U6301 Macroeconomics for International and Public Affairs Martsella Davitaya

Columbia University | SIPA

Problem Set #9
Suggested Solutions
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Deadline. 11:59 pm April 25, 2024
Instructions. The electronic version (either scanned or typed up) of solutions must be uploaded to
CourseWorks by the indicated deadline. Solutions submitted after the deadline will receive 0 points.
Solutions submitted via email will receive 0 points. Solutions can be submitted individually or by a
group of up to 4 students. You can work in a group with students from sections 1, 2, 3, and 4 only. If
you work in a group, please indicate all names and UNI-s on top of the first page.

Problem 1. AD-AS and Business Cycles

It is sometimes argued that economic growth that is “too rapid” will be associated with inflation. Use
AD–AS analysis to show how this statement might be true. When this claim is made, what type of
shock is implicitly assumed to be hitting the economy?

Growth that is “too rapid” most likely refers to a situation in which the aggregate demand curve has shifted to
the right and, in the short run, intersects the SRAS curve at a level of output that is greater than the full-
employment level of output. This situation is associated with inflation because, in the long run, prices will rise,
shifting the SRAS curve up to intersect with the LRAS and AD curves. The shock that is implicitly assumed to
be hitting the economy is an aggregate demand shock, since that is the only shock that increases output in the
short run and inflation in the long run.

Problem 2. Classical IS-LM-FE and AD-AS

The discovery of a new technology increases the expected future marginal product of capital.
a) Use the classical IS–LM model1 to determine the effect of the increase in the expected future MPK
on current output, the real interest rate, employment, real wages, consumption, investment, and
the price level. Assume that expected future real wages and future incomes are unaffected by the
new technology. Assume also that current productivity is unaffected.

The increase in MPKf leaves aggregate supply unchanged, since expected future labor income and expected future
wages are unchanged. But aggregate demand increases, because firms increase investment, shifting the IS curve
up and to the right. There is no shift in either the LM curve or the FE line.
Top panel shows that the increase in aggregate demand causes no change in output, since the AS curve is vertical,
but the price level increases. Bottom panel shows the shift up and to the right of the IS curve from IS1 to IS2. To
get the economy to equilibrium, the price level rises so that the LM curve shifts from LM1 to LM2. The real interest
rate increases as a result. In the labor market, there is no change in labor demand or supply, so employment and
output are unchanged. Since the real interest rate rises, saving increases and consumption declines. Since
investment equals saving, investment also rises.

b) Find the effects of the increase in the expected future MPK on current output and prices from the
AD–AS diagram based on the misperceptions theory. What accounts for the difference with part
(a)?

1
Classical economists believe that all prices, both for output and inputs, are fully flexible all the time. Therefore, the only relevant AS
curve is the vertical one.
The misperceptions theory gets a different result. The shift in the aggregate demand curve from AD1 to AD2
increases both output and the price level as the economy moves along the short-run aggregate supply curve SRAS.
The difference in this result compared to the result in part (a) comes from producers misperceiving the change in
the price level as a change in relative prices, and increasing their labor demand and output.

Problem 3. Keynesian IS-LM-FE

According to the Keynesian IS–LM model,2 what is the effect of each of the following on output, the
real interest rate, employment, and the price level? Distinguish between the short run and the long run.
a) In response to changes in regulations, banks increase the interest rate they pay on checking
accounts.

When banks pay a higher interest rate on checking accounts, the demand for money rises, shifting the LM curve
up and to the left from LM1 to LM2. As a result, the AD curve shifts down and to the left from AD1 to AD2. The

2
Keynesian economists believe that some of the prices are sticky in the short-run.
new short-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment
is lower, and the price level is unchanged.
In the long run, the price level decreases to shift the LM curve from LM2 to LM3, which is the same as LM1, to
restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts down from SRAS1 to
SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the
same, employment is the same, and the price level is lower.

b) The introduction of sophisticated credit cards greatly reduces the amount of money that people
need for transactions.

The introduction of credit cards reduces the demand for money—shifting the LM curve down and to the right
from LM1 to LM2. As a result, the AD curve shifts from AD1 to AD2. The new short-run equilibrium occurs at
point B, where output is higher, the real interest rate is lower, employment is higher, and the price level is
unchanged.
In the long run, the price level increases to shift the LM curve from LM2 to LM3, which is the same as LM1, to
restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts up from SRAS1 to SRAS2.
At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same,
employment is the same, and the price level is higher.

c) A severe water shortage causes sharp declines in agricultural output and increases in food prices.

The reduction in agricultural output shifts the FE curve to the left from FE1 to FE2, and shifts the LRAS line from
LRAS1 to LRAS2. The rise in agricultural prices increases the price level, so the short-run aggregate supply curve
shifts up from SRAS1 to SRAS2. Also, the rise in the price level shifts the LM curve up and to the left from LM1
to LM2. The short-run equilibrium is at point C. At point C, compared to the starting point, output is lower, the
real interest rate is higher, employment is lower, and the price level is higher.
If the water shortage persists, a new long-run equilibrium occurs at point C as well.
When the water shortage is over, then the economy goes back to point A in the long run, with no permanent
effects.

d) A temporary beneficial supply shock affects most of the economy, but no individual firm is affected
sufficiently to change its prices in the short run.

The beneficial supply shock makes more production possible at full employment, so the FE line shifts to the right
from FE1 to FE2, and the LRAS line shifts from LRAS1 to LRAS2. There is no immediate change in the price
level, so the LM curve remains at LM1 and the short-run aggregate supply curve remains at SRAS1. The shift
of the FE curve does not affect aggregate demand in the short run: output, the real interest rate, and the price
level are all unchanged in the short run. The shift in the production function shifts the labor demand curve up
and increases employment in the short run.
In the long-run, prices will decline, so the LM curve will shift from LM1 to LM2 and the SRAS curve will shift
from SRAS1 to SRAS2. As shown in the diagrams, the economy reaches a new equilibrium at point C, with a
higher output level, a lower real interest rate, and a lower price level.
When the supply shock disappears (in the future period), the economy returns to its equilibrium at point A.

Problem 4. All you need is…fear (Paradox of Thrift)

Recall the Keynesian consumption function 𝐶 = 𝐶̅ + 𝑀𝑃𝐶 × 𝑌𝐷 , where 0<MPC<1. Suppose everyone
believes a recession is coming. In anticipation of the “oncoming” recession everyone decides to
spend less now and save more, thus 𝐶̅ in the consumption function declines, irrespectively of output.
What happens to equilibrium income, interest rate and savings in response to this increased
thriftiness? Show the short-run effects of decrease in 𝐶̅ on Saving-Investment and IS-LM graphs.

This is an exogenous increase in national savings which shifts the savings curve and the IS curve down.
Output declines and interest rates decline. So just the thought of output declining makes it happen here.
Interest rates decline in the short run and equilibrium Savings and Investment increase.