1. Use graphs of IS-LM-FE and AS-AD models to explain why RBC models with productivity shocks and money-supply shocks fail to explain the pro-cyclicality of money growth and inflation. Inflation falls with an increase in output and is therefore countercyclical. However, an increase in the money supply causes the equilibrium price level to rise, and does not affect equilibrium output. Both are shown in the graphs below. i LM(P0) P FE FE1 LM(P1<P0) i 0 i 1 P0 IS P1 AD y y 0 y 1 y 0 y 1 y FE i LM P FE LM(M1/P0) i 0 P1 P0 IS AD1 y AD y 0 y 0 y
2.. In Figures 11.15 and 11.16, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change.
Figure 11.15 Figure 11.16
(a) In Figure 11.15, the increase in tax incentives increases investment, shifting the IS curve up and to the right from IS 1 to IS 2 in Figure 11.15(a), and shifting the AD curve from AD 1 to AD 2 in Figure 11.15(b). The short-run equilibrium is at point B. Output increases, the real interest rate increases, employment increases, and the price level is unchanged. To restore long-run equilibrium, the price level rises, shifting the LM curve from LM 1 to LM 2 in Figure 11.15(a) and the short-run aggregate supply curve from SRAS 1 to SRAS 2 in Figure 11.15(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is higher, employment is the same, and the price level is higher. (b) In Figure 11.16, the increase in tax incentives increases saving shifting the IS curve from IS 1 to IS 2 in Figure 11.16(a), and shifting the AD curve from AD 1 to AD 2 in Figure 11.16(b). The short-run equilibrium is at point B. Output decreases, the real interest rate decreases, employment decreases, and the price level is unchanged. To restore long-run equilibrium, the price level declines, shifting the LM curve from LM 1 to LM 2 in Figure 11.16(a) and the short-run aggregate supply curve from SRAS 1 to SRAS 2 in Figure 11.16(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is lower, employment is the same, and the price level is lower. (c) A wave of investor pessimism reduces investment. This shifts the IS curve down and to the left and the AD curve down and to the left, having the same result as in problem part (b). (d) An increase in consumer confidence increases consumption spending, shifting the IS curve up and to the right and the AD curve up and to the right, with the same result as in problem part (a).
3. In Figures 11.17 11.20, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change. (a) In Figure 11.17, when banks pay a higher interest rate on checking accounts, the demand for money rises, shifting the LM curve up and to the left from LM 1 to LM 2 in Figure 11.17(a). As a result, the AD curve shifts down and to the left from AD 1 to AD 2 in Figure 11.17(b). The new short-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment is lower, and the price level is unchanged. In the long run, the price level decreases to shift the LM curve from LM 2 to LM 3, which is the same as LM 1, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts down from SRAS 1 to SRAS 2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is lower. Figure 11.17
(b) In Figure 11.18, the introduction of credit cards reduces the demand for money shifting the LM curve down and to the right from LM 1 to LM 2 in Figure 11.18(a). As a result, the AD curve shifts from AD 1 to AD 2 in Figure 11.18(b). The new short-run equilibrium occurs at point B, where output is higher, the real interest rate is lower, employment is higher, and the price level is unchanged. In the long run, the price level increases to shift the LM curve from LM 2 to LM 3, which is the same as LM 1, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts up from SRAS 1 to SRAS 2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is higher. Figure 11.18
(c) In Figure 11.19, the reduction in agricultural output shifts the FE curve to the left from FE 1 to FE 2, and shifts the LRAS line from LRAS 1 to LRAS 2. The rise in agricultural prices increases the price level, so the short-run aggregate supply curve shifts up from SRAS 1 to SRAS 2. Also, the rise in the price level shifts the LM curve up and to the left from LM 1 to LM 2. The short-run equilibrium is at point B, assuming that the LM curve shifts so much that it intersects the IS curve to the left of the FE line. At point B, compared to the starting point, output is lower, the real interest rate is higher, employment is lower, and the price level is higher. Figure 11.19
If the water shortage persists, a new long-run equilibrium occurs at point C. To get to this equilibrium, the price level must decline, shifting the LM curve from LM 2 to LM 3, and the short-run aggregate supply curve from SRAS 2 to SRAS 3. Relative to point B, the new equilibrium has a higher output level, a lower real interest rate, higher employment, and a lower price level. (Relative to the initial equilibrium at point A, output and employment are lower, and the real interest rate and the price level are higher.) When the water shortage is over, then the economy goes back to point A in the long run, with no permanent effects. (d) In Figure 11.20, the beneficial supply shock makes more production possible at full employment, so the FE line shifts to the right in Figure 11.20(a) from FE 1 to FE 2, and the LRAS line shifts from LRAS 1 to LRAS 2 in Figure 11.20(b). There is no immediate change in the price level, so the LM curve remains at LM 1 and the short-run aggregate supply curve remains at SRAS 1. The shift of the FE curve does not affect aggregate demand in the short run: output, the real interest rate, and the price level are all unchanged in the short run. The shift in the production function shifts the effective labor demand curve and reduces employment in the short run.
