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Macro1 Exercise #4 Answers
Please limit your answers to the spaces provided. If necessary, write on the back of the page.
Do not attach printout or additional pages. All questions pertain to the Macro1 module in the
SimEcon® software package.
Make sure that you have read the “Macro1 Manual” and SimEcon® Operation Instructions”.
These materials may be found at the Class Web site prior to beginning the exercise. For many of
the exercise’s questions, it will be necessary to refer to those instructions. For many of the
exercise’s questions, it will be necessary to refer to your text.
Open the Macro1 module. You will see a table called “State of the Macroeconomy”. Select
“Inflation” and click “Continue”. You will see a table called “Initial Conditions: “Inflation”.
Print out this table for future reference. Click “Continue”. You will see a table entitled, “Macro
Policy Tools”. Other things being equal, with inflation the only consideration, it would be wise
to decrease (increase, decrease, leave unchanged) government spending, to increase
(increase, decrease, leave unchanged) taxes and to increase (increase, decrease, leave
unchanged) the interest rate. Select the button entitled, “Taxes” and click “Continue”. Set taxes
equal to $1,600 and click “Continue”. This action will result in a budget surplus (budget
deficit, budget surplus). What was the inflation rate before the change? 11.32%. What is the
long run inflation rate after the change? 0.71%. What was the unemployment rate before the
change? 4.00%. What is the long run unemployment rate after the change? 18.00%. Although
this policy succeeded in controlling inflation, what is the major drawback to this action?
Increasing taxes caused a recession with high unemployment.
Click “See Graph” and draw the resulting graph below. Indicate the old and new aggregate
expenditure curves, the aggregate supply curve, the old and new equilibrium points and label all
axes.
45• line
AE
AE
AE′
GDPE
GDPE′
AE = Old Aggregate Expenditure
AE′ = New Aggregate Expenditure
GDPE = Old Equilibrium
GDPE′ = New Equilibrium
Real GDP
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Macro1 Exercise #4 Answers
Page 2
As a result of this increase in taxes, the aggregate expenditure curve shifted down (up, down,
no change). What is the significance of the 45-degree line? The 45-degree angle indicates all
the points where aggregate expenditures (demand) equal aggregate supply.
Now click “AD-AD Graph”. Draw the resulting graph that you see below. Indicate the
aggregate supply curve, the aggregate demand curve, the equilibrium point, the full employment
line, and label all axes.
Price
Level
AS
GDPE = Equilibrium Point
GDPFE = Full Employment Output
AD
GDPE GDPFE
Real GDP
First of all, does this graph present a totally different situation from the first graph, or is it just
another way of presenting the same situation? It is another way of presenting the same
situation. What is measured on the horizontal axis on both graphs? Real GDP. What is
measured on the vertical axis for the first graph? Planned Spending. What is measured on the
vertical axis for the second graph? The Price Level. In the first graph, called the 45-degree
diagram, what is assumed about the price level? It is assumed to be constant. Consider the
second graph. Does the equilibrium indicate that the economy is above or below full
employment? Below full employment.
Click the “Back” button three times. You will arrive at the table entitled, “State of the
Macroeconomy”. This time, select “Recession” and click “Continue”. You will arrive at the
table entitled, “Initial Conditions: Recession”. Print out this table for future reference or write
down the contents. Click “Continue”. You will arrive at the table entitled, “Macro Policy
Tools”. Other things being equal, with the recession being the only consideration, it would be
wise to increase (increase, decrease, leave unchanged) government spending, to decrease
(increase, decrease, leave unchanged) taxes and to decrease (increase, decrease, leave
unchanged) the interest rate.
Select the button entitled, “Government Spending” and click “Continue”. Increase government
spending to $1,265 and click “Continue”. This action will result in a budget deficit (budget
deficit, budget surplus). What was the inflation rate before the change? 1.47%. What is the long
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Macro1 Exercise #4 Answers
Page 3
run inflation rate after the change? 1.49%. What was the unemployment rate before the change?
10.00%. What is the long run unemployment rate after the change? 8.00%.
Although this policy succeeded in keeping inflation under control, what is the major drawback to
this action? At 8%, the unemployment rate is still high.
