Economics 12 Intermediate Macroeconomic Theory Fall 2010

Second Problem Set ANSWERS

1. Suppose the economy begins with output equal to its natural level. Then the government
reduces income taxes.
a) Using the AS-AD model , show the effects of a reduction in income taxes on the
position of the AD, AS, IS, and LM curves in the medium run.
b) What happens to output, the interest rate, and the price level in the medium run?
What happens to consumption and investment in the medium run?

LM’
Interest rate

LM
i”

i’

IS’
IS

Yn Output
Price
AS’

P” AS

P’

Pe

AD’
AD

Yn Output
1. a. IS shifts right, and LM shifts up. AD shifts right as the increase in disposable
income raises consumption, moving short run output above the natural level,
prices rise to P’ , and the interest rate rises to i’ . As output is above the
natural level, the price level is higher than Pe that wage setters expected. As
they revise their expectations, AS shifts up and prices rise, moving up along
the AD’ curve until output returns to its natural level at AS’ and the price
level is equal the new expected price at P” with interest rate i” .
b. In the medium run Y returns to its natural level, but prices and interest rates
are higher. Investment will be lower because interest rates are higher at the
same level of output while consumption will be higher because disposable
income is higher at the same level of output.

2.

Interest rate
LM

LM’
i
LM”
i’

i” IS

IS’

Y’ Yn Output
Price
AS

P AS’

P’

P”
AD

AD’

Y’ Yn Output
2. Suppose the economy begins with output equal to its natural level. Then there is a
decrease in consumer confidence, as households attempt to increase their saving, for a
given level of disposable income.
a) In AS-AD and IS-LM diagrams, show the effects of the decline in consumer
confidence in the short run and the medium run. Explain why curves shift in
your diagrams.
b) What happens to output, the interest rate, and the price level in the short run?
What happens to consumption, investment, and private saving in the short run?
Is it possible that the decline in consumer confidence will actually lead to a fall in
private saving in the short run?
c) Repeat part (b) for the medium run. Is there any paradox of saving in the medium
run?
2. a. IS LM AD AS
SR: short run SR left down left no
change
MR: medium MR same down same down run
as SR further as SR
b-c.
Y i P
SR falls falls falls
MR back to falls falls
original Yn further further

C I Private S
SR falls ambiguous ambiguous
MR Increases rises rises
from SR (above (above
but still original original
lower than level) level)
original
level
a. In the short run, a decline in consumer confidence will lower consumption
and raise private saving at any level of income ( decrease in c0). The IS curve
shifts down to IS’ , moving the aggregate demand to AD’ lowering prices to
P’ . In the medium run, prices are below what wage setters expected and
they will revise their expectations downward, shifting AS to AS’ where
output is restored to its original level

b. In the short run, output falls below its natural rate to Y’ and prices fall to
P’. The short run decrease in the price level increases M/P so LM falls to
LM’ with short run interest rate at i’ . In the medium run, Y returns to its
original level as prices fall to P” . This reduction in price shifts the LM
further to LM” dropping the interest rate further to i” . The impact on
investment and hence private saving is ambiguous, lower output and lower
interest rate, so that it is possible for short run saving to fall.

c. In the medium run, consumption must be lower than its original level
because disposable income is unchanged, but consumer confidence is lower.
Similarly investment must rise because the interest rate is lower at the same
natural rate of output and therefore saving must rise.
3. Assume the economy starts at the natural level of output. Now suppose there is a decline
in business confidence, so that investment demand falls for any interest rate.
a) In an AD-AS diagram, show what happens to output and the price level in the
short run and the medium run.
b) What happens to the unemployment rate in the short run? In the medium run?

3.

Price
AS

P AS’

P’

P”
AD

AD’

Y’ Yn Output

3. a. The AD curve shifts left in the short run. Output falls below its natural rate
and the price level falls below the level wage setters expected. In the
medium run, the expected price level falls, and AS shifts right, returning the
economy to the original natural level of output, but at a lower price level.

b. The unemployment rate rises in the short run, but returns to its original level
(the natural rate, which is unchanged) in the medium run.

Suppose that the Federal Reserve decides to respond immediately to the decline in
business confidence in the short run. In particular, suppose that the Fed wants to prevent
the unemployment rate from changing in the short run after the decline in business
confidence.

c) What should the Fed do? Show how the Fed’s action, combined with the decline
in business confidence, affects the AD-AS diagram in the short run and the
medium run.

d) How do short run output and the short run price level compare to your aanswers
to part (a)?

e) How do the short run and medium run unemployment rates compare to your
answers to part (b)?

c. The Fed should increase the money supply, which shifts the AD curve right.
A monetary expansion of the proper size exactly offsets the effect of the
 decline in business confidence on the AD curve. The net effect is that the AD
curve does not move in the short run or medium run, and neither does the
AS curve.
d. Under the policy option in part (c), output and the price level are higher in
the short run compared to part a. In the medium run, output is the same in
parts (a) and (c), but the price level is higher in part (c).
e. The unemployment rate is lower in the short run in part (c). In the medium
run, the unemployment rate is the same in parts (b) and (c).

4.

Real Wage M/P

PS

PS’

WS

Un Un’ Unemployment rate

Price
AS”

AS’
P’ AS

Pe

AD

Y’n Y’ Yn Output
4. Assume that the economy starts at the natural level of output. Now suppose there is an
increase in the price of oil.

a) In an AD-AS diagram, show what happens to output and the price level in the
short run and the medium run.

b) What happens to the unemployment rate in the short run? In the medium run?

4. a. The AS curve shifts up to AS’ in the short run where it passes through the point at
the original expected price and the new natural rate of output (Pe , Yn’ ) . In the
medium run price will rise further because price is above the wage setters expected
price and the AS curve will shift further to AS” where expected price equals actual
price at the new natural level of output and employment.

b. The unemployment rate rises in the short run as output falls from Yn to Y’ and
rises further in the medium run as output falls to the new natural rate Y’n .

Suppose that the Federal Reserve decides to respond immediately to the increase in the
price of oil. In particular, suppose that the Fed wants to prevent the unemployment rate
from changing in the short run, after the increase in the price of oil. Assume that the Fed
changes the money supply once – immediately after the increase in the price of oil – and
then does not change the money supply again.
c) What should the Fed do to prevent the unemployment rate from changing in the
short run? Show how the Fed’s action, combined with the increase in the price of
oil, affects the AD-AS diagram in the short run and in the medium run.
d) How do output and the price level in the short run and the medium run compare
with your answers from part (a)?
e) How do the short-run and medium-run unemployment rates compare with your
answers to part (b)?

c. When the increase in markup shifted the AS to AS’ , the increase in price shifted the
LM to LM’ . The Fed could avoid the increase in unemployment by immediately
increasing the money supply to shift LM’ back to LM which will shift the AD curve
right to AD’ and bring output back to the original natural level, but at the higher
price level P”

d. Output and the price level are higher in the short run in part (c). Output is the
same in the medium run in parts (a) and (c), but the price level is higher in part (c).

e. The unemployment rate in the short run is lower in part (c), but the same in the
medium run in parts (a) and (c).
 Interest Rate
LM ( P’ )

LM ( Pe )

IS

Y’ yn Output
Price

AS’
P” AS

P’
Pe
AD’

AD

Y’n Y’ Yn Output