Some Answers for Problem Set # 9

Chapter 10 – Analytical Problems 3. The temporary increase in government purchases causes an income effect that increases workers’ labor supply. This results in an increase in the full-employment level of output from FE1 to FE2 in Figure 10.10. The increase in government purchases also shifts the IS curve up and to the right from IS1 to IS2, as it reduces national saving. Assuming that the shift up of the IS curve is so large that it intersects the LM curve to the right of the FE line, the price level must rise to get back to equilibrium at full employment, by shifting the LM curve up and to the left from LM1 to LM2. The result is an increase in output and the real interest rate.

Figure 10.10

Figure 10.11 shows the impact on the labor market. Labor supply shifts from NS1 to NS2, leading to a decline in the real wage and a rise in employment. Average labor productivity declines, since employment rises while capital is fixed. Investment declines, since the real interest rate rises.

Figure 10.11

To summarize, in response to a temporary increase in government purchases, output, the real interest rate, the price level, and employment rise, while average labor productivity and investment decline. (a) The business cycle fact is that employment is procyclical. The model is consistent with this fact, since employment rises when government purchases rise, causing output to rise. (b) The business cycle fact is that the real wage is mildly procyclical. The model is inconsistent with this fact, since it shows a decline in the real wage when government purchases rise and output rises. (c) The business cycle fact is that average labor productivity is procyclical. The model is inconsistent with this fact, since it shows a decline in average labor productivity when government purchases rise and output rises. (d) The business cycle fact is that investment is procyclical. The model is not consistent with this fact, as investment falls when government purchases rise and output rises. (e) The business cycle fact is that the price level is procyclical. The model is consistent with this fact, as the price level rises when government purchases increase and output increases.

4. (a) An increase in expected future output increases money demand, so the LM curve shifts up and to the left. As shown in Figure 10.12, the LM curve shifts from LM1 to LM2. General equilibrium in the economy can be restored by shifting the LM curve from LM2 to LM3, which occurs as the price level declines

Figure 10.12

(b) If the Fed wants to stabilize the price level, then it increases the money supply in response to the increase in money demand, so that the LM curve shifts from LM2 to LM3 without a decline in the price level. This represents reverse causation, because the rise in future output causes the current money supply to increase. It might appear that the rise in the current money supply caused the rise in future output because of this timing, but in fact the reverse is true. Chapter 11 – Numerical Question

1. The following table shows the real wage (w), the effort level (E), and the effort per unit of real wages (E/w).

w E E/w 8 7 0.875 10 10 1.00 12 15 1.25 14 17 1.21 16 19 1.19 18 20 1.11

The firm will pay a wage of 12, since that wage provides the maximum effort per unit of the real wage (E/w  1.25). The firm will employ 88 workers, since that is the number of workers for which w  MPN. As long as the supply of labor exceeds the demand for labor, labor supply has no effect on the firm’s decision.

Chapter 11 – Analytical Questions 1. In Figures 11.15 and 11.16, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change.

Figure 11.15 Figure 11.16 (a) In Figure 11.15, the increase in tax incentives increases investment, shifting the IS curve up and to the right from IS1 to IS2 in Figure 11.15(a), and shifting the AD curve from AD1 to AD2 in Figure 11.15(b). The short-run equilibrium is at point B. Output increases, the real interest rate increases, employment increases, and the price level is unchanged. To restore long-run equilibrium, the price level rises, shifting the LM curve from LM1 to LM2 in Figure 11.15(a) and the short-run aggregate supply curve from SRAS1 to SRAS2 in Figure 11.15(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is higher, employment is the same, and the price level is higher. (b) In Figure 11.16, the increase in tax incentives increases saving—shifting the IS curve from IS1 to IS2 in Figure 11.16(a), and shifting the AD curve from AD1 to AD2 in Figure 11.16(b). The short- run equilibrium is at point B. Output decreases, the real interest rate decreases, employment decreases, and the price level is unchanged. To restore long-run equilibrium, the price level declines, shifting the LM curve from LM1 to LM2 in Figure 11.16(a) and the short-run aggregate supply curve from SRAS1 to SRAS2 in Figure 11.16(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is lower, employment is the same, and the price level is lower. (c) A wave of investor pessimism reduces investment. This shifts the IS curve down and to the left and the AD curve down and to the left, having the same result as in problem part (b). (d) An increase in consumer confidence increases consumption spending, shifting the IS curve up and to the right and the AD curve up and to the right, with the same result as in problem part (a).

