Class performance – 18.07.

2018

1. Assume that households decide to save more, so autonomous consumption is reduced. Explain, step-by-step,
how the components of expenditure adjust to bring the economy to its new equilibrium. Using the IS curve
equation and the consumption function, compare the initial and new equilibria with respect to saving and the
real interest rate.

Answer: Consumption is reduced, so there is unplanned inventory investment that signals firms to reduce
output. Declining output causes consumption to decline further; unplanned inventory investment continues
and output continues to fall. The decline in consumption is continually shrinking, since households respond
to reductions in disposable income by reducing saving, as well as reducing consumption (the marginal
propensity to consume is less than one). When the decrease in consumption converges to zero, inventories

stop rising and output stops falling. The decline in output ∆Y = . The change in consumption ∆C =

∆ + mpc × - c × ∆r. Substituting the first of these equations into the second, simplifying, then
substituting with the first equation again, reveals that ∆C = ∆Y - c × ∆r. If the real interest rate does not
change, then saving in the new equilibrium equals the original saving in the old equilibrium (since output
has fallen by the same amount as consumption). And, if saving has not changed, then neither has the real
interest rate changed.

2. Assume that the economy is in equilibrium when the real interest rate rises. Explain, step-by-step, how the
components of expenditure adjust to bring the economy to its new equilibrium.

Answer: An increase in the real interest rate reduces consumption, investment, and net exports. Reduced
expenditures cause an unplanned inventory adjustment to which firms respond by reducing output. The
economy is moving to the left along the IS curve. The slope of the IS curve reflects the further output declines
that occur as consumption falls in response to declining output, until the change in consumption has
converged to zero (the marginal propensity to consume is less than one).

3. Suppose the government lowers unemployment by hiring more government workers. How does it matter
whether wages and prices are sticky?

Answer: As long as wages and prices are sticky, then the decrease in the unemployment rate will not cause
a substantial increase in wages. However, if workers throughout the economy perceive an opportunity to
seek an increase in their real wage, employers may need to comply in order to retain and attract qualified
workers. If nominal wages increase, producers will need to raise prices. The resulting inflation will cause
expected inflation to rise, sparking further increases in the nominal wage.

4. Unprecedented stimulative policies throughout the global economy have sparked debate over the inflationary
implications. Defenders of the policies argue that, even if the policies raise inflationary expectations, actual
inflation will remain low. Critics charge that current policies are nearly certain to result in excessive inflation.
What does the aggregate supply curve have to say?

Answers: As long as the negative output gap persists, rising expectations of inflation will not translate into
much actual inflation. However, if the output gap shrinks in absolute value as policy makers intend, nothing
will insulate inflation from expectations. To avoid the critics' prediction of excessive inflation, policy makers
must somehow manage expectations (and avoid allowing a positive output gap from emerging).

5. The short-run aggregate supply curve is π = + 0.8 (Y - 20) + ρ. Suppose inflation last year was 5
percent, current output is 20, and there is a price shock of 2 percent. Suppose, further, that potential output
rises next year to 21, while output remains at 20 and next year's price shock is zero. Calculate and explain
next year's inflation.
Answer: Current inflation is 5 + 0.8 (20 - 20) + 2 = 7 percent. Next year, inflation is 7 + 0.8 (20 - 21) + 0 =
6.2. Moving from the current to next year, short-run aggregate supply has shifted up because of the increase
in expected inflation from 5 to 7 percent, and shifted down by 0.8 × the increase in potential output = 0.8 ×
1 = 0.8. The negative output gap corresponds, thru Okun's law, to an increase in the unemployment gap.
Either the natural rate of unemployment has declined (a possible cause of the increase in potential output),
or the failure of actual output to grow along with potential means that unemployment has risen. Either way,
this loosening of the labor market causes wages and prices to rise less rapidly.