Questions under problems from your textbook.

Chapter 9-IS curve.

5. Suppose that Japan imposes an anti-dumping tariff on imports of Chinese solar panels. Given that
this will decrease Japanese imports of those goods, a) comment on the effect on the Japanese
IS curve; b) show the answer using a graph.

a. The decrease in Japanese imports of Chinese solar panels will increase Japanese net exports, one
of the components of planned expenditure. This will increase aggregate output at any interest
rate, therefore shifting the IS curve to the right.
b. The Figure should mimic Figure 9.3 in the text.

7. After the press conference that followed the Federal Open Market Committee meeting on a)
Calculate Dell’s inventory on December 31, 2016. b) Calculate Dell’s inventory investment
in 2017. c) What happens to inventory spending during the early stages of an economic
recession?
a. An increase in interest rates will decrease consumption expenditure, decrease planned investment
spending, and decrease net exports, as summarized by the terms c, d, and x in Equation 10.
This reduction in planned expenditure (assuming the goods market is in equilibrium) will
result in a decrease in aggregate output. The effect of an increase in interest rates is a
movement along the IS curve to the northwest. The IS curve does not shift.
b. See graph.

8. . Suppose that according to British newspapers prospects for stronger future economic growth
will lead the British sterling to strengthen and stock prices at the London Stock Exchange to
increase. Comment only on a) The effect of the strengthened sterling on the IS curve. b) The
effect of the increase in stock prices on the IS curve.

a.A stronger sterling will result in fewer British exports and more British imports, therefore it will
decrease net exports. This shifts the IS curve to the left, decreasing aggregate output at any
interest rate.
 b. An increase in stock prices is generally viewed as having positive effects on autonomous
planned investment, given the brighter future business perspectives. It could be argued that
increased stock prices increase financial wealth, with potential positive effects on
consumption (via the so-called wealth effect). All in all, these developments should shift the
IS curve to the right.

Chapter 11

3. . Suppose that the expectations-augmented Phillips curve is given by π = πe - 0.51U - Un2. If

expected inflation is 3% and the natural rate of unemployment is 5%, complete the
following: a) Calculate the inflation rate according to the Phillips curve if unemployment is
at 4%, 5%, and 6%. b) Plot the points from part (a) on a graph, and label the Phillips curve.

a. Substituting the values of expected inflation and the natural rate of unemployment yields the
following expression:   3  0.5(U  5) . According to this expression, inflation rates are 3.5
percent, 3 percent, and 2.5 percent when unemployment rates are 4 percent, 5 percent, and 6
percent, respectively.
b. See graph:

c. If wages become more rigid, then the slope of the Phillips curve becomes flatter.
Algebraically, the  parameter decreases in absolute value to express the rigidity in wages.
When prices become less flexible, the same unemployment gap has a smaller effect on
inflation rates, which translates into a more horizontal Phillips curve.

4. In 2008 the price of oil peaked at more than $130 per barrel, causing increases in inflation rates
in most developed countries. Unemployment rates did not seem to immediately respond to this
shock. Explain what happened to inflation and unemployment in 2008 using the modern Phillips
curve.

Price shocks can shift the modern Phillips curve. A negative price shock such as the 2008 oil price
increase raised prices independently of inflation expectations and labor market conditions,
resulting in a shift upwards of the Phillips curve. As a result, inflation was higher at any
unemployment rate.
5.. Suppose Okun’s law can be expressed according to the following formula: U - Un = -0.75 * 1Y -
YP2. Assuming that potential output grows at a steady rate of 2.5% and that the natural rate
of unemployment remains unchanged, a) Calculate by how much unemployment increases
when real GDP decreases by one percentage point. b) Calculate by how much real GDP
increases when unemployment decreases by two percentage points.

a.The percentage point change in unemployment is: % = - 0.75  (%Y). Therefore, a 1 percent
decrease in real GDP results in a 0.75 percentage point increase in unemployment.
b. The percentage point change in real GDP is: %Y = - 1.33% U. Therefore, a 2-percentage
point decrease in unemployment results in a 2.66 percent increase in real GDP.

Chapter 12

2. The economic measures undertaken in 2013 by the Japanese government of Prime Minister Abe
include the devaluation of the yen. Why could this stimulate the Japanese economy?

A depreciation of the Japanese currency would make Japanese exports cheaper for foreign consumers,
and at the same time it would make Japanese imports more expensive. This would result in
increased exports and decreased imports, therefore net exports would increase. Such an increase
would shift the aggregate demand curve to the right and upward. This can have positive effects
on the economy, but it could be counteracted (at least partially) by a left-and-upward shift of the
short-run aggregate supply curve if Japanese firms import a significant part of their inputs (which
become more expensive together with the rest of the Japanese imports).

3. Suppose that the Italian government decides to increase military spending to finance its missions
abroad, without cutting spending in other areas. a) Comment on the effect of this measure on
aggregate demand. b) Show your answer in a graph.

a.An increase in government spending results in an increase of aggregate demand at any inflation rate,
with beneficial effects on output.
b. The aggregate demand curve shifts to the right and upwards, as in Figure 12.3 step 1.

