Name: _________________________
(Last name, first name)
SID: _________________________
GSI: _________________________
Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2013
Problem Set #5 ANSWERS
Due: April 23, 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 #5 (Spring 2013)
1/5
A. Multiple Choice Questions (15 points). Computer highlight the best answer (3 points each).
1.
Suppose that inflation is at the target rate but output has fallen substantially below potential output. A
central bank with a primary objective of price stability should:
a.
b.
c.
d.
e.
2.
Which shocks to the macroeconomy cause a change in the equilibrium real interest rate:
a.
b.
c.
d.
e.
f.
3.
4.5%
5.5%
6.5%
7.0%
7.5%
The government budget constraint says that:
a.
b.
c.
d.
5.
Only permanent supply shocks.
Only temporary supply shocks.
Only aggregate demand shocks.
Aggregate demand, temporary supply, and permanent supply shocks.
Aggregate demand and permanent supply shocks but not temporary supply shocks.
Aggregate demand and temporary supply shocks but not permanent supply shocks.
Suppose that the central bank has a target inflation rate of 2% but that the current inflation rate is 3% and
there is an output gap is 2%. According to the Taylor rule, the nominal federal funds rate should be:
a.
b.
c.
d.
e.
4.
Ease monetary policy to avoid a decrease in the inflation rate.
Ease monetary policy to prevent an increase in the inflation rate.
Tighten monetary policy to avoid a decrease in the inflation rate.
Tighten monetary policy to prevent an increase in the inflation rate.
Do nothing because inflation cannot rise when unemployment is high.
Increases in spending must be matched by increases in revenue.
State and local governments, in the aggregate, cannot spend more than the federal government.
Interest on government debt must be paid before government revenues are spent on goods and
services or transfer payments.
The difference between government spending and revenues must equal new government
borrowing plus new money creation.
According to Ricardian Equivalence, a long-run impact on the economy will occur when the government:
a.
b.
c.
d.
e.
Raises taxes.
Lowers taxes.
Issues more government bonds.
Increases spending on capital goods.
None of the above.
Problem Set #5 (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, which is characterized by sticky wages and prices, is initially in
general equilibrium.
a.
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
π
LRAS0
LRAS0
SRAS0(πe = π0)
SRAS2(πe = π1)
SRAS0(πe = π0)
SRAS1(πe = π0)
πN = π2 = π1
= π0 = πT
π0
SRAS1(πe = π0)
=
SRAS2(πe = π1)
πN = π2 = π1
AD0 = AD2
Y0 = YP = Y2 = YN
Problem Set #5 (Spring 2013)
Y1
Y
AD1
AD0
AD1
Y0 = YP = Y1 = Y2 = YN
Y
3/5
b. Now suppose that in Year 1, there is a sharp decline in oil prices. The country’s policymakers are
trying to decide whether they should use monetary policy to stabilize inflation (at its initial general
equilibrium rate) or to stabilize unemployment (at the natural rate of unemployment). Based only on
this additional information, clearly and accurately show the Year 1 effects of stabilizing inflation (in
your diagram on the left) and stabilizing unemployment (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 both scenarios, the sharp decline in oil prices in Year 1 is a positive short-run supply shock.
This can be represented by a downward shift of the short-run aggregate supply curve from
SRAS0(πe = π0) to SRAS1(πe = π0). By itself, this would reduce inflation and increase economic
output (and lower the unemployment rate).
When the central bank uses monetary policy to stabilize inflation, they need to engage in an
expansionary monetary policy in Year 1. This can be represented by a rightward shift of the
aggregate demand curve from AD0 to AD1. As a result of this policy, economic output has
increased from Y0 to Y1 while inflation has remained at π0 = πT, i.e., π1 = π0 = πT.
When the central bank uses monetary policy to stabilize unemployment at the natural rate of
unemployment, they need to engage in a contractionary monetary policy in Year 1. This can be
represented by a leftward shift of the aggregate demand curve from AD0 to AD1. As a result of
this policy, economic output has remained at Y0 = YP, i.e., Y1 = Y0 = YP while inflation has
declined from π0 to π1.
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.
When the central bank is stabilizing inflation, then in Year 2 expected inflation, which is formed
by a one-period (year) adaptive process, remains at π1 = π0 = πT. Although expected inflation has
not changed, there is a positive output gap that increases inflation. This can be represented by
an upward shift of the short-run aggregate supply curve from SRAS1(πe = π0) to SRAS2(πe = π1)
= SRAS0(πe = π0). In order to stabilize inflation at its target level, the central bank needs to
engages in a contractionary monetary policy. This can be represented by a leftward shift of the
aggregate demand curve from AD1 to AD2 = AD0. As a result of these changes, economic output
has declined from Y1 to Y2 = YP while inflation has remained at πT, i.e., π2 = πT. The economy is
now in long-run equilibrium.
When the central bank is stabilizing unemployment, then in Year 2 expected inflation, which is
formed by a one-period (year) adaptive process, declines from π0 to π1. With expected inflation
now at π1 and no output gap, actual inflation in Year 2 is also at π1, i.e., π2 = π1 while economic
output is at its potential level, i.e., Y2 = YP. The economy is now in long-run equilibrium.
Problem Set #5 (Spring 2013)
4/5
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 by stabilizing INFLATION,
by stabilizing UNEMPLOYMENT, or whether it is THE SAME once final general equilibrium is
achieved.
i. Economic output: THE SAME
ii. Inflation: INFLATION
iii. The real interest rate: THE SAME
iv. The equilibrium real interest rate: THE SAME
v. Investment: THE SAME
Problem Set #5 (Spring 2013)
5/5