13. THE KEYNESIAN MODEL IN THE SHORT AND LONG RUN WITH A POSITIVELY SLOPED SRAS-CURVE. THE AS/AD-model. 2. Consider the following changes in the sticky-wage model. a. Suppose that labor contracts specify that the nominal wage be fully indexed for inflation. That is, the nominal wage is to be adjusted to fully compensate for changes in the consumer price index. How does full indexation alter the aggregate supply curve in this model? b. Suppose now that indexation is only partial. That is, for every increase in the CPI, the nominal wage rises, but by a smaller percentage. How does partial indexation alter the aggregate supply curve in this model? 3. Suppose that an economy has the Philips curve * = 1_,-0.5(1 -0.06) a. What is the natural rate of unemployment? b. Graph the short-run and long-run relationships between inflations and unemployment. c. How much cyclical unemployment is necessary to reduce inflation by 5 percentage points? Using Okun's law, compute the sacrifice ratio. d. Inflation is running at 10 percent. The fed (=central bank in the US)wants to reduce it to 5 percent. Give two scenarios that will achieve that goal. 4. According to the rational-expectations approach, if everyone believes that policymakers are committed to reducing inflation, the cost of reducing inflation-the sacrifice ratio-will be lower than if the public is sceptical about the policymakers' intentions. Why might this be true? How might credibility be achieved? 5. Assume that people have rational expectations and that the economy id described by the sticky-wage or sticky-price model. Explain why each of the following propositions is true: a. Only unanticipated changes in the money supply affects real GDP. Changes in the money supply that were anticipated when wages and prices were set do not have any real effects. b. If the Fed chooses the money supply at the same time as people are setting wages and prices, so that everyone has the same information about the state of the economy, then monetary policy cannot be used systematically to stabilized output. Hence, a policy of keeping the money supply constant will have the same real effects as a policy of adjusting the money supply in response to the state of economy. ( This is called the policy irrelevance proposition.) c. If the Fed sets the money supply well after people have set wages and prices, so the fed has collected more information about the state of economy, then monetary policy can be used systematically to stabilized output. 6. Suppose that an economy has the Philips curve * =X_, -0.5(u -1") and that the natural rate of unemployment is given by an average of the past two years" unemployment: 1" = 0.5(11_, - 10-2) a. Why might the natural rate of unemployment depend on recent unemployment (as is assumed in the preceding equation)? b. Suppose that the Fed follows a policy to reduce permanently the inflation rate by 1 percentage point. What effect would that policy have on unemployment rate over time? C. What is the sacrifice ratio in this economy? Explain. d. What do these equations imply about the short-run and long-run tradeoffs between inflations and unemployment? 7. If higher taxes cause people to want to work less and lower taxes cause people to want to work more. Consider this in the AS/AD-model: a. If this view is correct, how does a tax cut affect the natural rate of output? b. How does a tax cut affect the aggregate demand curve? The LRAS- and SRAS-curves? c. What is the short-run impact of a tax cut on output and the price level? How does your answer differ from the case without the labor-supply effect? d. What is the long-run impact of a tax cut on output and the price level? How does your answer differ from the case without the labor-supply effect?Exercises 55 2. Plug /; back into equation (6.9) to get the maximized profit of the household. Call this profit .". 3. Each household has preferences over its consumption c and labor supply s. These preferences are represented by the utility function: u(c, I,) = ci(1 -1,)1. Each house- hold has an endowment of labor can be used in the household's own business or rented to others at the wage w. If the household supplies labor /,, then it will earn labor income wi. Output, wages, and profit are all quoted in terms of real goods, so they can be consumed directly. Set up the household's problem for choosing its labor supply /.. Write it in the following form: max {objective} subject to: constraints choke 4. Carry out the maximization from part 3 to derive the optimal labor supply (. 5. Determine the equilibrium wage win this economy. 6. How does the equilibrium wage w change with the amount of capital & owned by each household? 