1 Figure 1 (A) shows what the IS LM model looks like for the case in which the Fed holds the

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1 1 Figure 1 (A) shows what the IS LM model looks like for the case in which the Fed holds the money supply constant. Figure 1 (B) shows what the model looks like if the Fed adjusts the money supply to hold the interest rate constant; this policy makes the effective LM curve horizontal. Figure 1 If all shocks to the economy arise from exogenous changes in the demand for and services, this means that all shocks are to the IS curve. Suppose a shock causes the IS curve to shift from IS1 to IS2. Figures 2 (A) and (B) show what effect this has on output under the two policies. It is clear that output fluctuates less if the Fed follows a policy of keeping the money supply constant. Thus, if all shocks are to the IS curve, then the Fed should follow a policy of keeping the money supply constant. Figure 2

2 If all shocks in the economy arise from exogenous changes in the demand for money, this means that all shocks are to the LM curve. If the Fed follows a policy of adjusting the money supply to keep the interest rate constant, then the LM curve does not shift in response to these shocks the Fed immediately adjusts the money supply to keep the money market in equilibrium. Figures 3(A) and (B) show the effects of the two policies. It is clear that output fluctuates less if the Fed holds the interest rate constant, as in Figure 3(B). If the Fed holds the interest rate constant and offsets shocks to money demand by changing the money supply, then all variability in output is eliminated. Thus, if all shocks are to the LM curve, then the Fed should adjust the money supply to hold the interest rate constant, thereby stabilizing output. Figure 3

3 2 a. If consumers decide to spend less and save more, then the IS* curve shifts to the left. Figure 1 shows the case of floating exchange rates. Since the money supply does not adjust, the LM* curve does not shift. Since the LM* curve is unchanged, output Y is also unchanged. The exchange rate falls (depreciates), which causes an increase in the trade balance equal to the fall in consumption. Figure 2 shows the case of fixed exchange rates. The IS* curve shifts to the left, but the exchange rate cannot fall. Instead, output falls. Since the exchange rate does not change, we know that the trade balance does not change either. Figure 2 In essence, the fall in desired spending puts downward pressure on the interest rate and, hence, on

4 the exchange rate. If there are fixed exchange rates, then the central bank buys the domestic currency that investors seek to exchange, and provides foreign currency. As a result, the exchange rate does not change, so the trade balance does not change. Hence, there is nothing to offset the fall in consumption, and output falls. b. The introduction of ATM machines reduces the demand for money. We know that equilibrium in the money market requires that the supply of real balances M/P must equal demand: M/P = L(r*, Y). A fall in money demand means that for unchanged income and interest rates, the right-hand side of this equation falls. Since M and P are both fixed, we know that the left-hand side of this equation cannot adjust to restore equilibrium. We also know that the interest rate is fixed at the level of the world interest rate. This means that income the only variable that can adjust must rise in order to increase the demand for money. That is, the LM* curve shifts to the right. Figure 3 shows the case with floating exchange rates. Income rises, the exchange rate falls (depreciates), and the trade balance rises. Figure 3 Figure 4 shows the case of fixed exchange rates. The LM* schedule shifts to the right; as before, this tends to push domestic interest rates down and cause the currency to depreciate. However, the central bank buys dollars and sells foreign currency in order to keep the exchange rate from falling.

5 This reduces the money supply and shifts the LM* schedule back to the left. The LM* curve continues to shift back until the original equilibrium is restored Figure 4 In the end, income, the exchange rate, and the trade balance are unchanged In this chapter we looked at three models of the short-run aggregate supply curve. All three models attempt to explain why, in the short run, output might deviate from its long-run natural rate the level of output that is consistent with the full employment of labor and capital. All three models result in an aggregate supply function in which output deviates from its natural rate Y when the price level deviates from the expected price level: The first model is the sticky-wage model. The market failure is in the labor market, since nominal wages do not adjust immediately to changes in labor demand or supply that is, the labor market does not clear instantaneously. Hence, an unexpected increase in the price level causes a fall in the real wage (W/P). The lower real wage induces firms to hire more labor, and this increases the amount of output they produce. The second model is the imperfect-information model. As in the worker-misperception model, this model assumes that there is imperfect information about prices. Here, though, it is not workers in

6 the labor market who are fooled: it is suppliers of goods who confuse changes in the price level with changes in relative prices. If a producer observes the nominal price of the firm s good rising, the producer attributes some of the rise to an increase in relative price, even if it is purely a general price increase. As a result, the producer increases production. The third model is the sticky-price model. The market imperfection in this model is that prices in the goods market do not adjust immediately to changes in demand conditions the goods market does not clear instantaneously. If the demand for a firm s goods falls, it responds by reducing output, not prices. 5 The natural rate of unemployment is the rate at which the inflation rate does not deviate from the expected inflation rate. Here, the expected inflation rate is just last period s actual inflation rate. Setting the inflation rate equal to last period s inflation rate, that is, = 1, we find that u = Thus, the natural rate of unemployment is 6 percent. b. In the short run (that is, in a single period) the expected inflation rate is fixed at the level of inflation in the previous period, 1. Hence, the short-run relationship between inflation and unemployment is just the graph of the Phillips curve: it has a slope of 0.5, and it passes through the point where = 1 and u = This is shown in Figure below. In the long run, expected inflation equals actual inflation, so that = 1, and output and unemployment equal their natural rates. The long run Phillips curve thus is vertical at an unemployment rate of 6 percent.

7 c. To reduce inflation, the Phillips curve tells us that unemployment must be above its natural rate of 6 percent for some period of time. We can write the Phillips curve in the form 1 = 0.5(u 0.06). Since we want inflation to fall by 5 percentage points, we want 1 = Plugging this into the left-hand side of the above equation, we find 0.05 = 0.5(u 0.06). We can now solve this for u: u = Hence, we need 10 percentage point-years of cyclical unemployment above the natural rate of 6 percent. Okun s law says that a change of 1 percentage point in unemployment translates into a change of 2 percentage points in GDP. Hence, an increase in unemployment of 10 percentage points corresponds to a fall in output of 20 percentage points. The sacrifice ratio is the percentage of a year s GDP that must be forgone to reduce inflation by 1 percentage point. Dividing the 20 percentage-point decrease in GDP by the 5 percentage-point decrease in inflation, we find that the sacrifice ratio is 20/5 = 4.

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