2. In Figures 11.17–11.20, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change. (a) In Figure 11.17, when banks pay a higher interest rate on checking accounts, the demand for money rises, shifting the LM curve up and to the left from LM1 to LM2 in Figure 11.17(a). As a result, the AD curve shifts down and to the left from AD1 to AD2 in Figure 11.17(b). The new short-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment is lower, and the price level is unchanged. In the long run, the price level decreases to shift the LM curve from LM2 to LM3, which is the same as LM1, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts down from SRAS1 to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is lower. Figure 11.17 (b) In Figure 11.18, the introduction of credit cards reduces the demand for money—shifting the LM curve down and to the right from LM1 to LM2 in Figure 11.18(a). As a result, the AD curve shifts from AD1 to AD2 in Figure 11.18(b). The new short-run equilibrium occurs at point B, where output is higher, the real interest rate is lower, employment is higher, and the price level is unchanged. In the long run, the price level increases to shift the LM curve from LM2 to LM3, which is the same as LM1, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts up from SRAS1 to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is higher.

Figure 11.18

(c) In Figure 11.19, the reduction in agricultural output shifts the FE curve to the left from FE1 to FE2, and shifts the LRAS line from LRAS1 to LRAS2. The rise in agricultural prices increases the price level, so the short-run aggregate supply curve shifts up from SRAS1 to SRAS2. Also, the rise in the price level shifts the LM curve up and to the left from LM1 to LM2. The short-run equilibrium is at point B, assuming that the LM curve shifts so much that it intersects the IS curve to the left of the FE line. At point B, compared to the starting point, output is lower, the real interest rate is higher, employment is lower, and the price level is higher.

Figure 11.19

If the water shortage persists, a new long-run equilibrium occurs at point C. To get to this equilibrium, the price level must decline, shifting the LM curve from LM2 to LM3, and the short- run aggregate supply curve from SRAS2 to SRAS3. Relative to point B, the new equilibrium has a higher output level, a lower real interest rate, higher employment, and a lower price level. (Relative to the initial equilibrium at point A, output and employment are lower, and the real interest rate and the price level are higher.) When the water shortage is over, then the economy goes back to point A in the long run, with no permanent effects. (d) In Figure 11.20, the beneficial supply shock makes more production possible at full employment, so the FE line shifts to the right in Figure 11.20(a) from FE1 to FE2, and the LRAS line shifts from LRAS1 to LRAS2 in Figure 11.20(b). There is no immediate change in the price level, so the LM curve remains at LM1 and the short-run aggregate supply curve remains at SRAS1. The shift of the FE curve does not affect aggregate demand in the short run: output, the real interest rate, and the price level are all unchanged in the short run. The shift in the production function shifts the effective labor demand curve and reduces employment in the short run.

Figure 11.20 If the supply shock persists, prices will decline, so the LM curve will shift from LM1 to LM2 and the SRAS curve will shift from SRAS1 to SRAS2. As shown in the diagrams, the economy reaches a new equilibrium at point C, with a higher output level, a lower real interest rate, and a lower price level. When the supply shock disappears, the economy returns to its equilibrium at point A.

3. A lag in the impact of policy of six months, which is about the time it takes firms to adjust prices, could cause policy to be destabilizing. That is, monetary policy may be pushing the economy away from equilibrium. To see this, suppose the economy is in a recession at point A in Figure 11.21. The short-run aggregate supply curve SRAS1 intersects the aggregate demand curve AD1 at point A, to the left of the long-run aggregate supply curve LRAS. Suppose the Fed engages in expansionary monetary policy to try to shift the aggregate demand curve from AD1 to AD2 in six months, to push the economy to point B. But the recession leads firms to reduce their prices, dropping the SRAS curve from SRAS1 to SRAS2. In the absence of monetary policy action, the economy would get back to full employment because of the fall in the price level to point C. But the Fed action leads to a new equilibrium at point D. So the Fed causes the economy to overshoot the equilibrium point. The result may be to exaggerate the business cycle, pushing output too high in expansions. Then if the Fed responds to an expansion by using contractionary monetary policy, it may overshoot on the other side, causing a new recession.

Figure 11.21

If the Fed could forecast recessions well, it could stabilize the economy by using monetary policy appropriately before a recession begins. Or if the Fed’s policy takes effect before firms adjust prices, then it can also help stabilize output by shifting the AD curve before the SRAS curve shifts.