7. What does this model imply about the wage differences between the U.S. and Mex- ico? What about immigration between the two countries?3. THE CLASSICAL MODEL FOR THE CLOSED ECONOMY= THE KEYNESIAN MODEL FOR A CLOSED ECONOMY IN THE LONG RUN Problem 3.7: The government raises taxes by 100 billions USD. If the marginal propensity to consume is 0.6. what happens to public, private, and national saving and to investment? Do they rise or fall? By what amounts? Problem 3.8: Suppose that an increase in consumer confidence raises consumers' expectations about their future income and thus increases the amount they want to consume today. This might be interpreted as an upward shift in the consumption function. How does this shift affect investment and the interest rate. Problem 3.9 Consider an economy described by the following equations: Y=C+I+G. Y=5000, G=1000. T=1000. C=250+0.75(Y-T). 1=1000-50r. A. In this economy, compute private saving. public saving, and national saving. B. Find the equilibrium interest rate. C. Now suppose that G rises to 1250. Compute private saving, public saving, and national saving. D. Find the new equilibrium interest rate. E. Now suppose T decreases to 750 (and G=1000). Compute private, public and national saving, and find the new equilibrium interest rate. Problem 3.10: Suppose that the government increases taxes and government purchases by equal amounts. What happens to the interest rate and investment in response to this balanced budget change? Does your answer depend on the marginal propensity to consume? Problem 3.11: When the government subsidizes investment, such as with an investment tax credit, the subsidy often applies to only some types of investment. Suppose that there are two types of investment in the economy: business investment and residential investment. And suppose that the government institutes an investment tax credit only for business investment. A How does this policy affect the demand curve for business investment? The demand curve for residential investment. B. Draw the economy's supply and demand for loanable funds. How does this policy affect the supply and demand for loanable funds? What happens to the equilibrium interest rate? C. Compare the old and the new equilibrium. How does this policy affect the total quantity of investment? The quantity of business investment? The quantity of residential investment? Problem 3.12: If consumption depended on the interest rate, how would that affect the conclusions reached in this chapter about the effects of fiscal policy?Write down T for true statement and F for false statement for the following statements:- 1. Prof. J. M. Keynes developed the concept of IS- LM model in economics. 2. According to Prof. J. M. Keynes, national income is determined at the level where aggregate demand equals aggregate supply. 3. According to Prof. Keynes, rate of interest is determined in the money market equilibrium by the demand for money and the supply of money. 4. By goods market, we mean the interaction between demand for money and the supply of money. 5. The money market is in equilibrium when aggregate demand is equal to income. 6. When the rate of interest falls the level of investment increases and vice versa. 95 | Page 7. The increase in investment demand will bring about increase in aggregate demand which in tum will raise the equilibrium level of income. 8. The LM curve seeks to find out the equilibrium level of national income as determined by the equilibrium in goods market by a level of investment determined by a given rate of interest. 9. The IS curve shows different equilibrium levels of national income with various rates of interest. 10. The lower the rate of interest, lower will be the equilibrium level of income. 11. The LM curve is the locus of those combinations of rate of interest and the level of national income at which goods market is in equilibrium. 12. It is the autonomous expenditure which determines the position of the IS curve and changes in the autonomous expenditure causes a shift in it. 13. The IS curve can be derived from the Keynesian theory from its analysis of money market equilibrium. 14. According to Keynes, demand for money to hold depends on transactions motive and speculative motive. 15. The LM curve relates the level of income with the rate of interest which is determined by money- market equilibrium corresponding to different levels of demand for money. 16. The IS curve tells what the various rates of interest will be (given the quantity of money and the family of demand curves for money) at different levels of income. 17. The LM curve slopes upward to the right. 18. The IS curve slopes upward to the right. 19. The LM curve is flatter if the interest elasticity of demand for money is high. 20. The LM curve is steep if the interest elasticity demand for money is low. 21. The LM curve shifts to the right when the stock of money is decreased. 22. The LM curve shifts to the right when the stock of money is increased. 23. The LM curve shifts to the right if there is a decrease in the money demand function. 24. The LM curve shifts to the left if there is an increase in the money demand function. 25. The IS- LM curves relate the two variables: income and the rate of interest