QUIZ 6: Winter 2012 Name: ___ANSWERS________________ Evening Section Registered "am#$s Evening Morning Wee%end &'()(

Mai !o der:

Q$i* ass$m#tions +REA),-: Use the models developed in class with our standard assumptions. In #artic$ ar. ass$me: Note: All consumers are non-liquidity constrained, non-Ricardian PIH (as developed in class !" # $ %&pected in'lation has no e''ect on money demand All chan(es are permanent and une&pected unless told otherwise )he economy is initially in lon( run equili*rium at +, No monetary or fiscal policy takes place unless I tell you otherwise )-P, ta&es, consumer con'idence, value o' leisure, population, (overnment spendin(, and the nominal money supply do not chan(e unless I tell you they chan(e /o$ can $se a 0 an% #iece a #a#er or 0 an% macro 1or%s'eets 1'en ans1ering t'ese 2$estions( /o$ s'o$ d not 'and t'ese in( Q$estion 1 +10 #oints 3 2 #oint eac'4iven t'e mode deve o#ed in c ass. 1'ic' o5 t'e 5o o1ing are $nam0ig$o$s 6 tr$e a0o$t a #ermanent increase in 7!& +A-8 "irc e a t'e tr$e statements( 7'ro$g'o$t. 5or sim# icit6. ass$me t'ere are no income e55ects on a0or s$## 6( a. .uppose prices are 'i&ed in the short run. .uppose the economy returns to lon( run equili*rium (+ returns to the new +, via the sel'-correctin( mechanism. /etween the short run and the lon( run, nominal wa(es (0 will increase and the money demand curve will shi't in. 7RUE

c a !s$ !$, !1, ! In t'e a0or mar%et. t'e a0or demand c$rve 1i s'i5t o$t( W'68 We %no1 M&N +5or "o009 )o$g as. M&N : (;A+<=N-(>- 1i increase as A increases( !rom t'e initia condition to t'e s'ort r$n. t'e increases 5rom N? to N( 7'ro$g' t'e se 5 correcting mec'anism. W increases +1e 1a % $# t'e a0or demand c$rve-( As W increases. t'e cost o5 #rod$ction increases. so SRAS 1i s'i5t in $nti / : t'e ne1 /?( As / 5a s. mone6 demand m$st s'i5t in( * !d1 !d$

*. .uppose prices are 'i&ed in the short run. .uppose the economy returns to lon( run equili*rium (+ returns to the new +, via -ed policy. /etween the short run and the lon( run, the la*or demand curve (!d will shi't in and investment (I will 'all. !A@SE -ed policy will a''ect the money supply (2 which will in turn a''ect + (as A3 shi'ts in , prices (as the A3 curve shi'ts in and interest rates (as the 42 curve shi'ts in . )he la*or demand curve is not a''ected *y 2, prices, or interest rates5 4et6s thin7 a*out what happens in the money mar7et. As + 'alls, money demand 'alls which will put downward pressure on interest rates. As money supply 'alls as a result o' -ed Policy, it will put downward pressure on interest rates. It seems the e''ect on interest rates is am*i(uous *ut it is not as we will see in the I.842 mar7et. In the I.-42 mar7et, the 42 curve shi'ts in (as 28P 'alls causin( interest rates to increase. Interest rates must increase in order 'or the economy to (et *ac7 to +,. As r increases, investment must 'all. )his part is true. c. .uppose prices 'all in the short run. .uppose the economy returns to lon( run equili*rium (+ returns to the new +, via the sel'-correctin( mechanism. /etween the initial condition and the lon( run, consumption (9 will increase and the a((re(ate demand (A3 curve will *e shi'ted ri(ht. 7RUE I' prices 'all in the short run, we 7now the ma(nitude o' the shi't out o' the .RA. curve (it shi'ts out *ecause production *ecomes more e''icient as technolo(y improves must *e (reater than the ma(nitude o' the shi't out o' the A3 curve (which shi'ts out 'rom the increase in consumption . + may or may not *e *elow +, in the short run (it depends on how much prices 'all and 08P increases. I' 08P increases a lot in the short run, ! can actual 'all *elow the new !,. . In order 'or the economy to return to +, and 'or ! to return to !,, 0 must 'all. 0e 7now the new 08P, will *e a*ove the old 08P, which means P:4R will increase. As P:4R increases, 9 will increase in the short run and stay increased in the lon( run. /etween the initial condition and the lon( run the A3 curve will remain shi'ted out as it is shi'ted out 'rom the increase in 9 and the increase in I(. and the sel' correctin( mechanism will a''ect the .RA. not the A3 curve. d. .uppose price rise in the short run. .uppose the economy returns to lon( run equili*rium (+ returns to the new +, via -ed policy. ;utput (+ will 'all *etween the short run and the lon( run and prices will 'all *etween the short run and the lon( run. 7RUE I' prices rise in the short run, we should assume the ma(nitude o' the shi't out o' the A3 curve will *e (reater than the ma(nitude o' the shi't out o' the .RA. curve. + will *e a*ove +, (as 08P 'alls in the sort urn and ! will *e a*ove !,. -ed policy will reduce 2, shi'tin( in the A3 curve which will cause P to 'all and + to 'all (returnin( to the new +, . e. .uppose prices rise in the short run. .uppose the economy returns to lon( run equili*rium (+ returns to the new +, via the sel'-correction mechanism. /etween the initial condition and the lon( run, the I. curve will *e shi'ted ri(ht and the 42 curve will *e shi'ted le't. 7RUE I' prices rise in the short run, we should assume the ma(nitude o' the shi't out o' the A3 curve will *e (reater than the ma(nitude o' the shi't out o' the .RA. curve. + will *e a*ove +, and ! will *e a*ove !,. )he I. curve will *e shi'ted out initially 'rom the increase in 9 (as P:4R increases . As the economy will return to equili*rium throu(h the sel' correctin( mechanism, we 7now the sel' correctin( mechanism a''ects the 42 curve in the I.-42 mar7et<not the I. curve. .o the I. curve