Figure 11.20 If the supply shock persists, prices will decline, so the LM curve will shift from LM 1 to LM 2 and the SRAS curve will shift from SRAS 1 to SRAS 2. As shown in the diagrams, the economy reaches a new equilibrium at point C, with a higher output level, a lower real interest rate, and a lower price level. When the supply shock disappears, the economy returns to its equilibrium at point A. 4. A lag in the impact of policy of six months, which is about the time it takes firms to adjust prices, could cause policy to be destabilizing. That is, monetary policy may be pushing the economy away from equilibrium.
To see this, suppose the economy is in a recession at point A in Figure 11.21. The short-run aggregate supply curve SRAS 1 intersects the aggregate demand curve AD 1 at point A, to the left of the long-run aggregate supply curve LRAS. Suppose the Fed engages in expansionary monetary policy to try to shift the aggregate demand curve from AD 1 to AD 2 in six months, to push the economy to point B. But the recession leads firms to reduce their prices, dropping the SRAS curve from SRAS 1 to SRAS 2. In the absence of monetary policy action, the economy would get back to full employment because of the fall in the price level to point C. But the Fed action leads to a new equilibrium at point D. So the Fed causes the economy to overshoot the equilibrium point. The result may be to exaggerate the business cycle, pushing output too high in expansions. Then if the Fed responds to an expansion by using contractionary monetary policy, it may overshoot on the other side, causing a new recession. Figure 11.21 If the Fed could forecast recessions well, it could stabilize the economy by using monetary policy appropriately before a recession begins. Or if the Fed s policy takes effect before firms adjust prices, then it can also help stabilize output by shifting the AD curve before the SRAS curve shifts. 5. (a) In response to expansionary monetary policy, aggregate demand increases, increasing output and labor demand. This causes the labor demand curve to shift from ND 1 to ND 2 in the primary labor market, shown in Figure 11.22. The result is an increase in employment and output with no change in the real wage in the primary labor market. Since more workers are now in the primary labor market, the labor supply in the secondary labor market decreases from NS 1 to NS 2. This causes an increase in the real wage, a decrease in employment, and a decrease in output in the secondary labor market.
Figure 11.22 (b) Increased immigration has no effect in the primary labor market, since labor supply changes in general have no effect. In the secondary labor market, the immigration shifts the labor supply curve to the right from NS 1 to NS 2, causing a reduction in the real wage, increased employment, and increased output. However, to some extent these effects may be mitigated by the fact that increased immigration leads to increased aggregate demand, increasing labor demand in both the primary and secondary markets (Figure 11.23). Figure 11.23 (c) If there is a shift in the effort curve, the efficiency wage rises in the primary labor market. Since effort exerted at the higher wage is the same as before the change, the shift in the effort curve has no impact on the marginal product of labor, so there is no shift in the labor demand curve. So the effect of the higher real (efficiency) wage is to reduce employment and thus output in the primary labor market. This means that labor supply in the secondary labor market increases, shifting the labor supply curve from NS 1 to NS 2. The real wage falls, employment rises, and output rises in the secondary labor market, as Figure 11.24 shows.
