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									Homework 6                                                                         Economics 101
Chapter 13

1. Suppose that in elections President Push wanted to help out Congressional
candidates in his party by making the economy look strong: high GDP figures
and low inflation. Suppose he increased government spending, hoping to
make GDP statistics rise in the period prior to the election. He knows this can
lead to higher inflation, but he hopes this policy will affect inflation statistics
(CPI) mainly after the election is over.
   a) Discuss the short-run and long run implications of the president’s fiscal
       policy on output, the price level and real interest rate. Use IS-LM &
       AS-AD graphs, where the short-run aggregate supply assumes that
       output is some positive function of price surprises.
   b) How does the success of the president’s strategy depend on how flat
       or steep the short-run aggregate supply curve is? Thinking of our
       stories of aggregated supply, what are some things that determine the
       steepness of this curve?
                                                         P                            LRAS
a)The president’s fiscal policy will shift the                                                        SRAS2
aggregate demand curve to the right, from                                         3
AD1 to AD2. In the short run, this will raise            P3                                               SRAS1
output and price some, as equilibrium moves              P2
from point 1 to point 2. Output goes up
because people are surprised by the rise                 P1
                                                                                  1                   AD2
in price, so they can be tricked into producing
more output than they were intending to.
                                                                                  Ybar     Y2         Y
In the long run, price expectations will adjust to the new policy, and shift the short run aggregate supply
curve left (from SRAS1 to SRAS2). So equilibrium moves from point 2 to point 3, where price level rises
much and output returns to Ybar. So the president could be successful in getting a rise in output prior to the
election, and getting most of the inflation after the election.

b) If the SRAS were steeper, then price would rise more in the short run. A steep SRAS means it
takes a bigger price rise to induce people into producing more. Perhaps a smaller fraction of
prices or wages are set ahead of time in contracts, or perhaps workers or suppliers are harder to
surprise (expectations are closer to the assumption of rational expectations).

2. Answer the following questions about the short-run aggregate supply equation:

a. Let = 0.5. Draw the aggregate supply curve.
b. As the term  increases, how does this change the supply curve?
c. If the expected price level increases, how does this change the supply curve?
2. a. The aggregate supply curve should be graphed from the following

where the first group of terms are the intercept and the slope is 1/.
b. As  increases, the aggregate supply curve becomes flatter and the
intercept with the y-axis increases
c. An increase in the expected price level will shift up the supply curve.

3. What is the difference between cost-push and demand-pull inflation?
Which was the primary cause of inflation in the early 1970's? What type of
inflation had the Federal Reserve been trying to prevent in 1998 and 1999?
What about in 2005 and 2006?

Answer: Cost-push inflation is caused by supply shocks that alter the cost of
production. Demand-pull inflation is caused by upward pressure on prices
from high aggregate demand. In the early 1970's, the OPEC oil price shock
was a primary cause of the high inflation. This is an example of cost-push
inflation. In 1998 and 1999 the Federal Reserve was worried about demand-
pull inflation caused by high demand in the current economic boom. In 2005
and 2006, rising oil prices had again made the Federal Reserve relatively
more concerned about cost-pull inflation.

4. a. Explain the link between the aggregate supply curve and the Phillip's

b. If the natural rate of unemployment falls, how will this affect the Phillip's

c. If the sacrifice ratio was 5 and the central bank wanted to lower inflation
by 8 percentage points, how much GDP would have to be sacrificed? Would
you recommend reducing the inflation all at once, or spreading it out over
several years? What would a proponent of rational expectations theory

Answers: a. The aggregate supply curve provides the link between output
and prices, which can be modified to link output and inflation. By
incorporating Okun's law, which links output and unemployment, we then
have the Phillip's curve relationship between inflation and unemployment.

b. The Phillip's curve is graphed from the following equation:
where the first group of terms is the y-axis intercept and the slope is -. A
decrease in the natural rate will shift down the Phillip's curve.

c. The sacrifice ratio is the percentage of a year's GDP that must be forgone
to reduce inflation by 1 percentage point. With a sacrifice ratio of 5, lowering
inflation by 8 percentage points would require 40 percent of GDP to be
sacrificed. This would be a lot of GDP to lose in a one-year period, so it may
be best to spread it out over several years in order to avoid mass
unemployment. On the other hand, a proponent of rational expectation would
argue that committing to the policy with a quick reduction would be the best
solution. They argue that this quick-reduction policy will alter people's
expectations and allow prices to fall quickly without the large loss in GDP.

Chapter 15
1. According to the Lucas critique, why should policy makers not rely upon the Phillips curve
relationship between inflation and unemployment as the formula for monetary policy.

Answer: If policy makers consistently used the Phillips curve to determine how
much inflation was needed to lower unemployment, people would react to this policy
by expecting higher inflation every time unemployment was high. This change in
inflation expectations would cause an outward shift in the Phillips curve, and an even
higher rate of inflation would now be needed to lower unemployment.

2. Describe how automatic stabilizers can help to "cool off" an economic boom.

Answer: Automatic stabilizers are policies that help stimulate or slow the economy
when needed without requiring any specific policy change. One stabilizer that helps
slow a booming economy is the income tax. As people earn more in a boom, the
amount of taxes they pay increases. This prevents consumers from spending a
higher fraction of their additional income, which would further boost the economy.

