**14.02
Principles of Macroeconomics**

**Problem Set 8**

**Posted:
Wednesday, November 15, 2000**

**Due:
Wednesday, November 22, 2000**

** **

Please
Note: This is the last problem set due
before the final quiz (there will be one final problem set due after quiz
three). It covers some material which
will be on the quiz, but may not have been covered in class. This is primarily Part 3: The Phillips
Curve. Reading chapter eight of the
text will be sufficient to complete this question (the question is the third
problem at the end of chapter eight).

**Part 1.
True/False Explain your answer carefully.** *(10 points, 2
points each.)*

- Increased competition in the economy
will raise the markup.

- Changes in the expected price level
shift the AS curve, but not the AD curve.

- A change in the price level shifts
the LM curve and hence the AD curve shifts too.

- A period of negative output and
price growth is referred to as stagflation.

- Monetary policy is neutral in the
medium run, but fiscal policy is not.

*(40 points:
(b) - (f) and (h) – (l) 3 points each., (m) 4 points, (n) 6 points, no credit
for (a) and (g))*

For the
following question please be sure to draw and label all of your graphs *clearly *(please don’t draw the graphs
too small). Assume that expectations
are adaptive: P^{e}_{t+1}=P_{t}

- Draw an AD-AS graph and an IS-LM
graph in which equilibrium output is the natural level of output. Label the appropriate curves AS, AD,
IS, and LM; label the equilibrium point 'a' on each graph, and show the
point Y
_{n}on the horizontal axes.

Now consider an
increase in autonomous investment, i.e. for any given level of the interest
rate and output firms now invest more.

- On the same graphs as in (a), show
the effects of this change in the short run. Label any lines which move with primes (e.g. if the IS curve
shifts, then label the new IS curve IS').
Label the new equilibrium point in both graphs as 'b'. How do you
know where to draw the short run AS curve?

- Again on the same graphs, show the
effects of this change in the medium run.
Label any lines which move with double primes (e.g. IS"). Label the new equilibrium point in both
graphs as 'c'.

- What were the short run effects on
output, unemployment, the interest rate, the price level, and investment?

- What were the medium run effects on
output, unemployment, the interest rate, the price level, and investment?

- What do you think the long run
effects of this change will be?

Now, consider a
decrease in the markup instead of an increase in autonomous investment.

- Draw an AD-AS graph and an IS-LM
graph in which equilibrium output is the natural level of output. Label the appropriate curves AS, AD,
IS, and LM; label the equilibrium point 'a' on each graph, and show the
point Y
_{n}on the horizontal axes.

- On the same graphs as in (g), show
the effects of this change in the short run. Label any lines which move with primes (e.g. if the IS curve
shifts, then label the new IS curve IS').
Label the new equilibrium point in both graphs as 'b'.

- Again on the same graphs, show the
effects of this change in the medium run.
Label any lines which move with double primes (e.g. IS"). Label the new equilibrium point in both
graphs as 'c'.

- What were the short run effects on
output, unemployment, the interest rate, the price level, and investment?

- What were the medium run effects on
output, unemployment, the interest rate, the price level, and investment?

- What kind of shock was the change in
part 1? What kind of shock was the
change in part 2? How can we
distinguish between these two types of shocks from data on output and
prices?

Now imagine that
something changes which causes both an increase in autonomous investment and a
decrease in the markup. (No credit:
What might this something be? What else might change?)

- Based on your answers to (e) and
(k), what do you think the medium run effects of this combined change on
output, unemployment, the interest rate, and investment will be (i.e.
positive, negative, or ambiguous)?

- Note that the medium run effect on
prices is ambiguous. Draw two
AS-AD graphs (you don’t need to draw the corresponding IS-LM graphs)
showing the initial, short run, and medium run curves (label them as in
parts 1 and 2), one in which prices rise and one in which prices
fall. Is there any difference in
the time path of ouput in the two cases?

**Part 3. The
Phillips Curve (Problem 3 page 163 in the text.) **

*(20 points: 3
points each, except (e) 5 points )*

* *

Suppose that the
Phillips Curve is given by:

p_{t} = p_{t}^{e} + 0.1 - 2u_{t}

where

p_{t}^{e} = q p_{t-1}

Also, suppose
that q is initially equal to zero.

- What is the natural rate of
unemployment?

Suppose that the
rate of unemployment is initially equal to the natural rate. In year t the authorities decide to bring
the unemployment rate down to 3% and hold it there forever.

- Determine the rate of inflation in
years t, t+1, t+2, t+10, t+15.

- Do you believe the answer you gave
in (b)? Why or why not? (Hint: think about how inflation expectations are
formed.)

Now suppose that
in year t+5 q increases from 0 to 1.

- Why might theta increase like this?
What is the effect on un?

Suppose that the
government is still determined to keep u at 3% forever.

- What will the inflation rate be in
years t+5, t+10, and t+15?

- Do you believe the answer given in
(e)? Why or why not?