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.