Problem

Set 3 *Solution*
Macroeconomics, ECON 2123

Part I: True/False/Uncertain Please justify your answer with a short argument for each question and
draw a diagram if necessary.

1. Suppose that workers in the Republic of Communia are highly unionized, while workers in the
Republic of Individuela are not. In all other respects, the two countries are exactly the same. Then
Communia is likely to have a higher natural level of output than Individuela.
False.

In our model of the labor market, the level of unionization is captured by the

Communia is likely to have a higher natural rate of unemployment than Individuela. Hence Communia is
likely to have a lower natural level of output than Individuela.

2. Suppose there is a decrease in the price level from P to P. Given the stock of nominal money, M, this
leads to an increase in the real money stock, M/P, which shifts the LM curve down. This implies that the
AD curve shifts to the right.

3. When output is below the natural level of output, the actual price level is lower than the expected price
level.
True. The actual price level equals the expected price level when output is equal to the natural level of
output. Because the AS curve is upward-sloping, if output is below its natural level, the actual price level
is lower than expected. See diagram:

4. In terms of changing output, monetary policy is relatively more effective when the AS curve is
relatively flat, while fiscal policy is more effective when the AS curve is relatively steep.
False. Monetary and fiscal policies affect the AD curve, not the AS curve. Monetary and fiscal policies
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are both more effective in changing output when the AS curve is flatter and less effective when the AS
curve is steeper. In the extreme case, when the AS curve is vertical, neither policy has any effect on
output (the only effect of monetary and fiscal policy in this case is a change in the price level).
5. The aggregate demand relation slopes down because at a higher price level, consumers wish to
purchase fewer goods.
False. The AD curve slopes down because an increase in P leads to a fall in M/P, so the nominal interest
rate increases, and investment I and output Y fall.

Part II: The Labor Market (Chapter 6)

1. The existence of unemployment
(a) Suppose previously the unemployment rate was relatively high. But now things change: the
unemployment rate becomes very low this year. What change happens in terms of the relative bargaining
power of workers and firms when the unemployment rate becomes very low? What do your answers
imply about what happens to the wage as the unemployment rate gets very low, given expected price and
actual price constant?
(When the unemployment rate is very low, it is very difficult for firms to find workers to hire and very
easy for workers to find jobs. As a result,) the bargaining power of workers is very high relative to firms
when the unemployment rate is very low. Therefore, the wage gets very high as the unemployment rate
gets very low.
(b) Given your answer to part (a), why is there unemployment in the economy? (What would happen to
real wages if the unemployment rate approached zero? Suppose expected price and actual price remain
constant.)
Presumably, the real wage would grow without bound as the unemployment rate approached zero since
the wage is a decreasing function of unemployment rate. (Since a worker could always find a job if the
unemployment rate equaled zero, there would be nothing to constrain aggressive wage bargaining.) At
any positive rate of unemployment, however, there is some constraint on workers' bargaining power, so
the real wage cannot grow without bound. (You can also show this using the wage-setting relation curve
in the diagram).

Part III: The IS-LM Model and the AS-AD Model (Chapter 5 and Chapter 7)
1. The Republic of Keynesia is a closed economy and obeys our short-run IS-LM model. Assume it starts
out in equilibrium in both the goods market and the money market. Keynesias economy is described by
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the following set of equations:

Goods market:

C = c0 + c1 (1-t)Y, where C is consumption; Y is income; t represents a proportional tax; and c0 and

c1 are positive constants

I = b0 b1 i, where I is investment; i is the interest rate; and b0 and b1 are positive constants

G = G , where G is a positive constant

Money market:

M = P (m0 + m1Y m2 i), where M is nominal money demand; P is the price level; m0 (a positive
d

constant) represents exogenous changes to M ; and m1 and m2 are also positive constants
Let Ms represent nominal money supply
(a) Derive the IS relation and the LM relation equations.
IS:

LM: Ms = Md
Ms/P = m0 + m1 Y - m2 i

(b) Now suppose 1/[1-c1(1-t)]= for simplicity. Derive the expression for aggregate demand using
your answer to part (a). (Hint: To derive the AD curve, just substitute in for i into the IS equation
from the LM equation. You will obtain an equation of Y as a function of P.)

(c) Now let:

c0=200

c1=0.5

b0=300

b1=0.4

m0=400

m1=1

m2=0.8

Ms=200

G=100

t=0

Yn=550

Derive the AD equation using these figures. (All figures are in millions of HK dollars.)

(d) Use the same condition in part (c). Suppose the aggregate supply takes the following form:
P = Pe + (1/50)( Y Yn ) and P=1. Assume we are in the short-run for now. What is the equilibrium
output, Y*? What is the expected price level, Pe? Draw and label the AS-AD diagram for this case
and denote the equilibrium in this economy as point A. Also denote the natural level of output in the
diagram.
First, use the AD equation from part (c), substitute P=1, you will obtain the equilibrium Y*=500.
Then, use the AS equation, obtain Pe=2.

(e) If Y happened to be equal to the natural level of output Yn, what is the relation between P and Pe?
When Y=Yn, P= Pe

(f)

The Keynesian government is up for reelection soon, and so it wants to achieve the natural level of
output. (We are still in the short run.) Propose two different policy options that would do the job.
For each policy option, draw the AS-AD and the IS-LM diagrams, and show how the two diagrams
are related to each other. Calculate by how much the government must increase/decrease
government spending to achieve the natural level of output. For monetary policy, you dont need to
do any calculations. What is the difference between the effects of the two policy options?

(g) The Keynesian government decides not to listen to you, and raises government spending by more
than would be required to achieve the natural level of output. Its argument is that higher output is
better. The voters apparently think so too, and the government gets reelected. What happens as time
passes and we get to the medium run? (You do not have to do any calculations, just draw
diagrams and give some intuition/explanation.)

2. Closed Economy AS-AD (33 marks)

Price Setting Relation: W = Pe F (u, z)

Wage Setting Relation: P = (1 + ) W
Goods Market: Y = C(Y, T) + I(Y, i) + G
Financial Market: Ms /P = Md (Y, i)
(a) Find the aggregate supply relation. Describe the channel through which the AS curve slopes up/down.
(3 marks)

(b) Assume that the economy is at a point such that the unemployment rate is equal to the natural rate of
unemployment. What does this imply about the price level and output? Explain. (2 marks)

(c) If the Fed carries out a monetary contraction, what happens in the short-run (SR) and the
medium-run (MR)? Start from point A where P = Pe. Label the following: all curves including
(IS0, ISSR, ISMR, LM0, LMSR, LMMR, ADSR, ADMR, ASSR, ASMR, where the subscript 0 denotes
initial status), the short-run equilibrium as point B, the medium-run equilibrium as point C, and
output associated with natural rate of unemployment. (10 points)
See in-class notes.
(d) What does neutrality of money imply about the effectiveness of contractionary monetary policy in
affecting output and interest rate in the short- and medium-run? (2 marks)

(e) If the price of oil increases sharply, what happens in the short-run (SR) and the medium-run (MR)?
Start from point A where P = Pe. Label the following: all curves including (IS0, ISSR, ISMR, LM0,
LMSR, LMMR, ADSR, ADMR, ASSR, ASMR, where the subscript 0 denotes initial status), the short-run
equilibrium as point B, the medium-run equilibrium as point C, and output associated with natural
rate of unemployment. (10 marks)

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(f) Indicate whether these variables increase, decrease or remain the same when the price of oil rises
sharply. (You may use arrows.) (6 marks)

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