Transcript ECON 102 Tutorial: Week 11

ECON 101 Tutorial: Week 20
Shane Murphy
[email protected]
Office Hours: Monday 3:00-4:00 – LUMS C85
Outline
• Roll Call
• Problems
Chapter 33: Problem 3
The economy is in a recession with high
unemployment and low output.
a) Use a graph of AD-AS to illustrate the current
situation.
Chapter 33: Problem 3
The economy is in a recession with high
unemployment and low output.
b) Identify an open-market operation that would
restore the economy to its natural rate.
The central bank will want to stimulate aggregate
demand. Thus, it will need to lower the interest rate
by increasing the money supply. This could be
achieved if the central bank purchases government
bonds from the public.
Chapter 33: Problem 3
c) Use a graph of the money market to illustrate the
effect of this open-market operation.
the central bank’s purchase of government bonds
shifts the supply of money to the right, lowering the
interest rate.
Chapter 33: Problem 3
The economy is in a recession with high
unemployment and low output.
d) Use a graph similar to the one in part (a) to show
the effect of the open-market operation on output
and the price level.
The central bank’s purchase of
government bonds will increase
aggregate demand as consumers
and firms respond to lower
interest rates. Output and the
price level will rise.
Chapter 33: Problem 7
Assume the economy is in a recession. Explain how each
of the following would affect consumption and
investment.
a) An increase in government spending.
An increase in government spending would shift the
aggregate demand curve to the right, increasing output.
The rise in output would raise consumption spending,
since people would have higher incomes, and raise
investment spending through the accelerator. But
money demand would also increase, raising the interest
rate. This would tend to reduce consumption, as people
would save more, and reduce investment, since the cost
of investing would be higher. Overall, the changes in
both consumption and investment are ambiguous.
Chapter 33: Problem 7
b) A reduction in taxes.
A reduction in taxes would directly increase consumption
spending, since people would have higher after-tax incomes.
Also, since the reduction in taxes increases consumption
spending, aggregate demand increases, so total output
increases. The rise in output would raise consumption
spending further, since people would have higher incomes,
and raise investment spending through the accelerator. But
money demand would also increase, raising the interest rate.
This would tend to reduce consumption, as people would save
more, and reduce investment, since the cost of investing
would be higher. Overall, consumption must increase
(otherwise aggregate demand would not have increased at all)
while the change in investment is ambiguous.
Chapter 34: Problem 7
c) An expansion in the money supply
An expansion in the money supply reduces the
interest rate, thus increasing aggregate demand and
output. The rise in output would raise consumption
spending, since people would have higher incomes,
and raise investment spending through the
accelerator. The lower interest rate would increase
consumption, as people would save less, and
increase investment, since the cost of investing
would be lower. Overall, both consumption and
investment would increase.
Chapter 34: Problem 9
Recently some members of the legislature have
proposed a law that would make price stability the
sole goal of monetary policy.
a) How would the central bank respond to an event
that contracted aggregate demand?
If there were a contraction in aggregate
demand, the central bank would need to
increase the money supply to increase
aggregate demand and stabilize the price
level, as shown in the figure. By increasing the
money supply, the Fed is able to shift the
aggregate demand curve back to AD1 from
AD2. This policy stabilizes output as well as the
price level.
Chapter 34: Problem 9
Recently some members of the legislature have
proposed a law that would make price stability the
sole goal of monetary policy.
b) How would the central bank respond to an event
that cause an adverse sift in SR-AS
If there were an adverse shift in short-run aggregate
supply, the central bank would need to decrease the
money supply to stabilize the price level, shifting the
aggregate demand curve to the left from AD1 to AD2,
as shown in the figure. This worsens the recession
caused by the shift in aggregate supply. To stabilize
output instead of the price level, the central bank
would need to increase the money supply, shifting
the aggregate demand curve from AD1 to AD3, but
this action would raise the price level.
