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.)

 

  1. Increased competition in the economy will raise the markup.

 

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

 

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

 

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

 

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

 

 

Part 2. Aggregate Supply-Aggregate Demand

(40 points: (b) - (f) and (h) Ė (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 donít draw the graphs too small).†† Assume that expectations are adaptive: Pet+1=Pt

 

  1. 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 Yn 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.

 

  1. 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?

 

  1. 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'.

 

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

 

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

 

  1. 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.

 

  1. 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 Yn on the horizontal axes.

 

  1. 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'.

 

  1. 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'.

 

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

 

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

 

  1. 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?)

 

  1. 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)?

 

  1. Note that the medium run effect on prices is ambiguous.Draw two AS-AD graphs (you donít 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:

pt = pte + 0.1 - 2ut

where

pte = q pt-1

Also, suppose that q is initially equal to zero.

 

  1. 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.

 

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

 

  1. 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.

 

  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.

 

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

 

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