4. Oil prices declined in the summer of 2008, following months of increases since the winter of 2007.
Considering only this fall in oil prices, explain the effect on short-run aggregate supply and long-
run aggregate supply, if any.
The decrease in oil prices made production possible at lower costs by decreasing the price of energy,
transportation, and a number of raw materials. It therefore lessened pressure for firms to raise
prices, reducing inflation at every equilibrium level of output. Graphically, the short-run
aggregate supply curve shifted downward and to the right. Because neither technology nor
factors of production were affected by this price shock, the long-run aggregate supply curve
remained unchanged.

5. Suppose that in an effort to reduce the current federal government budget deficit, the White
House decides to sharply decrease government spending. Assuming the economy is at its longrun
equilibrium, carefully explain the shortand long-run consequences of this policy
The decrease in government spending will result in a decrease in aggregate output at every inflation
rate and, therefore, will shift the aggregate demand curve downward and to the left in the short
run. The economy will be at a short-run equilibrium with output below its potential and a lower
 inflation rate. The corresponding decrease in expected inflation and the relatively higher
unemployment rate (i.e., a slack labor market) cause a downward and rightward shift of the
short-run aggregate supply curve. The self-correcting mechanism has restored the economy to its
long-run equilibrium, where output is at its potential and the inflation rate has decreased even
further. In conclusion, the short-run effect of this policy is a temporary reduction in output and
inflation, whereas inflation decreases further, and output remains unchanged in the long run.

6. According to aggregate demand and supply analysis, what would be the effect of appointing a
Federal Reserve System chairman known to have no interest in fighting inflation?

The appointment of a Fed chairman who has no interest in fighting inflation will most likely result in
an increase in expected inflation. Both firms and workers will expect inflation rates to be higher
at any output level. With aggregate demand and supply analysis, we illustrate these expectations
by shifting the short-run aggregate supply curve upward and to the left. In the short run, inflation
increases, and output decreases. Depending on the ability of the new chairman to fight inflation,
inflation expectations might be lowered later, and the economy will then return to its initial long-
run equilibrium. If inflation expectations cannot be reduced, then the economy might find itself
at the short-run equilibrium characterized by higher inflation and lower output for a long time.

9. An article in the Wall Street Journal reported that inflation-adjusted wages have slumped in
recent years. Is this statement consistent with the aggregate demand and supply analysis of the
recent U.S. economic crisis? Explain.

Technological change affects the long-run aggregate supply curve. More fuel efficient cars result in a
decrease in the demand for gas at the same time that innovations in energy production make it
possible to increase the supply of energy at any price level. Innovations in these fields result in a
shift to the right in both the short- and long-run supply curves. In conclusion, inflation decreases,
and output increases in the long run.

Additional questions

1. What determines the slope of IS curve? The LM curve

2. Use IS-LM model to explain the following

 The government institutes a severe cut in government expenditure

 The central bank starts a QE program

 The central bank fears inflationary pressures and raises interest rates

 The government raises taxes to cut the budget deficit.

 3. Explain the effects of deflation using the IS-LM framework

Answers

1. The slope of the IS curve is determined by the responsiveness of consumption and

investment expenditure to changes in interest rates. The slope of the LM curve is
determined by the responsiveness of the demand for money to changes in interest rates. In
both cases, it is not the existence of a relationship that economists disagree about, but the
strength of the relationship – just how responsive is consumption and investment
expenditure to interest changes? And how responsive is the demand for money to interest
rate changes? The argument is really about the extent of the crowding out effect. The more
sensitive is consumption and investment expenditure to changes in interest rates the greater
will be the crowding out effect.

2. a. Significant cuts in government spending will shift the IS curve to the left. The extent of the fall
in interest rates and national income that result will depend on the slope of the LM curve, and
this depends on how responsive is the demand for money to changes in interest rates. Assuming
that the LM curve has a positive slope and is not vertical, there will be some reduction in interest
rates and the effect of reduced government spending on economic activity will be less than
would otherwise have been the case.

b. Expanding the money supply will shift the LM curve to the right. The extent of the fall in
interest rates and the rise in national income that result will depend on the slope of the IS curve,
and this depends on how responsive is consumption and investment expenditure to changes in
interest rates.

c. If the central bank wishes to raise interest rates it must engage in open market operations to
sell bonds and so reduce the money supply. This action is reflected in a lefttward movement of
the LM curve. This size of the reduction in money supply needed to raise interest rates to a
particular level will depend on the slope of the IS curve – the flatter the IS curve the greater the
shift the LM curve that will be needed, and the greater will be the associated reduction in
national income.

d. An increase in taxation will shift the IS curve to the left. The effect will thus be similar to that
described in answer to question 10a.
3. A period of deflation refers to a period in which the price level, P, falls and so the supply of real
money balances increases. This is illustrated in the IS-LM model by a shift to the right in the LM
curve. On the other hand the deflation may cause the IS to shift to the left. A new general
equilibrium will result, with the outcome depending on the strengths of the two opposing
effects.