Solutions to Practice Problems

Money market and the LM curve

  1. Real balances = M/P.
  2. see textbook.
  3. Fed controls the money supply through buying and selling gov't debt (open market operations).
  4. Real money demand, LD, depends on Y (+), r (-) and expected inflation (-).
  5. The LM curve is combinations of r and Y such that money demand = money supply.
  6. Anything that increases the money supply shifts the LM out; anything that increases money demand shifts the LM in.
  7. The slope of the LM curve depends on the slope of the money demand function.

IS and LM together

  1. Increase in G implies r and Y increase: IS shifts right.
  2. Increase in M implies r decreases and Y increases: LM shifts right.
  3. Increase in expected inflation implies r decreases and Y increases: LM shifts right.
  4. Increase in FMPK implies r and Y increase: IS shifts right.
  5. Increase in corporate profits tax implies r and Y decrease: IS shifts left.
  6. Increase in the tax rate on interest income implies r and Y increase: IS shifts right.
  7. Increase in the interest rate on money implies r increases and Y decreases: LM shifts left.
  8. Increase in FY implies r and Y increase: IS shifts right.

Policy questions using the long-run classical model

  1. Increase in M: AD shifts right and P goes up to clear the market. Y, r, W/P, N, S and I stay the same; P is higher.
  2. Increase in G with no wealth effect on labor supply: IS and AD shift right, P rises, LM shifts left and r rises. Y, W/P and N stay the same; r is higher; S and I are lower.
  3. Increase in G with a wealth effect on labor supply: IS and AD shift right, NS shifts right because people feel less wealthy due to the increased budget deficit and so W/P falls and N rises. As N rises, supply (Y) rises and the FE and long-run AS curves shift right.

Important definitions

  1. The AD curve is all combinations of (P,Y) such that IS = LM.
  2. The long-run AS curve is the same as the FE line.
  3. The lucal supply curve is an upward sloping short-run aggregate supply curve that relates actual output to potential output, the actual price level and the expected price level: Y = Y* + b(P - Pe).

Classical real business cycle models in the short-run

Solutions to Old Midterm 2

Definitions

  1. An endogenous variable is determined within a model and is explained by exogenous variables.
  2. Ricardian equivalence holds if an increase in gov't purchases (not financed by increasing taxes) leads to an equal decrease in consumption (increase in saving) due to individuals saving more today to meet future tax liabilities.
  3. Money neutrality refers to the result in the classical long-run model that an increase in the money supply has no effect on real variables (e.g. r, Y, W/P).
  4. The classical AS curve is a vertical line in P-Y space indicating that in long-run equilibrium supply is fixed by labor market conditions and the production function.
  5. Business cycles are reoccuring expansions and contractions of aggregate economic activity.
  6. An exogenous variable is determined outside of a given model.
  7. Rational expectations obtains when economic agents use all information available to make optimizing decisions. It also assumes that agents know the complete workings of the economy and that they don't make systematic mistakes.

Business cycles

    1. M1 is procycle and leading.
    2. W/P is procyclical and coincident (mildly).
    3. r is acyclical with unclassified timing.
    4. u is countercyclical with unclassified timing.
    5. P is procyclical and lagging.
    1. Supply shocks (or real shocks) are responsible for business cycles in the classical model. The real business cycle school focusses on productivity shocks.
    2. Oil price increase, technological breakthrough.

IS/LM and AD

    1. IS shifts in, r and Y decrease.
    2. LM shifts up, r increases and Y decreases.
    3. LM shifts down, r decreases and Y increases.
    4. No change in IS or LM.
    5. IS shifts in,r and Y decrease.
  2. The AD curve is all combinations of (P,Y) such that IS = LM. AD slopes downward because as P decreases the LM curve shifts left which drops the real interest rate, r. As r falls, investment and consumption demand increase which increases AD.

IS/LM/FE - AD/AS: Decrease in M

As M0 falls to M1, the LM curve shifts back raising r and reducing Y (demand). As Y falls the AD curve shifts down. At the initial price level, P0, AD < AS which puts downward pressure on P. As P falls to P1 the LM curve shifts back to its original position so that r and Y (demand) retrun to their initial levels. The end result is no change in Y, N, r, W/P, M/P and a lower price level.

There is no business cycle (trick question); this example does not explain procyclical and leading money.

IS/LM/FE - AD/AS: Oil shock in reverse

The decrease in the price of oil increases productivity (A) so the production function shifts up and the labor demand curve shifts up as well. The new equilibrium in the labor market is at a higher level of employment (N) and a higher real wage (W/P). From the production function, a higher level of N leads to a higher level of Y. This shifts the FE and long-run AS curves to the right. At the initial price level, P0, AS is now greater than AD which puts downward pressure on P. As P falls the LM curve shifts down reducing r and increasing Y (demand). As P falls and Y increases the economy moves along the AD curve. The end result is higher Y, N, W/P, M/P and A; lower r and P.

This is an example of a classical boom. The business cycle facts explained are procyclical Y, N, W/P and Y/N. The inconsistent result is counter cyclical P.