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Economics 102 Introductory Macroeconomics
Spring 2006, Professor J. Wissink
Problem Set 6
ANSWERS
1. Briefly, explain the relationship between cost-push inflation AND increases in labor productivity.
Cost push inflation can be caused by several factors including, for example, increases in wages.
However, increases in labor productivity work in the opposite direction. So if wages increase by more
than labor productivity increases, then there is cost push inflation, i.e., a shift "in" and to the left for the
SR-AS curve, but it would not be as “bad” as if only wages rose. On the other hand, if the wage
increase is equal to or smaller than the rise in labor productivity, you would not observe cost push
inflation.
2. For each event taken one at a time (that is, not one adding to the next) you would get the following.
a. Any given short run Phillips Curve would likely become steeper since wages would rise more
quickly and perhaps nearly at same time that other prices are rising, increasing inflation more
quickly when the unemployment rate drops below UFE. No change in long run Phillips curve.
b. Long run Phillips curve shifts to the right. [Note, this is not needed for you to get full points on the
problem set answer, but note that as you move the LR-PC, the SR-PC moves along with it – that is to
say, the two are “grouped” together. If the SR-PC with expected inflation = 4% crossed the LR-PC
at 4% inflation before when U*=5%, then now the SR-PC with expected inflation = 4% will cross
the new LR-PC which is vertical atU* = 6%.
c. The SR-PC shifts up and to the right. No change in the long run Phillips curve.
3. Explain what NAIRU represents. Explain what happens if the actual unemployment rate does not
equal NAIRU. And finally, discuss what factors might cause NAIRU to change.
NAIRU, the non-accelerating inflation rate of unemployment, is the unemployment rate that occurs
when there is no pressure for the inflation rate to increase. If the actual unemployment rate is below
NAIRU, the inflation rate will increase. And if the actual unemployment rate is above NAIRU, the
inflation rate will decrease. For all intents and purposes, we have used NAIRU and natural rate of
unemployment as one in the same concept in looking at the long run Philips Curve. (There are actually
some subtle differences but we will not go into that.) So things that would change the natural rate of
unemployment would change NAIRU for us. Recall that the natural rate of unemployment is basically
frictional and structural employment. Note that the book takes a slightly different take on this, which is
ok to add to the idea and we will accept answers along these lines - this is that cost shocks can shift the
PP curve as described in the book, which would shift the NAIRU. Growth, cost shocks, labor market
dynamics, and, for example, increased foreign competition are the types of things that can cause changes
in NAIRU.
4. State whether EACH of the following descriptions best represents demand-pull inflation OR costpush inflation/supply-shock inflation.
a. Wages increase  costs increase  prices increase.
COST PUSH
b. The price of oil goes up costs of production increase  prices increase.
COST PUSH - Frequently denoted also as a SUPPLY SHOCK to emphasize that oil is an extremely
important strategic raw material.
c. Prices increase  costs increase  wages increase.
COST PUSH [An acceptable alternative is demand pull followed by cost push – depends on what
caused the price level increase in the first place.]
d. Total spending in an economy exceeds total output at current prices  prices rise.
DEMAND PULL
5. The table below lists four events and four possible impacts these events might have on the
unemployment rate. For EACH event listed on the left hand side of the table, choose the most likely
impact it will have on unemployment.
Event A  impact 3
Event B  impacts 1 & 3
Event C  impacts 2 & 4
Event D  impact 4
6. You have the following data on the economy: Ypotential = 5,000 and Y* = 6,000.
a. See diagram showing the state of the economy, point A, that includes AD, AS (Short run), and AS
(Long run).
price level
LR-AS
SR-AS1
SR-ASo
B
A
C
ADo
AD 1
Ypot
Y*
5000
6000
real Y
b. There will be upward pressure on the price level which will result in inflation and then, eventually,
wage rates will increase creating a leftward shift back in the short run aggregate supply curve. We
achieve Ypotential again but with a higher price level as indicated by point B.
c. Fiscal policies to try: increase taxes, decrease government expenditures, decrease transfer payments,
etc. Monetary policies to try: increase the discount rate, increase the required reserve ratio, open
market sales, etc. All the above policies will shift the aggregate demand curve to the left so that we
achieve the full/potential employment again but this time at point C. What “cost” do you pay to get
Ypotential? Well that can be answered several ways depending on if you wait for the economy to
self-adjust or try to stimulate it to self adjust. But either way you are looking at lower Y and lower
employment levels (higher unemployment) and possibly a higher price level. Again the answer to
this question is contingent on what the policy makers do.