Chapter 34: Problem 3
Suppose that a fall in consumer
Spending causes a recession.
A) Illustrate the changes in the
economy using AS-AD and Phillips curve diagram.
In both diagrams, the economy begins at full employment at point A.
The decline in consumer spending reduces aggregate demand, shifting
the aggregate demand curve to the left, from AD1 to AD2. The
economy initially remains on the short-run aggregate supply curve
SRAS1, so the new equilibrium occurs at point B. The movement of the
aggregate demand curve along the short-run aggregate supply curve
leads to a movement along short-run Phillips curve SRPC1, from point
A to point B. The lower price level in the aggregate supply/aggregate
demand diagram corresponds to the lower inflation rate in the Phillips
curve diagram. The lower level of output in the aggregate
supply/aggregate demand diagram corresponds to the higher
Chapter 34: Problem 3
b) Now suppose over time expected inflation changes in
the same direction that actual inflation changes. What
happens to the position of the short run Phillips curve?
After the recession, is inflation-unemployment worse
than before?
As expected inflation falls over time, the short-run
aggregate supply curve shifts down from AS1 to AS2,
and the short-run Phillips curve shifts down from SRPC1
to SRPC2. In both diagrams, the economy eventually
gets to point C, which is back on the long-run aggregate
supply curve and long-run Phillips curve. After the
recession is over, the economy faces a better set of
inflation-unemployment combinations.
Chapter 34: Problem 3
b) Now suppose over time expected inflation
changes in the same direction that actual inflation
changes. What happens to the position of the short
run Phillips curve? After the recession, is inflationunemployment worse than before?
Chapter 34: Problem 4
Suppose the economy is in LR equilibrium.
a) Draw the economy’s SR and LR Phillips curve
Chapter 34: Problem 4
b) Suppose a wave of pessimism reduces AD. If the central bank
expands MS, can it return the economy to the original inflation and
unemployment
A wave of business pessimism
reduces aggregate demand,
moving the economy to point b
in the figure. The
unemployment rate rises and
the inflation rate declines. If the
central bank undertakes
expansionary monetary policy, it
can increase aggregate demand,
offsetting the pessimism and
returning the economy to point
a, with the initial inflation rate
and unemployment rate.
Chapter 34: Problem 4
b) Suppose the price of oil rises. If the central bank expands MS, can it
return the economy to the original inflation and unemployment. If it
contracts MS?
The higher price of imported oil shifts the short-run
Phillips curve up from SRPC1 to SRPC2. The economy
moves from point a to point c, with a higher inflation
rate and higher unemployment rate. Now if the
central bank engages in expansionary monetary
policy, it can return the economy to its original
unemployment rate at point d, but the inflation rate
will be higher. If the central bank engages in
contractionary monetary policy, it can return the
economy to its original inflation rate at point e, but
the unemployment rate will be higher. This situation
differs from that in part (b) because in part (b) the
economy stayed on the same short-run Phillips curve,
but in part (c) the economy moved to a higher shortrun Phillips curve, which gives policy makers a less
favourable trade-off between inflation and
unemployment.
Chapter 34: Problem 8
Imagine an economy in which all wages are set in three-year
contracts. In this world, the central bank announces a
disinflationary change in monetary policy to begin immediately.
Everyone in the economy believes the central bank’s
announcement. Would this disinflation be costless? What might the
central bank do to reduce the cost of disinflation?
If the central bank announces a disinflation, but nominal wages
have been set in three-year contracts, then the lower rate of
inflation will mean real wages are too high until the contracts can
be renegotiated in three years. As a result, firms will not hire as
much labour and the unemployment rate will exceed the natural
rate, so the disinflation would be costly. To reduce the cost of
disinflation, the central bank could announce that it would reduce
inflation three years from now, so contracts could be adjusted.
Alternatively, the central bank could reduce inflation very slowly, so
real wages wouldn't be too high for quite as long, and the costs of
disinflation would be lower.