Problem Set 3 Macroeconomics I - Paul Pichler

1. Consider the following IS-LM relationship:

Y = Y + cY bi,
M
= d1 Y d2 i
P
where 0 < c < 1, and Y , b, d1 , d2 are positive constants.
(a) Derive the AD curve and show that output depends negatively on the price level.
(b) Discuss the effects of
i. an increase in the price level,
ii. expansionary monetary policy,
iii. expansionary fiscal policy,
iv. a reduction in the marginal propensity to consume,
on the AD curve.
2. Consider the following economy:

Y = C(Y, T ) + I(Y, i) + G, [goods market equilibrium]

Ms M d (Y, i)
= , [money market equilibrium]
P P
e
W = P F (u, z), [wage setting]
P = (1 + )W, [price setting]

(a) Derive the AS curve. Explain whether it establishes a positive or negative relationship between
output and the price level.
(b) Assume the economy is in its medium run equilibrium. The central bank chooses to conduct a
contractionary monetary policy. Describe the short and medium run effects using IS-LM and
AS-AD diagrams.
3. Graphically illustrate and explain the effects of an increase in unemployment benefits in the IS-LM
and AS-AD framework. Then state the effects on output, in the short run and in the medium run.
Assume that before the increase in unemployment benefits, the economy was at the natural level
of output.

4. Assume that the economy starts at the natural level of output. Now suppose there is an increase
in the price of oil (which leads to an increase in the markup).
(a) In an AS-AD 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?

5. Continuation of Problem 4: 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 price of oil and then does not
change the money supply again.
(a) What should the Fed do to prevent the unemployment rate from changing in the short run?
Show how the Feds action affects the AD-AS diagram in the short and medium run.
(b) How do output and the price level in the short run and the medium run compare to your
answers from 4(a)?
(c) How do the short run and medium run unemployment rates compare to your answers from
4(b)?