Unemployment and inflation

The rise in energy prices reduces the productivity of capital per worker. This causes sf(k) to shift down from sfl(k) to sf2(k). The result is a decline in steady-state k. Steady-state consumption per worker falls for two reasons:

(1) Each unit of capital has a lower productivity, and (2) steady-state k is reduced. population growth rate permanently increased due to increased immigration Immigration raises n from nl to n2. The rise in n lowers steady-state k, leading toa lower steady-state consumption per worker. c.

A temporary rise in s has no effect on the steady-state equilibrium. The increase in the labor force participation rate does not affect the growth rate of the labor force, so there is no impact on the steady-state capital-labor ratio or on consumption per worker. However, because a larger fraction of the population is working, consumption per person increases.

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Question 1

How would each of the following affect the national saving, investment the current account balance and the real interest rate in the large economy (a) The home countrys saving curve shifts to the right, from Sl to S2.

The real world interest rate falls, so that the current account surplus in the home country equals the current ccount deficit in the foreign country. National S rises, I rises, CA rises, rw falls. (b) The foreign countrys saving curve shifts to the right, from Sl For to S2For. The real world interest rate must fall, so the current account surplus in the foreign country equals the current account deficit in the home country. National S falls, I rises, CA falls, rw falls.

The foreign countrys saving curve shifts to the left, from Sl For to S2For. The real world interest rate must rise, so the current account deficit in the foreign country equals the current account surplus in the home country. National S rises, I falls, CA ises, rw rises. (c) If Ricardian equivalence holds, there is no effect. If Ricardian equivalence does not hold, then the result is the same as in part (b), as the toreign count saving curve shifts to the right.

That is because all else equal, higher taxes increase government saving more than they reduce private saving. Question 3. Explain how each of the following transaction would enter the Bahamas.

Question 2

An Income receipt from abroad: credit entry in current account. b Import of assets: debit entry in capital and financial account. (c Import of services: debit entry in current account. (d Increase in foreign ownership of U. S. assets: credit entry in capital and financial account.

Question 3

Assume (a) Desired consumption declines as the real interest rate rises because the higher return to saving encourages higher saving; desired investment declines as the real interest rate rises becauses the user cost of capital is higher, reducing the desired capital stock, and thus investment. (b) Recall that Sd = Y -Cd - G, so Sd = 9000 -Cd - ld 2 6100 1 500 3 1400 1 ooo 4 5900 1300 1100 9200 5 1200 6 5700 equilibrium. Given Y 9000, the equili brium condition holds only at r = 5%. Atr = 5% it is also true that Sd = = 1200.

Question 4

Keynesians and classicals differ sharply in their beliefs about how long it takes the economy to reach a long-run equilibrium. Classical economists believe that prices adjust rapidly (within a few months) to restore equilibrium in the face of a shock, while Keynesians believe that prices adjust slowly, taking perhaps several years. Because of the time it takes for the economy's equilibrium to be restored, Keynesians see an important role for the government in fighting recessions. But because classicals believe that equilibrium is restored quickly, there's no need for government policy to fght recessions.

Since classicals think equilibrium is restored quickly in the face of shocks, aggregate demand shocks can't cause recessions, since they can't affect output for very long. So classical economists think recessions are caused by aggregate supply shocks. Keynesians, however, think that both aggregate demand and aggregate supply shocks are capable of causing recessions.

Question 5

Growth that is "too rapid" most likely refers to a situation in which the aggregate demand curve has shifted to the right and, in the short run, intersects the SRAS curve at a level of output that's greater than the full-employment level of output.

This situation is associated with inflation because, in the long run, prices will rise, shifting the SRAS curve up to intersect with the LRAS and AD curves. The shock that is implicitly assumed to be hitting the economy is an aggregate demand shock, since that's the only shock that increases output in the short run and inflation in the long run.

Question 6

The temporary increase in government purchases causes an income effect that increases workers' labor supply. This results in an increase in the full-employment level of output from FEI to FE2 in Figure 10.

