Universitat Pompeu Fabra
Introducción a la Macroeconomía
Problem Set 6
1. Consider the effects of a decline in consumers’ confidence, that is, more pessimistic expectations of future income. Is this a demand shock or a supply shock?
A demand shock (it affects C)
1.1 First, look at the short-run effects (assuming that expectations of the price level Pe have not changed). Show what happens in the AS-AD graph, indicating the new short-run equilibrium. Show the short-run changes also in the IS-LM graph. Explain briefly what happens to all the macro variables (and why): output, price level, interest rates, consumption, investment, employment, nominal and real wages.
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↓consumers confidence → ↓C for given Y → ↓goods demand for given r, that is IS shifts to the left → ↓aggregate demand for given P, that is AD shifts to the left (expectation of price level Pe
r
Y
IS LM
Y n r0
Y 1 r1
a
b
Y AS P
Yn Pe
AD
Y1
has not changed, so AS has not moved) → from a to b: ↓Y to Y1, ↓P to P1 (so LM shifts down a
bit, since ↓P→↑M/P); C is lower (both because of pessimistic expectations and lower Y); r is lower, but current Y and expected future Y are also lower, so investment I not sure; employment N is lower; nominal wages w are a bit lower (higher unemployment, lower workers’ bargaining power), the real wage w/P is the same (if the PS is horizontal – P has decreased in proportion to w)
1.2 Then, look at the medium-run effects. Show what happens in the AS-AD graph when price level expectations are revised, indicating the final medium-run equilibrium. Show it also in the IS-LM graph. Compare the final levels with the initial ones for all the macro variables: output, price level, interest rates, consumption, investment, employment, nominal and real wages. Explain briefly the adjustment process.
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Expectation of price level Pe is revised, now lower, so AS shifts down → from b to c: nominal
wages w decrease more (because of lower Pe), so ↓P to P
2 and Y goes back to its natural level
Yn ; LM shifts down because ↓P, so ↓r → ↑I→ ↑goods demand back to Yn ; C is higher than in b
(for the recovery of Y), but not as high as it was in a (since consumers’ expectations of future income are lower); I is higher and makes up for the lower C; employment N is back to its natural level and the real wage w/P is the same (w and P have decreased in the same proportion).
2. Consider an economy with the following price-setting relation: P = (1+μ) w/A
where prices are set with a mark-up μ over the marginal cost of production w/A. A is a parameter indicating the level of productivity: in the usual case it is equal to 1; an increase in productivity means A>1, so firms’ marginal costs for the same wage are lower.
Now suppose that the economy experiences an increase in labor productivity A (due to a technological or organizational improvement). Is this a demand shock or a supply shock? A supply shock (it affects production costs, so the price-setting relation; and the production function – the relation between output and labor employed)
2.1 First, look at the short-run effects (assuming that expectations of the price level Pe have not changed). Show what happens in the AS-AD graph, indicating the new short-run equilibrium. Show the short-run changes also in the IS-LM graph and in the labor market. Explain briefly what happens to all the macro variables (and why): output, price level, interest rates,
consumption, investment, employment, nominal and real wages.
Price-setting relation P = (1+μ) w/A → w/P = A/(1+μ)
↑productivity A → ↓production costs → ↓P for given w → ↑w/P (PS shifts up) → ↑Nn (natural
level of employment), ↓un (natural level of unemployment) → ↑Yn (natural level of output) both
because of ↑Nn and of ↑A (labor more productive)
For the same expected price level Pe, the AS curve shifts down (lower costs → lower P at any Y),
as the natural level of output shifts to the right (to Y′n). Short-run movement from a to b: ↑Y to
Y1, ↓P to P1 (so LM shifts down, since ↓P→↑M/P); C is higher; ↓r → ↑I ; employment N is
higher (N1), but not as much as the new natural level N′n (price expectations have not changed
and nominal wages are too high); nominal wages w are a bit higher (lower unemployment, higher workers’ bargaining power), the real wage w/P has increased (↑w and ↓P).
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2.2 Then, look at the medium-run effects. Show what happens in the AS-AD graph when price level expectations are revised, indicating the final medium-run equilibrium. Show it also in the IS-LM graph and in the labor market. Compare the final levels with the initial ones for all the macro variables: output, price level, interest rates, consumption, investment, employment, nominal and real wages. Explain briefly the adjustment process. What has happened to the natural levels of output and employment (and to the natural rate of unemployment)?
Y IS
r LM
r1
Y 1 r0
Y
n Y′n
a b
Y AS P
Yn AD
Y1 P1
Pe
Y′n a
Expectation of price level Pe is revised, now lower, so AS shifts down → from b to c: nominal
wages w decrease (because of lower Pe), so ↓P to P
2 and Y increases up to its new natural level Y
′n ; LM shifts down more because ↓P, so ↓r → ↑I ; C is higher; employment N goes up to its new
natural level N′n (unemployment goes down to its new natural rate u′n) and the real wage w/P
stays at its higher level.
DEMAND SHOCKS
3. Consider the following AS-AD model: (AD) Y = 300 + 30 (M/P)
(AS) Y = Y + 10 (P – Pe)
where M=400 is the money supply, Pe is the expected price level and Y=500 is the natural level of output.
