Cosumnes River College Principles of Macroeconomics Problem Set 9 Due November 10, 2015

Transcription

1 Name: Solutions Cosumnes River College Principles of Macroeconomics Problem Set 9 Due November 10, 2015 Fall 2015 Prof. Dowell Instructions: Write the answers clearly and concisely on these sheets in the spaces provided. Do not attach extra sheets. 1. Use a graph to illustrate the effect an expansionary fiscal policy will have on the money market. What happens to the interest rate? What impact will this have on the effectiveness of fiscal policy? An expansionary fiscal policy will increase the demand for money and increase the interest rate. If investment is sensitive to the interest rate, an increase in the interest rate may cause investment to fall. If consumption is sensitive to the interest rate, an increase in the interest rate may cause consumption to fall. Fiscal policy will not be as effective if investment and consumption are sensitive to the interest rate. 2. The demand for money is a country is given by M d 10,000 10, 000r PY where M d is money demand in dollars, r is the interest rate, (a ten percent interest rate means that r = 0.1), and PY is national income. Assume that PY is initially 5,000. a. Graph the amount of money demanded (on the horizontal axis) against the interest rate on the vertical axis. Suppose the money supply is set by the central bank at $10,000. On the same graph as your money demand curve, add the money supply curve. What is the equilibrium rate of interest? How did you arrive at your answer? The equilibrium is at r =.5 or 50%, which is found as the intersection of the money demand and money supply curves. Alternatively, we can solve for r algebraically by setting M d = M s : 10,000 10,000r + 5,000 = 10,000 r = 5,000/10,000 =.5. Principles of Macroeconomics: Problem Set 9 Solutions Page 1

2 b. Suppose income rises from PY = 5,000 to PY = 7,500. What happens to the money demand curve you drew in part a? Draw the new curve if there is one. What happens to the equilibrium rate of interest if the Fed does not change the money supply? With P Y = 7,500, the intersection occurs at r =.75. Algebraically, 10,000 10,000r + 7,500 = 10,000 r = 7,500/10,000 =.75 or 75%. c. If the Fed wants to keep the equilibrium interest rate at the same value as in part a, by how much should it increase or decrease the supply of money given the new equilibrium level of national income? We need the money supply equal to what money demand would be when r =.5. Money Demand = 10,000 10,000(.5) + 7,500 = 12,500. Increase the money supply by $2,500, to $12,500. d. Suppose the shift in part b has occurred and the money supply remains at $10,000 but there is no observed change in the interest rate. What might have happened that could explain this? One possibility is that the price level has fallen, shifting the money demand curve back to its original position. 3. Illustrate each of the following situations with a graph showing the IS curve and the Fed rule, and explain what happens to the equilibrium values of the interest rate and output: a. An increase in G with the money supply held constant by the Fed Both equilibrium output and the equilibrium interest rate will increase. b. An increase in G with the Fed changing M S by enough to keep the interest rate constant Equilibrium output increases and the equilibrium interest rate remains constant. c. An increase in P with no change in government spending Equilibrium output decreases and the equilibrium interest rate increases. d. A decrease in Z with no change in government spending Equilibrium output increases and the equilibrium interest rate decreases. e. A decrease in P and an increase in G; Equilibrium output definitely increases and the equilibrium interest rate may increase, decrease, or remain constant (as is shown in the graph), depending on the magnitude of the curve shifts. See diagrams on next page. Principles of Macroeconomics: Problem Set 9 Solutions Page 2

3 4. Consider the case in which there is an increase in aggregate demand, and assume that firms in the economy are imperfectly competitive. The increase in aggregate demand shifts the demand curves facing individual firms out. If the firms wages do not also increase, then firms can increase their profits by raising prices and increasing output. In other words, the response of the overall economy to the aggregate demand increase will be an increase in output and the price level a positive slope of the short-run AS curve. What is the key assumption in this story that makes it work? Explain. A key assumption in this story is that firms wages and thus their marginal cost curves do not also shift. A key input into the production processes of firms is labor, and labor costs are a large fraction of total costs. If wages do not respond quickly to price increases, there may be some period of time in which firms raise prices without seeing wage rates rise. 5. If input prices are increasing at the same rate as prices what can we conclude about the shape of the aggregate supply curve? We can conclude that the aggregate supply curve is vertical. Principles of Macroeconomics: Problem Set 9 Solutions Page 3

4 6. Using aggregate supply and aggregate demand curves, indicate what impact each of the following would have on the price level and on the equilibrium level of aggregate output in the short run. a. The Fed buys bonds in the open market. Aggregate demand will increase and the price level and the equilibrium level of output will increase. b. The economy is far below capacity and the government increases government spending. Aggregate demand will increase, the price level will increase by a small amount, and the equilibrium level of output will increase by a large amount. Principles of Macroeconomics: Problem Set 9 Solutions Page 4

5 c. The floods in the Midwest in 1993 destroyed a large portion of the United States' agricultural crops. Aggregate supply decreased, the price level increased, and the equilibrium level of output fell. 7. Discuss why the aggregate supply function is relatively flat within the low ranges of aggregate output. Discuss why the aggregate supply function is relatively vertical within the ranges of high aggregate output. The relatively flat portion of the aggregate supply function is associated with excess or unused productive capacity. As a result, increases in aggregate demand will contribute to production increases but very limited changes in price. It is the range of excess capacity. The vertical portion of the aggregate supply function is associated with full utilization of capacity and high levels of output. As a result, increases in aggregate demand will contribute to limited output gains and sharp increases in the price level. It is the range of full capacity utilization. 8. Draw the short-run aggregate supply and long-run aggregate supply curve on the same graph along with the aggregate demand curve. Illustrate the effects of an increase in aggregate demand on both the price level and the output level both in the short-run and the long-run. Principles of Macroeconomics: Problem Set 9 Solutions Page 5