented by a
shift in the MP curve.]
In the AD – AS diagram, actual inflation is now below expected inflation, i.e., πe = π0 <
π1. With a simple, one-period adaptive expectations formula, inflation expectations
decline from πe = π0 to πe = π1, causing the SRAS to shift down from SRAS1(πe = π0) to
SRAS2(πe = π1).
In addition, the decline in aggregate demand causes economic output to fall
from Y1 to Y2. Because wages and prices are sticky, inflation declines from π1
to π2 along the SRAS curve SRAS2(πe = π1).
As a result of the decline in inflation from π1 to π2, the real interest rate has declined
from r1 to r2 along the MP curve, i.e., the central bank has reduced the real interest rate
endogenously because of lower inflation.
Finally, the leftward shift in the IS curve from IS1 to IS2 results in a decline in economic
output from Y1 to Y2 although this reduction is tempered by the decline in the real
interest rate from r1 to r2. Economic output of Y2 in the IS diagram is consistent with
economic output of Y2 in the AD – AS diagram.
The net result in 2009 from the sharp reduction in bank lending is that economic output has
fallen from Y1 to Y2, inflation has declined from π1 to π2, and the real interest rate has dropped
from r1 to r2. The economy is in a new short-term equilibrium but is still not in general
equilibrium.
Problem Set #2 (Spring 2012)
5/6
g.
On your diagrams above, clearly and accurately show the final (long-run general) equilibrium
assuming there are no other exogenous shocks to the economy. These changes should be shown in
GREEN.
h. Discuss what happens to economic output, inflation, and the real interest rate during the economy’s
adjustment to its final (long-run general) equilibrium. Be sure to explain why this takes place.
The economy is now in a short-run equilibrium with a negative output gap. Because of the
negative output gap, actual inflation will be below expected inflation. With inflation
expectations being determined by a simple, one-period adaptive process, inflation expectation
will decline each year that there is a negative output gap. This causes the SRAS curve to
continually shift down, reducing actual inflation further.
As actual inflation declines with each downward shift of the SRAS curve, the real interest rate
will decline along the MP curve. These declines in the real interest rate will increase bank
lending and consumer and business borrowing and spending along the IS and AD curves,
resulting in higher economic output.
This process continues until the economy has re-attained its full-employment output level at YP.
Once general equilibrium is reached, economic output will be at the economy’s potential output
level, i.e., YX = YP, inflation will have been permanently reduced to πX < π0, and the real interest
rate will have been permanently reduced to rX < r0.
Problem Set #2 (Spring 2012)
6/6