Problem Set 8 -
Solutions

Part 1.
True/False

a. False.
Increased competition should lower the markup.

b. True. The expected price level is a parameter in
the labor market and hence effects the Aggregate Supply curve, not the
Aggregate Demand curve.

c. False.
A change in the price level is a shift along the AD curve, not of the
curve. Changing the price level and
finding the associated equilibrium level of output from the goods and financial
market is how the AD curve is derived.
Note that graphically this means the LM curve can shift without the AD
curve shifting.

d. False.
Stagflation is a period of negative output growth and positive price
growth: stagnation and inflation.
(Unfortunately, the grammar of this question confused some people, so
you may have gotten the same answer in terms of the definition of stagflation
and said that the answer was true. You
will not lose any points for this as long as you wrote the correct definition
of stagflation.)

e. True.
Monetary policy only affects prices in the medium run, but fiscal policy
affects some real variables, e.g. investment.

Part 2.

See the
accompanying graphs in addition to the following written answers:

b. The AS curve always passes through the point
(Y_{n}, P^{e}). In this
case, we have (Y_{n}, Pt-1) where Pt-1 is the price level associated
with the original equilibrium point (a), so the AS curve doesn't move
immediately. In the second half of this
question, though, the short run AS curve is different from the initial and long
run curves. You can tell where the
short run AS curve lies by the same intuition: you know that P^{e }t+1
= Pt. Pt is the point where the new AD
curve intersects the original AS curve.
Since (Y_{n}, P^{e }t+1 = Pt) must lie on the short run
AS curve, you can pinpoint the location of this curve on your graph. Note that the short run equilibrium is NOT
the same as the point (Y_{n}, P^{e }t+1 = Pt) – instead, it is
the point where the short run AS intersects the new AD curve.

d. The short run effects are an increase in
output, a decrease in unemployment, an increase in the interest rate, an
increase in the price level, and an ambiguous, but probably positive change in
investment (Y and i both rise, but since the rise in output is driven by the
increase in autonomous investment we should have an increase in I).

e. The medium run effects are no change in
output, no change in unemployment, an increase in the interest rate, an
increase in the price level, and no change in investment. We know investment is the same because we
are back at the old level of output and no components of C, G, money demand,
etc. have changed. Note that this tells
us exactly how much the interest rate has increased: it rose by just enough to
offset the increase in autonomous investment.

f. In the long run, we probably expect the
temporary increase in investment to have a positive effect on output (or
growth). The size of this effect will
depend on how long it takes for the economy to return to the original level of
output and investment. (Note that this
question uses the book's useful distinction between the medium run, in which
technology and institutions are exogenous, and the long run, in which these may
be endogenous.)

j. The short run effects are an increase in
output, a decrease in unemployment, a decrease in the interest rate, a decrease
in the price level, and an increase in investment (since output rose and the
interest rate fell).

k. The medium run effects are an increase in
output, a decrease in unemployment, a decrease in the interest rate, a decrease
in the price level, and an increase in investment.

l. The first shock was an aggregate demand
shock, the second shock was an aggregate supply shock. A demand shock causes output and prices to
move in the same direction initially, but the final result is a movement in
prices only. A supply shock causes
prices and output to move in opposite directions. The changes in output and prices are long lasting.

m. Based on the
above answers, we would expect a positive effect on output, a negative effect
on unemployment, an ambiguous effect on the interest rate, and an increase in
investment.

n. Prices rise in the medium run when the
demand shock dominates. In this case
the short run level of output is above the medium run level: output overshoots. This overshooting does not occur when the
supply shock dominates and prices fall.

Part 3.

a. Setting the actual and expected rate of
inflation to zero we find that the natural rate of unemployment is 5%.

b. With theta (or q) equal to zero, the formula
tells us that inflation will be .1-2*.03=4% in each year after the change in
unemployment.

c. Theta equal to zero means that the expected
inflation rate is zero each year. If
inflation is consistently 4%, this is not rational. So you shouldn't believe the answer given in (b).

d. Theta should increase because people realize
that inflation is now 4% every year and change how they set their
expectations. This does not change the
natural rate of unemployment.

e. The inflation rate will now increase by 4
percentage points each year: p(t+5)=8%, p(t+10)=28%, p(t+15)=48%.

f. Now the expected inflation rate is last
year's inflation rate. But inflation is
consistently increasing, so this is not a rational way to form expectations
anymore. Eventually people should
expect inflation to be four percent higher each year.