1.1 When the interest rate on a bond rises, the price of the bond. 1.2 In the aggregate demand curve, when the price level decreases demand for goods

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1 Elements of Macroeconomics Econ Fall 2017 Problem Set 5 Due in TA section: 10/06/2017 or 10/07/2017 Name (Print): Section/TA: 1. Fill in the blanks 1.1 When the interest rate on a bond rises, the price of the bond 1.2 In the aggregate demand curve, when the price level decreases demand for goods 1.3 Type of good where it is not possible to exclude any individual from consuming the good 1.4. The long-run aggregate supply curve is a line at the level at output An unexpected increase in oil prices would shift the aggregate supply curve to the 1.6. Term that describes a period of rising inflation during a recession 1.7 A positive shift in demand in an economy currently operating above potential output would have a relatively large/small effect on output (pick one) and a large/small effect on prices (pick one): 1.8 Federal government spending is about percent of GDP. The top three components are,, and. 1.9 In addition to federal and local income taxes, workers also pay 1.10 The top federal income tax rate was about in the 1950s and is now 1

2 2. Aggregate Demand 2.1 Draw and label an aggregate demand curve below. 2.2 In microeconomics we think that demand curves slope down. One reason for that is the substitution effect all else equal, households are more willing to buy Toyotas if they become cheaper relative to other cars. Explain why the substitution effect does not explain why the AD curve slopes down. 2.3 Give one reason why the AD curve slopes down. 2.4 Draw in three separate diagrams what happens to the AD curve when: i) wealth rises, ii) consumer confidence decreases, iii) the price level increases.

3 3. Aggregate Supply 3.1 Draw and label a short-run and a long-run aggregate supply curve below in the same graph. 3.2 Why does the long run aggregate supply curve (LRAS) slope the way it does? Does its shape imply that short run fluctuations in aggregate demand can have an effect on long-run output? 3.3 Give a reason why the short run aggregate supply curve (SRAS) slope the way it does. Does its slope imply that short run fluctuations in aggregate demand can have an effect on short-term output?

4 4. Aggregate Demand and Aggregate Supply 4.1 Draw AD, SRAS, and LRAS curves for an economy in long-run and short-run equilibrium. Label the equilibrium. 4.2 Suppose the economy experiences a price shock oil prices rise significantly because of supply disruptions in other countries. Graphically depict the new equilibrium. Draw in below the original equilibrium together with the new short run equilibrium. Label the two equilibria clearly. 4.3 In the model, which curve determines long-run output?

5 4.4 How does the economy transition to its long-run equilibrium? Show in a graph below how the economy transitions from the second to the third and final equilibrium. 5. Slope of the SRAS curve. Suppose that higher wealth in the US leads to higher demand for jewelry. As a result, the aggregate demand curve shifts to the right in the diamond producing countries Botswana and Sierra Leone. For simplicity, you can assume that both economies have the same aggregate demand and supply curves. However, the economies might be in different stages of the business cycle. 5.1 Following the increase in demand for diamonds, suppose you observe a large increase in output and small increase in prices in Sierra Leone. Conversely, there is a small increase in output and large increase in prices in Botswana. What can you infer about the slope of the SRAS curve in each country right before the demand increase? Assume that the AD curve in each country increased by the same amount. 5.2 Based on the difference in the slopes, which of the two countries would most likely have output that is above potential output?

6 5.3 For each country, draw SRAS and LRAS curves consistent with your answer above. 6. Phillips Curve 6.1 Write down an equation for the Phillips Curve. 6.2 Explain in words what the equation implies about inflation today. (Explain what each of the terms mean) 6.3 Suppose that α = 1.4, U =.05, U t =.05, and π e =.02. What is current inflation π t equal to?

7 6.4 If the unemployment rate doubles, what does the equation predict will be the value of inflation, all else equal? 6.5 In the Great Recession, the unemployment rate indeed doubled. Compared to actual inflation, did our calibration for the Phillips curve over or underpredict inflation? 6.6 Some economists disagree about the value of α in the Phillips curve. Would a lower or higher α help the Phillips curve fit the data better? 6.7 Does a lower α imply lower or higher credibility in the central bank for determining inflation?