1.1 When the interest rate on a bond rises, the price of the bond falls

Transcription

1 Elements of Macroeconomics Econ Fall 2017 roblem Set 5 Due in TA section: 10/06/2017 or 10/07/2017 Name (rint): Section/TA: 1. Fill in the blanks 1.1 When the interest rate on a bond rises, the price of the bond falls 1.2 In the aggregate demand curve, when the price level decreases demand for goods increases 1.3 ublic good 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 vertical line at the level at potential output An unexpected increase in oil prices would shift the aggregate supply curve to the left 1.6. Stagflation 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) Small and a large/small effect on prices (pick one): Large 1.8 Federal government spending is about 20 percent of GD. The top three components are Medicare, Social Security, and Defense. 1.9 In addition to federal and local income taxes, workers also pay payroll taxes (social security) 1

2 1.10 The top federal income tax rate was about 90 percent in the 1950s and is now about 40 percent 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 curve slopes down. Sub effect applies for relative price changes (Toyotas get cheaper than Hondas). The rice level on the y-axis is the aggregate/overall price level for the economy. 2.3 Give one reason why the curve slopes down. Wealth effect and interest rate effect. 2.4 Draw in three separate diagrams what happens to the curve when: i) wealth rises, ii) consumer confidence decreases, iii) the price level increases. i) shifts to right ii) shifts to left iii) Movement along curve to left

3 3. Aggregate Supply 3.1 Draw and label a short-run and a long-run aggregate supply curve below in the same graph. LRAS SRAS 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? It s vertical because the long run level of output is determined by the economy s technology and not the price level. 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? Rising marginal costs because of diminishing returns to labor. The curve doesn t immediately shift because of sticky wages. Accept rising marginal costs or sticky wages.

4 4. Aggregate Demand and Aggregate Supply 4.1 Draw, SRAS, and LRAS curves for an economy in long-run and short-run equilibrium. Label the equilibrium. LRAS SRAS 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. LRAS SRAS2 SRAS1 2 1

5 4.3 In the model, which curve determines long-run output? LRAS curve 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. Wages go down because of the recession. That shifts the LRAS curve down to its original level, we return to the original 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 curve in each country increased by the same amount. SRAS curve is steeper in Botswana 5.2 Based on the difference in the slopes, which of the two countries would most likely have output that is above potential output? Botswana

6 5.3 For each country, draw SRAS and LRAS curves consistent with your answer above. Botswana (large increase in prices, small increase in output) LRAS SRAS Sierra Leone (small increase in prices, large increase in output) SRAS

7 6. hillips Curve 6.1 Write down an equation for the hillips Curve. π t = π e + α(u U t ) 6.2 Explain in words what the equation implies about inflation today. (Explain what each of the terms mean) Current inflation depends 1-to-1 on expected inflation and on the unemployment gap times the parameter alpha. 6.3 Suppose that α = 1.4, U =.05, U t =.05, and π e =.02. What is current inflation π t equal to? π t = ( ) = If the unemployment rate doubles, what does the equation predict will be the value of inflation, all else equal? π t = ( ) = In the Great Recession, the unemployment rate indeed doubled. Compared to actual inflation, did our calibration for the hillips curve over or underpredict inflation? Underpredict inflation 6.6 Some economists disagree about the value of α in the hillips curve. Would a lower or higher α help the hillips curve fit the data better?

8 Lower alpha inflation would be less responsive to changes in the unemployment gap (U*-U_t). 6.7 Does a lower α imply lower or higher credibility in the central bank for determining inflation? Lower alpha would imply higher credibility in the central bank s ability to set the inflation rate equal to its expected value. At alpha = 0, we have pi_t = pi^e.