Download ECON366 - KONSTANTINOS KANELLOPOULOS

INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE: ECON-211-01-SUI13 Intermediate Macroeconomics
SEMESTER: Summer Session I, 2013
Tutorial 5 – for tutor
INSTRUCTIONS
Students are required to study the following questions and problems indicated and to be
able to solve them by themselves.
Although this is not a required part of a coursework, the purpose of the tutorial is
twofold: to help the student understand the methodology for solving the problems and to
help him/her prepare for the courseworks and/or exams. The utilisation of this resource
can be maximised depending on the time and effort each individual student devotes.
Konstantinos Kanellopoulos
10th June 2013
PART 1 SELF-TEST QUESTIONS
1. “In the classical AS-curve case, an increase in government spending will increase
interest rates and real money balances.” Comment on this statement.
An increase in government spending shifts the AD-curve to the right, causing an excess demand for
goods and services at the original price level. As the price level increases to restore equilibrium, real
money balances decrease and interest rates increase. This will lead to a decrease in the level of
investment spending and maybe even net exports until a new equilibrium is reached at the original
level of output but at a higher price level and higher interest rates. Thus, real money balances will
decline but interest rates will increase.
2. Comment on the following statement:
“If we assume that people have rational expectations, then fiscal policy is always
irrelevant. But monetary policy can still be used to affect the rate of inflation and
unemployment.”
Individuals and firms with rational expectations consistently make optimal decisions based on all
information available. As long as a policy change is anticipated, people are able to assess its long-run
outcome and will try to immediately adjust. Since fiscal policy doesn't affect unemployment or
inflation in the long run, it will be ineffective even in the short run if wages and prices are assumed to
be completely flexible. An anticipated change in monetary growth, on the other hand, will cause a
change in the inflation rate without any increase in the unemployment rate if wages are assumed to be
completely flexible. In other words, if workers could adjust their wage demands immediately after a
policy change, no significant change in the unemployment rate would occur. However, even if people
have rational expectations, wages tend to be fairly rigid in the short run due to the existence of wage
contracts. Therefore it will always take some time for the economy to adjust back to a long-run
equilibrium. This implies that both fiscal and monetary policy can affect the rate of inflation and
unemployment to some degree in the short run.
PART 2 EXAM-TYPE PROBLEMS
Problem 1. Assume a technological advance leads to lower production costs. Show the
effect this will have on national income, unemployment, inflation, and interest rates
with the help of an AD-AS diagram, assuming completely flexible wage rates.
A decrease in production costs shifts the AS-curve to the right. The price level decreases, leading to a
higher level of income and lower interest rates. Since wages are completely flexible, the AS-curve is
vertical and we are always at full-employment (this is the classical case). This implies that the
unemployment rate will remain at the natural rate, but output will increase since workers will be more
productive. The adjustment process can be described as follows:
1.2. Cost of prod.  == > AS  Ex.S. == > P  == > real ms  == > i 
== > I  == > Y 
Effect: YFE 
URN = constant
P
i
2
P
ASo
AS1
Po
P1
AD
0
YoFE
Y1FE
Y
Problem 2. “Falling oil prices will lead to increased employment, higher wage rates and
increased real money balances.” Comment on this statement with the help of an AD-AS
diagram and explain the short-run and long-run adjustment processes.
A decline in oil prices will shift the upward-sloping AS-curve to the right, leading to excess supply at
the existing price level. A new short-run equilibrium will be reached at a higher level of output and a
lower price level. But since output is now above the full-employment level Y*, there will be upward
pressure on wages and prices and the upward-sloping AS-curve will start shifting back to the left. A
new long-run equilibrium will be reached back at the original position (Y*), and the original price
level (assuming that the change in material prices did not affect the full-employment level of output).
Since nominal wages (W) will have risen but the price level (P) will not have changed, real wages
(W/P) will have increased.
P
AD1
AS1
AS2
1
P1
P2
2
0
Y*
Y2
Y
The adjustment process can be described as follows:
1==>2: oil prices ↓ ==> cost of production ↓ ==> the AS-curve shifts right
== > excess supply ==> P ↓ ==> real ms ↑ ==> i ↓ ==> I ↑ ==> Y ↑
Short-run effect: Y ↑ , i ↓, P ↓
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2==>1: Since Y > Y* ==> nominal wages ↑ ==> the AS-curve shifts left ==> excess demand
==>
P ↑ ==> real ms ↓ ==> i ↑ ==> I ↓ ==> Y ↓
Short-run effect: Y↓ , i ↑, P ↑
Long-run effect: Y back at Y*, i remains the same, P remains the same.
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