The increase in government urchases also shifts the IS curve up and to the right from ISI to IS2, as it reduces national saving. Assuming that the shift up of the IS curve is so large that it intersects the LM curve to the right of the FE line, the price level must rise to get back to equilibrium at full employment, by shifting the LM curve up and to the left from LMI to LM2. The result is an increase in output and the real interest rate. figure 10. 11 shows the impact on the labor market. Labor supply shifts from NSI to NS2, leading to a decline in the real wage and a rise in employment.

Average labor productivity declines, since employment rises while capita ixed. Investmentdeclines, since the real interest rate rises. To summarize, in response to a temporary increase in government purchases, output, the real interest rate, the price level, and employment rise, while average labor productivity and investment decline.

• The business cycle fact is that employment is procyclical. The model is consistent with this fact, since employment rises when government purchases rise, causing output to rise.
• The business cycle fact is that the real wage is mildly procyclical.
• The model is inconsistent with this fact, since it shows a decline in the real wage when government purchases rise and
• The business cycle fact is that average labor productivity is output rises. procyclical. The model is inconsistent with this fact, since it shows a decline in average labor productivity when government purchases rise and output rises.
• The business cycle fact is that investment is procyclical. The model is not consistent with this fact, as investment falls when government purchases rise and output rises.
• The business cycle fact is that the price level is procyclical.

The model is consistent with this fact, as the price level rises when government purchases increase and output increases.

Question 7 and 8

  An increase in government purchases reduces national saving, causing the real interest rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand will be lower. The price level must rise. The result is that output is unchanged, the real interest rate increases, and the price level increases. When expected inflation falls, real money demand increases.

There is no effect on employment, saving or investment, so output and the real interest rate remain unchanged. With higher real money demand and an unchanged nominal money supply, the equilibrium price level must decline. When labor supply rises, full- employment output increases. Higher output means higher income, so saving will increase. More saving means the real interest rate will decline. Both higher output and a lower real interest rate increase real money demand. Higher money demand with a constant money supply means the price level must decline. When the interest rate paid on money increases, real money demand rises. That is because the cost of holding money falls. With no effect on employment or saving and investment, output and the real interest rate remain unchanged. With higher real money demand and an unchanged nominal money supply, the quilibrium price level must decline.

Question 9 and 10

In Figures 11 . 17-11. 20, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change. (a) In Figure 11. 7, when banks pay a higher interest rate on checking accounts, the demand for money rises, shifting the LM curve up and to the left from LMI to LM2 in Figure 11 . 17(a). As a result, the AD curve shifts down and to the 2 in Figure ) The new snort-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment is lower, and the price level is unchanged. In the long run, the price level decreases to shift the LM curve from LM2 to LM3, which is the same as LMI, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts down from SRASI to SRAS2.

At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is lower. The introduction of credit cards reduces the demand for money”shifting the LM curve down and to the right from LMI to LM2 in Figure 11 . 18(a). As a result, the AD curve shifts from ADI to AD2 in Figure 11. 8(b). The new short-run equilibrium occurs at point B, where output is higher, the real interest rate is lower, employment is higher, and the price level is unchanged.

In the long run, the price level increases to shift the LM curve from LM2 to LM3, which is the same as LMI, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts up from SRASI to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is higher. Figure 11. 18 (c) In Figure 11. 9, the reduction in agricultural output shifts the FE curve to the left from FEI to FE2, and shifts the LRAS line from LRASI to LRAS2.

The rise in agricultural prices increases the price level, so the short-run aggregate supply curve shifts up from SRASI to SRAS2. Also, the rise in the price level shifts the LM curve up and to the left from LMI to LM2. The short-run equilibrium is at point B, assuming that the LM curve shifts so much that it intersects the IS curve to the left of the FE line. At point B, compared to the starting point, output is lower, the real interest rate is higher, employment is lower, and the price level is higher. Figure 11. 19 If the water shortage persists, a new long-run equilibrium occurs at point C.

To get to this equilibrium, the price level must decline, shifting the LM curve from LM2 to LM3, and the short-run aggregate supply curve from SRAS2 to SRAS3. Relative to point B, the new equilibrium has a higher output level, a lower real interest rate, higher employment, and a lower price level. (Relative to the initial equilibrium at point A, output and employment are lower, and the real interest rate and the price level are higher.

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