Figure 11.24 (d) The productivity improvement shifts the labor demand curve to the right, so at the fixed real (efficiency) wage, firms demand more labor. Employment increases, so output increases in the primary labor market. The increase in employment in the primary labor market reduces the labor supply in the secondary labor market, shifting the labor supply curve from NS 1 to NS 2. This increases the real wage, and reduces employment and output in the secondary labor market. See Figure 11.25.
Figure 11.25 (e) The productivity improvement in the secondary labor market has no effect on the primary labor market. In the secondary labor market, increased productivity increases the marginal product of labor so that labor demand increases from ND 1 to ND 2. The result is a higher real wage, higher employment, and increased output (Figure 11.26).
Figure 6. Explain how the Fed should adjust the interest rate to each of the following situations initially assuming that its objective is to keep the price level constant. Assume that a technology shock both raises FE and shifts IS right. a) The rightward shift in IS and FE is exactly the same. In this case there is will be no change in the price level if the interest rate stays constant. Therefore, the Fed chooses not to change the interest rate. As IS and FE shift right, the money supply increases to shift LM right keeping the interest rate constant. r FE FE 1 LM LM 1 r 0 IS 1 IS Y Y 1 Y b) The rightward shift in IS is larger than the rightward shift in FE. In this case prices will rise over time if the interest rate were unchanged. The Fed wants to raise the interest rate by reducing the money supply, shifting LM left to prevent the price level from rising.
r FE FE 1 LM 1 LM r 1 r 0 IS 1 IS Y Y 1 Y c). Now assume that the technology shock shifts FE rightward more than IS, and consider how the Fed wants to adjust the interest rate. Now, there is a tendency for the price level to fall, so the Fed wants to reduce the interest rate by shifting LM right by enough to assure that the intersection of IS and LM is at the new FE.. r FE FE 1 LM LM 1 r 0 r 1 IS 1 IS Y Y 1 Y d). Now, realize that the Fed does not actually observe shocks in deciding how to adjust interest rates. It does observe output and prices, although with a lag. How should the Fed respond to recent strong output growth and the increase in inflation? An increase in output and inflation indicates that the IS curve has shifted right more than the FE curve, suggesting an increase in interest rates if the Fed wants to keep price constant.
e) Would the Fed behave differently if it cared about deviations of output from full employment and price stability? No because with this type of shock, it can achieve both simultaneously. f) How should the Fed react to a negative supply shock which is large enough to create a price shock? The Fed s job is more difficult here. The price shock will increase prices, shifting LM left and reducing output. If the Fed raises the interest rate by adjusting the money supply until LM 1 intersects the new FE curve, then output falls, and there is no tendency for the price increase created by the shock to disappear. Alternatively, if the Fed keeps the interest rate constant by increasing the money supply to offset the effect of the price increase on LM then output is determined by the intersection of the original IS and LM and does not change. However, there will be inflation since output is above the new FE. r FE 1 FE LM 1 LM r 1 r 0 IS Y 1 Y Y 7. Use the monetary misperceptions model to explain stagflation when an increase in expected price is not validated by an increase in the money supply. What does an increase in expected inflation imply about the Phillips Curve description of inflation for a given quantity of output? An increase in expected price shifts AS left, reducing equilibrium output and raising equilibrium price if an increase in the money supply does not shift AD right. The increase in price and the fall in output is stagflation. In terms of the Phillips Curve the increase in inflationary expectations must raise inflation for a given amount of output relative to potential (unemployment). Representing the Phillips curve with inflation on the vertical axis, the Phillips Curve shifts upwards. In the example above the new equilibrium is one with higher inflation and lower output (higher unemployment).