QUIZ 6: Fall 2014
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Quiz assumptions (READ!): Use the models developed in class with our standard assumptions.
In particular, assume:
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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 (10 points – 2 point each)
Given the model developed in class, which of the following are unambiguously true about a
permanent decline in oil prices? Circle all the true statements. Throughout, for simplicity,
assume there are no income effects on labor supply.
Note: When the Fed is involved, assume they have a goal of keeping Y close to Y*. As always,
assume the Fed policy occurs after the economy gets to its short run equilibrium.
In our economy, oil is a major input in production. We treat a decrease in oil prices as a
positive technology shock (like an increase in TFP).
In the labor market, the labor demand curve will shift out. Why? We know MPN will increase
as oil prices decrease. As the labor demand curve shifts out, N* increases and W/P* increases
(increasing PVLR). We told you in the assumptions that there are no income effects on labor
supply. Thus, the labor supply curve does not shift as PVLR increases.
In the short run, workers are temporarily off their labor supply curve on the new labor demand
curve at point b where N is above N*.
a
b
Nd1
Ns0
Nd0
N0* N1* N
Because oil prices decrease (like an increase in A) and N* increases, we unambiguously know
that the LRAS curve shifts out, setting a new long-run equilibrium at Y1*. As the price of oil
decreases, the cost of production falls shifting out the SRAS curve.
In the assumptions, we told you that consumers are non-liquidity constrained PIH. Thus, as
PVLR increases, consumption (C) increases. In the IS-LM market, the IS curve shifts out
increasing Y and causing r to increase. In the AS-AD market, the AD curve shifts out,
increasing Y above Y*.
a. Suppose prices are fixed in the short run. Suppose the economy returns to long run
equilibrium (Y returns to the new Y*) via the self-correcting mechanism. Between the short
run and the long run, nominal wages (W) will increase and the money demand curve will
shift in.
TRUE. Above, we established that in the short run workers are temporarily off their labor
supply curve at N above N*. We also established that in the short run, the AD curve and IS
curves have shifted out so Y is above Y*. Through the self-correcting mechanism, W increases
(we walk up the labor demand curve). As W increases, the cost of production increases, so
SRAS will shift in until Y = the new Y*. As Y falls, money demand must shift in.
b. Suppose prices are fixed in the short run. Suppose the economy returns to long run
equilibrium (Y returns to the new Y*) via Fed policy. Between the short run and the long
run, the labor demand curve (Nd) will shift in and investment (I) will fall.
FALSE. Fed policy will lower the money supply (M) shifting in the AD curve bringing Y back
to Y*. In the IS-LM market, the LM curve shifts in as M falls bringing Y back to Y* and
increasing r. As r increases, I falls. The labor demand curve is not affected by M, prices, or
interest rates!
c. Suppose prices fall in the short run. Suppose the economy returns to long run equilibrium (Y
returns to the new Y*) via the self-correcting mechanism. Between the initial condition and
the long run, consumption (C) will increase and the aggregate demand (AD) curve will be
shifted right.
TRUE. Note: Unlike a or b, in this example, we allow prices to change. If prices fall in the short
run, we know the magnitude of the shift out of the SRAS curve (it shifts out because production
becomes more efficient as technology improves) must be greater than the magnitude of the shift
out of the AD curve (which shifts out from the increase in consumption). Y may or may not be
below Y* in the short run (it depends on how much prices fall and W/P increases. If W/P
increases a lot in the short run, N can actual fall below the new N*.). In order for the economy
to return to Y* and for N to return to N*, W must fall. We know the new W/P* will be above
the old W/P* which means PVLR will increase. As PVLR increases, C will increase in the short
run and stay increased in the long run. Between the initial condition and the long run the AD
curve will remain shifted out as it is shifted out from the increase in C and the increase in I(.)
and the self-correcting mechanism will affect the SRAS not the AD curve.
d. Suppose price rise in the short run. Suppose the economy returns to long run equilibrium (Y
returns to the new Y*) via Fed policy. Output (Y) will fall between the short run and the
long run and prices will fall between the short run and the long run.
TRUE. If prices rise in the short run, we should assume the magnitude of the shift out of the AD
curve will be greater than the magnitude of the shift out of the SRAS curve. Y will be above Y*
(as W/P falls in the sort urn) and N will be above N*. Fed policy will reduce M, shifting in the
AD curve which will cause P to fall and Y to fall (returning to the new Y*).
e. Suppose prices rise in the short run. Suppose the economy returns to long run equilibrium
(Y returns to the new Y*) via the self-correction mechanism. Between the initial condition
and the long run, the IS curve will be shifted right and the LM curve will be shifted left.
TRUE. If prices rise in the short run, we should assume the magnitude of the shift out of the AD
curve will be greater than the magnitude of the shift out of the SRAS curve. Y will be above Y*
and N will be above N*. The IS curve will be shifted out initially from the increase in C (as
PVLR increases). As the economy returns to equilibrium through the self-correcting
mechanism, we know the self-correcting mechanism affects the LM curve in the IS-LM
market—not the IS curve. So the IS curve remains shifted out. The self-correcting mechanism
will cause wages to increase to get the labor market back to the new N*. The increase in wages
will shift back the SRAS curve as production becomes more expensive which will put upward
pressure on prices. As prices increase, the LM curve will shift left which will cause Y to fall.
Question 2 (10 points – 2 point each)
Which of the following are unambiguously true about a permanent increase in labor income
taxes (tn)? Assume the self correcting mechanism returns the economy to its potential level.
Finally, assume the income effect on labor supply is greater than the substitution effect on labor
supply. Circle all true answers.
As labor income taxes increase, after-tax wages fall (that is the policy). The income effect tells
us that as after-tax wages fall, workers work more shifting out the labor supply curve. The
substitution effect tells us as after-tax wages fall, workers want to take more leisure, shifting in
the labor supply curve. We told you in the assumptions that the income effect was greater. On
net, the labor supply curve shifts right, setting a new N1* above N0*.
As N* increases, the LRAS curve shifts right, setting a new Y1* above Y0*.
As after-tax wages permanently fall, PVLR decreases. Thus, consumption must fall. This shifts
in the AD and IS curves and Y falls below Y*. As the AD curve shifts in, prices fall. As prices
fall, the LM curve shifts out. As the IS curve shifts in, interest rates fall increasing I in the short
run.
In the short run in the labor market, as P decreases, W/P increases and workers are
temporarily off their labor supply curve.
The self-correcting mechanism causes W to fall until W/P equals W/P1*and N = N1*. As W falls,
the SRAS curve shifts out until Y=Y1* causing P to fall. As P falls, the LM curve shifts out until
Y=Y1*.
a. The labor supply curve (Ns) will shift right (on net) between the initial condition and the short
run.
TRUE. The labor supply curve shifts right (we told you the income effect dominates). This
occurs immediately - even if we are not on our labor supply curve in the short run.
b. The absolute value change in investment (I) between the initial condition and the long run
will exceed the absolute value change in consumption (C) between the initial condition and
the long run.
TRUE. This must be true for the self-correcting mechanism to return the economy to the new
Y*. The new Y* is higher than the old one.
c. The money demand curve (Md) will shift left between the initial condition and the short run.
TRUE. As consumption falls and Y falls, the money demand curve shifts in.
d. The labor demand curve (Nd) will shift left between the initial condition and the short run.
FALSE. Nothing happens to the labor demand curve.
e. Before tax real wages (W/P) will increase between the initial condition and the short run.
TRUE. As the AD curve shifts in, prices fall causing W/P to increase between the initial
condition and the short run.