** **

** Part 1.True/False/Uncertain.Explain your
answer carefully. (12 points ,3 points each.)**

1. The Natural Rate of Unemployment is
fixed and cannot be changed.

False. The natural rate of unemployment depends on
labour market institutions (captured in z) and the markup rate, both of which
may change.

2. If the price level rises more than
expected, workers receive lower

real wages than they expected to have.

True. Real wages are W/P. If the denominator is larger than expected,
the real wage is lower than expected.

3. The unemployment rate is the percentage
of adults without a job and

thus is the best indicator of available
workers in the economy.

False. It is the percentage of people in the labour
force without a job. It may not be the
best indicator of available workers since it does not count discouraged workers
(the unemployed who want to work, but are not actively looking for a job and so
are not included in the labour force).

4. In the absence of fiscal or monetary
policy changes, the economy

will always remain at the natural level of
output.

False. Due to shocks (e.g. the oil price shocks of
the 1970's) the economy does not remain at the natural level of output even in
the absence of policy changes.

** Part 2.Labor Market Equilibrium (28 points)**

In a certain economy, wages are set
according to the following

equation:

W = APz(1 - u),

where W is wages, P is prices, u is the
unemployment rate, and z

captures other factors involved in wage
setting. Prices are set:

P = (1 + m )W/A,

where m is the markup of price over cost. Output is Y = AN. The
labor force is L

1.
Solve for the equilibrium unemployment rate, real wage, and output.

u=1-1/[(1+m)z], W/P=A/(1+m), Y=A(1-u)L=AL/[(1+m)z].

(Or, using the
incorrect price setting equation, P = (1 + m )W, you would get:

u=1-1/[(1+m)zA], W/P=1/(1+m), Y=A(1-u)L=L/[(1+m)z].)

2. Suppose that the government mandates
that all employers provide

their workers with health insurance.
Assuming they weren't already

doing so, what parameter should this
change? What will be the direction

of the effect on unemployment? On real
wages? On prices?

You could argue
many ways of modeling this. Since it’s an increase in benefits, we could model
this as an increase in z. If you think
of it as similar to the increase in the price of oil, i.e. an increase in
non-wage costs of producers, then you model it as a rise in the markup. Finally, you might think that now that
workers are receiving health care from their employers they are willing to work
for a lower wage, so it is best modeled by a decrease in z.

From the
formulas in question 1 we can see:

An
increase in z results in an increase in u and
no change in W/P.

A decrease in z results in a
decrease in u and no change in W/P

An increase in the markup
results in an increase in u and a decrease in W/P.

In all cases,
prices are not determined in the labour market, so we can not specify an effect
on the price level.

(The answer is
the same with the incorrect price setting equation.)

3. A more laissez-faire government is
elected. This government has a

much more lax anti-trust policy than the
old one, and the price markup

rises as a result. What will be the
direction of the effect on

unemployment? On real wages? On prices?

An increase in
the markup causes u and W/P fall, we can not specify an effect on prices.

(The answer is
the same with the incorrect price setting equation.)

4. There is a technological innovation that
makes workers more

productive. As a result, A rises. What will
be the direction of the

effect on unemployment? On real wages? On
prices?

This has no
effect on unemployment, but both output and real wages rise.

(With the
incorrect price setting equation, this would have no effect on the real wage or
output, but would cause unemployment to rise.)

** Part 3.Aggregate Supply - Aggregate Demand (30
points)**

An economy is described by the following
equations:

Y = C + I + G

C = c0 + c1(Y -
T)

I = I0 - I1i

M = PY(1/i)

Y = AN

W = P^{e}Az(1-u)

P = (1 + m)W/A

L = 1

1. Find the natural level of unemployment,
the natural level of

output, the actual output and the actual
unemployment.Derive the

Aggregate Supply curve, and show that it
has the slopes in the correct

direction.

Note that the
labour market equations are the same as in Part 2: so u_{n}=1-1/[(1+m)z], Y_{n}=A/[(1+m)z].

Actual output is
Y=A(1-u)=AP/[(1+m)P^{e}z]
and actual unemployment is u=1-Y/A=1-P/[(1+m)P^{e}z].

The AS curve is
P=P^{e}(1+m)z(1-u)=P^{e}(1+m)zY/A, which is clearly upward sloping.

(With the
incorrect price setting equation: u_{n}=1-1/[(1+m)zA], Y_{n}=1/[(1+m)z].

Actual output is
Y=A(1-u)=AP/[(1+m)P^{e}z]
and actual unemployment is u=1-Y/A=1-P/[(1+m)P^{e}z].

The AS curve is
P=P^{e}(1+m)Az(1-u)=P^{e}(1+m)zY, which is clearly upward sloping.)

2. Derive the Aggregate Demand curve as a
function of G, T, M, and the

price level.Show that it slopes in the
correct direction.

Goods market
equilibrium yields: Y=(B-I1i)/(1-c1) where B=c0-c1T+I0+G

Financial market
equilibrium yields: M=PY/i

Combining these
we get: Y=B/(1-c1+I1P/M), which is downward sloping in Y,P space.

3. Graph your results (and the equilibria)
in (i,Y) space and in (P,Y) space.

You do not need
to solve for the expression for the equilibrium, but you should show that Yn,Pe
is a point on the AS curve.

4. A change in federal labor law gives
unions greater bargaining power

with employers. This raises z. What are the
new natural rates of

unemployment and output? Assume that P^{e}_{t+1
}= P_{t}. Show the changes in

(i,Y) space and in (P,Y) space. What
happens in the long run?

This is the same
as in Part 2: the natural rate of unemployment rises and the natural level of
output falls. For given P^{e},
Y falls so the AS curve shifts to the left.
The dynamics are those shown on page 142 of the text in figure
7-11. In the long run, the AS curve
passes through the AD curve at the natural level of output, so output has
fallen and prices have risen. Note that
the AD curve does not move. Also note
that in equilibrium the real wage is unchanged (it still equals A/(1+m)).

5. How do these changes compare to the
effect of an increase in

A? Which would workers prefer?

An increase in A
shifts the AS curve to the right and leaves the AD curve unchanged. Unemployment is unchanged, prices fall, and
output increases. Note that workers are
receiving a higher real wage. So
workers would definitely prefer an increase in A over an increase in z.

(However, if you
used the incorrect price setting equation you would have gotten that A is not
in the AS curve (or the AD curve), so a change in technology does not move
output or prices. Note that, as in part
2, real wages are unchanged but unemployment is higher. So it is not clear what workers would
prefer, it depends on which case has the smaller increase in unemployment. Note that output is higher in the technology
case, but leaving A out of the price setting equation means that the change is
like an increase in the markup: firms get all of the benefits from the
improvement in technology.)

6. The Central Bank is worried about
inflation and is determined to

keep the price level constant. What should
it do in the short run? Can

it continue this in the long run?

If the central
bank is concerned with price stability then it must accommodate money supply in
such a way that the AD schedule shifts and intersects the new AS schedule at
the old price level. Thus we need an
expansionary monetary policy in order not to have deflation as in part 5. Since prices don't change the new price
level is at the level of expectations and we thus know that the equilibrium is
already at the natural level of output and thus the AS curve will no longer
shift. There are no further pressures
on prices and price stability is maintained in the long run (actually there is
no difference between long and short run in this case).

(With the
incorrect price setting curve, prices haven’t moved so the question is pretty
meaningless. If you answer it for a
change like in 4, however, you get a very similar answer to the one given
above.)