3. Describe two benefits and two costs of an inflation-targeting rule for monetary

Answer: The benefits of inflation targeting include the increased accountability of
the central bank because people are able to easily judge its performance. Another
benefit is added credibility caused by providing clear guidelines for the goals of
monetary policy. Costs of inflation targeting include a lack of discretion to address
other economic problems that may occur. Also, the targeting may require extreme
policy adjustments to keep inflation within the required bands, which may lead to
higher volatility in other areas such as GDP and unemployment.

4. Why do you think the level central-bank independence is not correlated with a
country's average growth rate of real GDP?

Answer: From our study of money neutrality in previous chapters, we know that
monetary policy does not affect real GDP in the long run. Thus, we should expect
that the degree of central-bank independence is not correlated with the country's
average (long run) growth rate.
Chapter 5 and 12
1. Neoclassical Model of Open Macro Economy:
  Consider an economy described by the following equations:
      Y = C + I + G + NX,
      Y = 5,000,     G= 1,000,       T = 1,000,
      C = 250 + 0.75(Y – T),
      I = 1,000 – 50r,
      NX = 500 – 500  
      r= r* = 5.
   a. In this economy, solve for national savings, investment, the trade balance, and the
      equilibrium exchange rate.
   b. Suppose now that G rises to 1,250. Solve for national saving, investment, the
      trade balance, and the equilibrium exchange rate. Explain what you find.
   c. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again
      1,000). Solve for national saving, investment, the trade balance, and the
      equilibrium exchange rate. Explain what you find.

a) National saving is the amount of output that is not purchased for current consumption by
households or the government. We know output and government spending, and the consumption
function allows us to solve for consumption. Hence, national saving is given by:
      = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750.
Investment depends negatively on the interest rate, which equals the world rate r* of 5. Thus,
        I = 1,000 – 50x5 = 750.
Net export equals the difference between saving and investment. Thus,
        NX = S – I
             = 750 – 750 = 0.
Having solved for net exports, we can now find the exchange rate that clears the foreign-
exchange market:
        NX = 500 -500 x
          0 = 500 -500 x      =>  = 1.

b) Doing the same analysis with new value of government spending we find:
           = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250 = 500.
         I = 1,000 – 50 x 5 = 750.
         NX = S – I
              = 500 – 750 = -250.
         NX = 500 -500 x 
         -250 = 500 -500 x   = 1.5.
The increase in government spending reduces national saving, but with an unchanged world real
interest rate, investment remains the same. Therefore, domestic investment now exceeds domestic
saving, so some of this investment must be financed by borrowing from abroad. This capital
inflow is accomplished by reducing net exports, which requires that the currency appreciates.
c) Repeating the same steps with new interest rate,
           = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750.
         I = 1,000 – 50 x 10 = 500.
         NX = S – I
              = 750 – 500 = 250.
         NX = 500 - 500 x 
         250 = 500 - 500 x  =>  = 0.5.
Saving is unchanged from part (a), but the higher world interest rate lowers investment. This
capital outflow is accomplished by running a trade surplus, which requires that the currency

2. What will happen to the trade balance and the real exchange rate of a small open
economy when government purchases increase, such as during a war?

Answer) The increase in government spending decreases government saving and national
saving; this shifts the saving schedule to the left. Given the world interest rate r*, the decrease in
domestic saving puts an upward pressure on real exchange rate and reduces net export. (The
effect on the trade balance depends on our starting point. If we start from a trade balance i.e.,
NX=0an increase in government expenditure makes it deficit i.e., NX<0).

3. Mundell-Fleming Model
Use the Mundell-Fleming Model to predict what happens to aggregate income y, the
exchange rate e, and the trade balance NX, under both floating and fixed exchange rates
in response to each of the following shocks:
    a. A fall in consumer confidence about the future induces consumers to spend less
        and save more.
    b. The introduction of a stylish line of Toyotas makes some consumers prefer
        foreign cars over domestic cars.
    c. The introduction of automatic teller machines reduces the demand for money.

   a.   A fall in consumer confidence shifts planned expenditure line and the IS* curve to
        the left. Under floating exchange rate the fall in IS* curve is completely absorbed
        by rising NX following a reduction in exchange rate. Therefore aggregate output
        does not change. But when exchange rate is fixed a fall in IS* curve induces a fall
        in money supply (LM* curve shifts left ward) so that exchange rate remains
        unchanged. As a result aggregate output falls.

    b. A shift toward foreign cars increases imports and shifts NX cure left ward. This
       shifts IS* curve to the left. Under floating exchange rate this reduces exchange
       rate such that the level of NX goes up to its original level. But Aggregate output
       demanded does not change. Under fixed exchange rate a leftward shift in LM*
       follows the fall in IS*. Foreign exchange rate stays the same but both NX and
       aggregate output fall.
c. Reduction in demand for money shifts LM and hence LM* curves to the right,
   leading to a rise in equilibrium aggregate output demand. Under floating
   exchange rate this will reduce exchange rate and increase NX. Under fixed
   exchange rate LM curve shifts back to its original level to keep exchange rate

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