Click “Reset Policy”. Increase government spending further to $1,310 and click “Continue”.
What is the new long run unemployment rate after this action? 4%. Does it appear that the
recession has ended? Yes. What is the major drawback to the successful reduction of the long
run unemployment rate? Inflation has increased to 27.92%. That is unacceptable.
Click “See Graph” and draw the resulting graph below. Indicate the old and new aggregate
expenditure curves, the aggregate supply curve, the old and new equilibrium points and label all
axes.
45• line
AE′
AE
AE
AE = Old Aggregate Expenditure
AE′ = New Aggregate Expenditure
GDPE = Old Equilibrium
GDPE′ = New Equilibrium
Real GDP
What happened to the aggregate expenditure curve? It shifted up. As a result of the increase in
government spending, what happened to output, i.e., the equilibrium amount of real GDP? It
increased. Click “AS-AD Graph”. Draw the resulting graph below.
Price
Level
AS
AD
GDPFE GDPE
Real GDP
GDPE = Equilibrium Point
GDPFE = Full Employment Output
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Macro1 Exercise #4 Answers
Page 4
What is meant by a “natural” rate of unemployment? The natural rate of unemployment
refers to the avoidable level of unemployment in an economy where labor factors are
continuously in transition.
Economists in the United States often refer to unemployment as probably being “natural” as long
as it is below what percent? 5%. Could an economy with a current unemployment rate of 4% be
referred to as at “full employment”? Yes (Yes, No). Is it possible for an economy to be
temporarily above full employment? Yes (Yes, No). If yes, how can this happen? An
economy can be temporarily above full employment by people working overtime and/or
retired workers, students and others who normally would not be in the labor force being
temporarily drawn into it. Also, some people may search for a new job for one week
instead of two because they are fooled into thinking the real wage they have been offered is
really high -- because they haven’t realized how much inflation there will be.
Click the “Back” button once to take you back to the “Long Run Results”. Also, refer back to
your printout of the table, “Initial Conditions: Recession”. What was the indicated GDP and
consumption on the “Initial Conditions: Recession” table?
$4,018.18 and $2,589.68,
respectively. What is the new long run GDP and consumption after government spending was
increased? $4,618.18 and $3,129.68, respectively. Using this information, you can compute the
marginal propensity to consume. Indicate all your calculations and your final answer on the next
page.
New Consumption - Old Consumption = Change in Consumption:
$3,129.69 - $2,589.68 = $540.00
New GDP – Old GDP = Change in GDP
$4,618.18 – $4,018.18 = $600.00
Change in Consumption divided by Change in GDP = Marginal Propensity to Consume
$540/$600 = 0.90 = MPC
Given that the long run inflation rate is now over 27%, and assuming that inflation is now the
only concern, other things being equal, it would be wise to decrease (increase, decrease, leave
unchanged) government spending, to increase (increase, decrease, leave unchanged) taxes and
to increase (increase, decrease, leave unchanged) the interest rate. Click “Reset Policy” and
then click the “Back” button once to arrive at the table entitled “Macro Policy Tools”. One of
the tools indicated is to change the interest rate. In the real world, how is that best accomplished,
through monetary or fiscal policy? It is accomplished through monetary policy. What is
monetary policy? Monetary policy describes actions of the Federal Reserve Bank to
regulate the money supply. Select “Interest Rate” and click “Continue”. Increase the interest
rate to 6.6% and click “Continue”. What is the new inflation rate? 1.40%. What is the new
unemployment rate? 12.00%. Has this action succeeded in controlling inflation? Yes (Yes,
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Macro1 Exercise #4 Answers
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No). What was the major drawback to this increase in the interest rate? The unemployment
rate rose to 12.00%.
All these examples indicate a relationship between unemployment and inflation. What is that
relationship? There is a trade-off between unemployment and inflation. As inflation falls,
unemployment rises and vice versa. Is it also possible to have unemployment and inflation at
the same time? Yes (Yes, No). Consider the late 1970’s in the United States. Was
unemployment high during that time? Yes (Yes, No).
Was inflation high during that time? Yes (Yes, No). What term do economists use to refer to a
situation such as that of the 1970’s? It is referred to as stagflation.