Multiple Choice
1) The aggregate demand curve slopes downward in part because at higher price levels
a) the purchasing power of consumers’ assets declines and consumption increases.
b) producers can get more for what they produce, and they increase production.
c) the purchasing power of consumers’ assets declines and consumption decreases.
d) the purchasing power of consumers’ assets increases and consumption increases.
2) If the United States were to pass legislation that would make it considerably easier for laborers to
emigrate to the United States and work, this would very likely cause
a) the short-run aggregate supply curve to become nearly vertical at all levels of output.
b) the short-run aggregate supply curve to shift to the left.
c) the long-run aggregate supply curve to become flatter.
d) the short-run aggregate supply curve to shift to the right.
3) Which of the following is a CORRECT sequence of events during an expansion?
a) Unemployment falls, income falls, tax revenue falls, unemployment benefits rise, and the budget
deficit falls.
b) Unemployment rises, income falls, tax revenue falls, unemployment benefits rise, and the budget
deficit rises.
c) Unemployment rises, income falls, tax revenues rises, unemployment benefits fall, and the budget
deficit falls.
d) Unemployment falls, income rises, tax revenue rises, unemployment benefits fall, and the
budget deficit falls.
4) If the long-run aggregate supply curve is vertical, then the multiplier effect of a change in net taxes on
aggregate output, in the long run,
a) depends on the price level.
b) is one.
c) is zero.
d) is infinitely large.
5) If wages are sticky, an increase in labor
a) demand decreases the wage rate.
b) supply increases the wage rate.
c) demand increases the wage rate.
d) None of the above.
NOTE IT IS ALSO OK IF THE STUDENT SELECTED (c)
6) After introducing the “price level” to our model of income determination, which of the following
statements is correct?
a) The aggregate demand curve shifts to the right when the price level increases.
b) A lower price level leads to a higher interest rate.
c) A higher price level causes the demand for money curve to shift out generating a movement
along the aggregate demand curve
d) A lower price level causes the demand for money to shift out generating a movement along the
aggregate demand curve
e) The aggregate demand curve shifts to the left when the price level increases.
7) Wages might be “sticky” – fail to adjust instantaneously to changes in the economy – for which of the
following reasons?
a) Unions refuse to let wages drop.
b) An implicit understanding exists between firms and workers that firms will not do anything to harm
workers relative to other workers in the same industry.
c) Because the economy changes all the time, firms have only imperfect information and may set wage
rates too high or too low.
d) Firms may set wages above the equilibrium so that they can keep their most efficient workers who
might otherwise be hired away by other firms.
e) All of the above are explanations for why wages might be “sticky”.
8) According to the short-run Phillips Curve, if policy makers want to reduce the unemployment rate,
they must accept
a) a lower inflation rate.
b) a higher inflation rate.
c) a reduction in aggregate demand.
d) a reduction in aggregate supply.
9) If the economy of the U.S. consumes more than it produces, then:
a) imports must exceed exports.
b) government spending must exceed government tax revenue.
c) exports must exceed imports.
d) no economy can consume more than it produces.
10) A wife spends five hours a week sending bills to her husband’s customers. She is not paid for her
work. She spends the rest of her time as a full-time homemaker. She would be classified as:
a) not in the labor force.
b) employed.
c) unemployed
d) a discouraged worker.
e) none of the above.
11) Monetary policy is most likely to result in inflation when the aggregate supply curve is
a. vertical and the Fed lowers the discount rate.
b. vertical and the Fed raises the reserve requirement.
c. horizontal and the Fed sells securities.
d. horizontal and the Fed lowers the reserve ratio.