3.1 Suppose that the economy is initially in its medium run equilibrium, with output equal to its natural level. Find the price level (Hint: use the AD). Now find the expected price level (Hint: use the AS)
We use the AD curve to find the price level when the economy is in equilibrium, given that in equilibrium, the level of production will be the natural level of output, ie, Y = 500:
Y=300+30M P 500=300+30400
P
⇒P=60
To find the expected price level consistent with equilibrium, we use the AS curve:
Y
=
Y
+
10
(
P
−
P
e)
500
=
500
+
10
(
60
−
P
e)
Graphical representation of the AS-AD equilibrium:
3.2 Draw the medium run equilibrium using the AD and the AS curves. Call A the equilibrium point. Now supposes that the Central Bank unexpectedly (and immediately) increases the Money supply to M’ > M. Show graphically the short run effect on the level of prices and output. Call B this point.
Graphically, we see that the unexpected and permanent increase in the money supply by the central bank results in a rightward shift of the AD curve:
A P
Y ASS R
AD ASM
R
Y = 500 P=Pe=
60
B A P
Y Y = 500
P=Pe= 60
ASS R
AD ASM
R
3.3 Suppose M’ = 700. Compute numerically the short run equilibrium point. Note that unexpected changes in the AD do not change the expected price level in the short run. M’ = 700
Y=300+30700
P Y=500+10(P−60)
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Solving the system:
300+30700
P =500+10(P−60)
Solving for the value of P we obtain:
10P2−400P−21000=0
We must find the roots of the quadratic polynomial:
P
=
400
±
√
400
2
+
4
×
21000
×
10
2
×
10
P
1=
70
P
2=−
30
As the price level can not be negative, we choose the first value. We can find the production level by replacing the price level in the AD or AS equation:
PB=70⇒YB=600
3.4 Suppose that people revise their price expectations in accordance with the new medium run equilibrium price level.
Calculate the revised expected price
Represent graphically the new medium run equilibrium.
With rational expectations, agents revise the expected price level taking into consideration the
To find this new medium run equilibrium price level, we use the new AD’ curve:
Y=300+30700 P '
Y=500⇒500=300+30700 P'
⇒
P '
=
P
e=
105
If we consider that agents have rational expectations, the situation is as follows:
In this case the new short run AS curve will be ASSR'. The new short run equilibrium, B 1,
coincides with the medium run equilibrium C.
QUESTION 4
Consider the European Commission Press Release about Winter 2016 Economic Forecast. a. Consider the following paragraph:
“Unemployment rates are set to continue falling, albeit at a slower pace than last year. The decline should be more pronounced in Member States where labour market reforms have been implemented.“
How can labour market reforms reduce the unemployment rate in the medium-run? Use the wage-setting and the price-setting equations that we have seen in class to answer to this question.
In order to reduce unemployment in the medium run one needs to modify the natural rate of unemployment. Graphically/mathematically this is achieved by shifting the wage setting curve to the left (or downwards) or move the price setting equation downwards. Policies shifting the price setting equation downwards are increased antitrust measures and policies affecting the wage setting behavior in the wished way are cuts in unemployment benefits or abolishment of existing
P’=P’e
B A
ASS R’
C=B1 P
Y Y = 500
P=Pe= 60
ASS R
AD ASM
R
minimum wages. Shocks in these variables either directly (reduce of mark-up) or indirectly (lower demanded wages by decreasing reservation wages) decrease prices set by firms for given price expectations and thus move the AS curve to the right. Then second order effects (price expectations are adjusted downwards) move the AS curve even further to the right.
b. Consider the following paragraph:
“Annual inflation in the euro area was only slightly above zero towards the end of 2015, mainly due to a further drop in oil prices. Consumer price increases in the euro area are expected to remain very low in the first half of the year and should start picking up in the second half when the impact from the sharp fall in oil prices abates.“
Consider the AS-AD model that we have seen in class. In these days, the world is experiencing an exceptional reduction in oil-prices. What is the impact of such a phenomenon on prices and GDP in the short-term and in the medium-term?
(Negative) oil price shocks affect price setting behavior through a reduction in the mark-up (Lower costs of production, lower mark-up). That implies lower natural unemployment and higher natural GDP.
In the short run, prices decrease quickly as a first-order reaction to the cost-shock. This means the AS curve shifts down and there is new short run equilibrium. This transition should be accompanied by high deflation or (in case other prices are still increasing due to other factors than the oil price shock) very low inflation.
The medium run dynamics depend on whether the shock is anticipated to be permanently or not. The situation at the short run equilibrium is one where prices are lower than expected prices. If agents believe that the oil price will increase again they will not lower their price expectations and the AS curve stays where it is until oil prices increase again and it moves up to its very initial position. This period then is accompanied by high inflation.
If the shock is believed to be permanently then agents will adjust their price expectations downwards and the AS curve will move even more to the right. That means prices will fall even more and output will increase further. This period should be accompanied by low, steady inflation rates until price expectations and prices coincide.
c. Consider the following paragraph:
“Euro area export growth should accelerate over the course of 2016 following a moderation in the second half of 2015. This is due to lagging effects from the euro’s past depreciation, lower unit labour costs, and a gradual increase in foreign demand.”
Why do exports respond to euro’s past depreciation?
QUESTION 5
Consider the attached article titled “Trans-Pacific Trade Pact Would Lift US Incomes, but Not Jobs Overall, Study Says” (New York Times)
a. Consider the AS-AD model and assume that the Trans-Pacif Trade Pact would increase competition in the domestic product market and reduce the mark-ups over marginal costs that are charged by domestic firms.
What would be the impact of this change in product market competition on GDP in the medium term? What is going to be the impact in the short term?
Medium Run
If mark-ups decrease, the natural unemployment rate decreases and natural output increases. The vertical Long Run AS curve shifts to the right: Medium Run (Potential) GDP will be higher.
Short Run