remains shi'ted out. )he sel' correctin( mechanism will cause wa(es to increase to (et the la*or mar7et *ac7 to the new !,. )he increase in wa(es will shi't *ac7 the .RA. curve as production *ecomes more e&pensive which will put upward pressure on prices. As prices increase, the 42 curve will shi't le't which will cause + to 'all.

Q$estion 2 +10 #oints 3 2 #oint eac'W'ic' o5 t'e 5o o1ing are $nam0ig$o$s 6 tr$e a0o$t a #ermanent dec ine in a0or income taAes +tn-8 Ass$me t'e income e55ect on a0or s$## 6 is greater t'an t'e s$0stit$tion e55ect on a0or s$## 6( "irc e a tr$e ans1ers( a. 9onsumption (9 will rise *etween the initial condition and the lon( run. 7RUE A'ter ta& wa(es will increase as la*or income ta&es decline. )his means, P:4R will increase which means consumption will increase *etween the initial condition and the lon( run. *. Interest rates (r will rise *etween the initial condition and the lon( run. 7RUE /etween the initial condition and the short run, interest rates will increase as the I. curve shi'ts out (as consumption increases and the money demand curve will also shi't out (as + increases 'rom the increase in 9 . /oth o' these shi'ts will put upward pressure on interest rates. !ow let6s thin7 a*out what happens *etween the short run and lon( run. /ecause the income e''ect dominates, we 7now the la*or supply curve will shi't in. 0hy= A'ter ta& wa(es increase as a result o' the decrease in la*or income ta&es. )hus, the income e''ect tells us that people will 'eel permanently richer and want to wor7 less. )he new !, will *e *elow our ori(inal !,. As the A3 curve shi'ts out 'rom the increase in consumption, prices will increase in the short run, which means 08P will 'all. .o ! will *e a*ove !,. In order to (et *ac7 to the equili*rium condition, *etween the short run and lon( run, 0 will have to increase *y a lot which will shi't *ac7 our .RA. curve (production is more e&pensive . As the .RA. shi'ts in, prices will increase. As prices increase, the 42 curve (28P will shi't in which will put upward pressure on interest rates. )he cumulative e''ect is that interest rates will increase *etween the initial condition and the lon( run. c. 2oney demand will shi't ri(ht *etween the initial condition and the short run. 7RUE As 9 increases, + will increase. )his means, the I. and money demand curves will shi't out *etween the initial condition and the short run. d. )he la*or demand (!d curve will shi't ri(ht *etween the initial condition and the short run. !A@SE )he la*or demand curve is a''ected *y A and >. )here are no chan(es to A or >. e. /e'ore ta& real wa(es (08P will 'all *etween the initial condition and the short run. 7RUE /etween the initial condition and the short run, 08P 'alls as P increases 'rom the shi't out o' the A3 curve (as a result o' the increase in 9 .