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Macro3 Problem #2 Answers (
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(1)
Select the inflation option. Record the initial conditions provided, and
continue. Without changing the policy values select “No Shock” from the
menu and compare the results with the initial conditions.
(2)
Select “No Shock-Long Run” and record the results.
(3)
Offer one possible explanation for why this economy was in an inflationary
situation in the first place. That is, offer one reason -- a policy or change in
private behavior why this economy had inflation. (Hint: Selecting “See
Graph” may provide you with some insight into the adjustment process.)
Judging by the initial graph as well as the numerical data this economy was in a demandpull inflation. The unemployment rate was low while the inflation rate was high and the
initial graph shows an elevated aggregate demand line intersecting with the original
aggregate supply curve at a GDP level above the full employment line. If there had been
a supply decrease to cause cost-push inflation the unemployment rate would have been
high, not low, and the graph would have shown a reduced AS line intersecting the
original (white) demand line at a GDP below the full employment level. There are many
possible reasons why AD might have increased and caused this inflation. It could have
been a previous policy change (higher government spending or money supply, lower
taxes).
(4) Compare the long run results with the short run no shock results. Use this
comparison to guide your explanation of how this economy moved, with no
change in policy values, from the short-term inflation to the long run
equilibrium. (Hint: selecting “See Graph” may provide you with some
insight into the adjustment process.)
In the long run the economy wound up with a higher unemployment rate (5%), lower real
GDP, and an inflation rate near zero. In addition the real wage (wage divided by the
price level) and real interest rates were higher in the long run, and so was the price level.
What appears to have happened is that after a period of demand pull inflation there was a
period of cost push inflation which causes the AS curve to shift to the left over time. The
shift in AS caused the price level to rise even higher, so the economy moved along the
existing AD curve. As it did, the higher price level meant a smaller real money supply
(the nominal money supply set by policy divided by the higher price level). The smaller
real money supply caused equilibrium interest rates in the money market to rise (the
nominal interest rates will wind up lower once the inflation disappears, but the real rate
stays higher). Higher real interest rates mean less incentive to invest, and investment
spending is lower in the long run equilibrium than in the short run. Higher real rates also
discourage consumer spending, but consumer spending is lower both for this reason and
because real GDP has fallen—less income means less consumer spending, just a lower
consumer spending means lower real GDP.
Net exports are a little less negative in the long run; presumably lower real income has
lowered import demand. If the higher price level had discouraged exports and
encouraged imports this result could have been reversed, however, there is no evidence
that happened. That is because the exchange rate dropped by almost as much as the
increase in the price level, so the effects of the increasing price level on imports and
exports was mostly offset by the change in the value of this nations money compared to
the money of other nations.
(5)
Select “Back” then “Continue” to reset your options on the menu. This time
change one of the policy variables and select “No Shock”. Observe the short
run results, and then observe the long run “No Shock” results.
(6)
Compare the short run results of your policy change with the short run
results with no policy change. Explain the differences your policy change
made.
I reduced government spending by 100. In the short run this caused a small drop in real
GDP (a change of less than 2). Offsetting the reduction in government spending was the
increase in private spending (consumption up by about 23, investment up about 75, net
exports up about 0.1). Private spending rose due to the decline in the real interest rate
(down almost 1 percent). An initial decline in real GDP when government spending
dropped caused a decrease in money demand, which in turn reduced interest rates (real
and nominal) and encouraged spending. This is a case of “crowding in.” the lower
interest rates also discouraged financial investment in this country so that the exchange
rate dropped with this policy change. The small reduction in real GDP was enough to
cause the inflation rate to drop by about 1.5%.
(7)
Compare the long run results with your policy change and the long run
results when there was no change in policy. Explain why some of the long
run results have changed and why some have not.
In the long run the level of real GDP was the same with or without the policy change.
This is because the change in government spending had no effect on the potential real
GDP -- it did not change the real resources or technology available. The policy change
also had no effect on long run unemployment, or the real wage, for the same reasons as in
the case of real GDP (the policy change presumably did not affect incentives to work or
other determinants of unemployment and real GDP).
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Even in the long run the mix of private and public spending was different as a result of
this policy change. Government spending was lower by 100, so since real GDP was the
same with or without this policy difference, private spending had to be higher by 100. It
was higher due to the effect, even in the long run, of lower real interest rates on private
spending -- consumer spending was about 24 higher, investment spending was almost
75 higher (this indicates a greater sensitivity of investment than consumer spending to
interest rates). The lower inflation rate in the short run meant a smaller change in the
price level as a result of the reduction in government spending. Lower interest rates
continued to discourage financial inflows even in the long run, so the exchange rate was
lower. This contributed to a slightly less negative value for net exports.
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