178.200 06-6

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178.200 Intermediate MacroeconomicsTutorial (6)

Aggregate Supply

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Multiple-Choice Questions(2005 Exam Question)

1. The three models of the short-run aggregate supply curve include all of the following EXCEPT the:

a. sticky-wage modelb. sticky-price modelc. industry-misperception modeld. imperfect-information modelAnswer: c.Hint: (See P357).

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Multiple-Choice Questions

2. The factor that is sticky-wage model is:

a. the real wage.

b. the nominal wage.

c. output.

d. inflation.

Answer: b.

Hint: (See P349).

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3. In the sticky-wage model, when GDP increase and there are no supply shocks, real wages:

a. rise.b. fall.c. remain constant.d. may rise, fall, or remain constant.Answer: b.

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4. The sticky-wage model predicts that:a. the short-run aggregate supply curve is vertical.b. the short-run aggregate supply is unrelated to

the price level.c. firm move along a stationary labor demand

curve.d. none of the above.Answer: c.Hint: (See P350).

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Multiple-Choice Questions(2005 Exam Question)5. According to the imperfect-information model,

when prices unexpectedly rise, suppliers infer that their relative price have _______, which induces them to _______ output.

a. increased; increaseb. decreased; decreasec. increased; decreased. decreased; increaseAnswer: a.Hint: (See PP352-353).

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6. In the sticky-price model:a. all firms adjust prices instantly in response to

changes in demand.b. no firms adjust prices instantly in response to

changes in demand.c. some firms adjust prices instantly in response to

changes in demand while others do not.d. output is constant.Answer: c.

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7. If all firms in the economy have fixed prices in the short run:

a. the short-run and long-run aggregate supply curves will be identical.

b. the short-run supply curve will be vertical.

c. the short-run supply curve will be horizontal.

d. none of the above will be true.

Answer: c.

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8. The sticky-price model can explain why countries with variable aggregate demand have short-run aggregate supply curves that are:

a. flat.b. steep.c. horizontal.d. vertical.Answer: b.Hint: (See P354).

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9. All three models of aggregate supply predict:

a. an upward-sloping SRAS curve.

b. a vertical LRAS curve.

c. that the actual level of output is equal to its natural rate in the long-run.

d. all of the above.

Answer: d.

Hint: (See P357).

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10. According to the Phillips curve, the inflation rate depends on:

a. expected inflation.b. the difference between the actual and

natural rates of unemployment.c. supply shocks.d. all of the above.Answer: d.

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11. When unemployment is below the natural rate and inflation rises, it characterized as:

a. demand-pull inflation.

b. cost-push inflation.

c. a supply shock.

d. stagflation.

Answer: a.

Hint: (See P362).

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Multiple-Choice Questions(2005 Exam Question)12. Compared with the assumption of adaptive

expectations, the assumption of rational expectations implies that the transition to the new long-run equilibrium following a credible change in monetary or fiscal policy will take:

a. less time.b. more time.c. the same amount of time.d. any of the above.Answer: a.Hint: (See P367)

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13. The Philips curve immediately shifts upward whenever:

a. inflation rises.b. unemployment falls.c. an adverse supply shock, such as an oil price

increase, occurs.d. all of the above.Answer: c.Hint: (See P362).

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14. A typical estimate of the sacrifice ratio is about 5. Thus, if the inflation rate were to be lowered by 2 percentage points, the amount of one year’s GDP we must give up is:

a. 2%.b. 2.5%c. 5%d. 10%Answer: d.Hint: (See P367).

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15. According to the hypothesis of unemployment hysteresis, a prolonged recession will:

a. increase the natural rate of unemployment.b. decrease the natural rate of unemployment.c. have no effect on the natural rate of

unemployment.d. never occur.Answer: a.Hint: (See P371).

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Numerical Questions

(1) Assume the following model of the economy, with the price level fixed at 1.0:

C = 0.8(Y-T) T = 1000

I = 800 – 20r G = 1000

L = 0.4Y – 40r M = 1200

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Numerical Questions

i. Write a numerical formula for the IS curve, showing Y as a function of r alone.

Answer:

Y = C + I + G

= 0.8(Y – 1000) + (800 – 20r) + 1000

IS: Y = 5000 – 100r

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Numerical Questions

ii. Write a numerical formula for the LM curve, showing Y as a function of r alone.

Answer:

M = L

1200/1 = 0.4Y – 40r

LM: Y = 3000 + 100r

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Numerical Questions

iii. What are the equilibrium values of Y, r, (Y – T), C, and I?

Answer:

From i and ii we haveY = 5000 – 100r (1)

Y = 3000 + 100r (2)

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Numerical Questions

(continued)

(1) – (2)

200r = 2000

r = 10

Bring r back to (1) or (2), then Y = 4000.

Y – T = 4000 – 1000 = 3000

C = 0.8 * 3000 = 2400

I = 800 – 20 * 10 = 600

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Numerical Questions

iv. Assume that G increase by 200. By how much will Y increase? What is the government purchases multiplier?

r

15

10

4000 4500 Y

LM

IS1

IS2

E1

E2

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Numerical Questions

Answer:

G = 1000 + ΔG = 1000 + 200 = 1200

IS: Y = C + I + G = 6000 – 100r (3)

LM: Y = 3000 + 100r (4)

(3) – (4), then r = 3000/200 = 15

Bring r back to (3) or (4), Y = 4500

ΔY = 4500 – 4000 = 500

ΔY/ΔG = 500/200 = 2.5

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Numerical Questions

v. Assume that G is back at its original level of 1000, but M increases by 200. By how much will Y increases in? What is the multiplier for money supply?

r

10

7.5

4000 4250 Y

LM1

LM2

IS

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Numerical QuestionsAnswer:M = 1200 + ΔM = 1200 + 200 = 1400LM: M = L 1400 = 0.4Y –40r Y = 3500 + 100r (5)IS: Y = 5000 – 100r (6)(5) – (6), r = 1500/200 = 7.5and then Y = 4250.ΔY = 4250 – 4000 = 250.ΔY/ΔM = 250/200 = 1.25

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Numerical Questions

(2) Suppose the economy’s short-run production equation is

The demand for labour equation is

Ld = 175 – 12.5(W/p),

and the labour supply equation is

Ls = 70 + 5(W/p).

204.014 LLy

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Numerical Questionsa. Find labour market equilibrium when the price level

is 1.00 and 1.25.Answer: The equilibrium value of labour market exists

when Ld = Ls. Therefore, 175 – 12.5(W/1) = 70 + 5(W/1) 17.5W = 105 W = $6 Then L = 100. We can use the same method to obtain W = $7.50

and L = 100 when the price level is 1.25.

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Numerical Questions

b. Find short-run output when there is labour market equilibrium at price level 1.00 and 1.25.

Answer:

From (a) we can see that labour market equilibrium is unaffected by the price level.

Thus,

10001000004.010014

04.014 2

y

LLy

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Numerical Questions

(3) Question 3 on page 373.

Suppose that an economy has the Phillips curve

)06.0(5.01 u

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Numerical Questions

a. What is the natural rate of unemployment?Answer: The natural rate of unemployment is the

rate at which the inflation rate does not deviate from the expected inflation rate.

Therefore, -0.5(u – 0.06) = 0u = 0.06 = 6%.

1

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Numerical Questions

b. Graph the short-run and long-run relationships between inflation and unemployment.

π

π-1

0.5

LRPC

SRPC

0.06 u

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Numerical Questions

c. How much cyclical unemployment is necessary to reduce inflation by 5%? Using Okun’s law compute the sacrifice ratio.

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Numerical Questions

Answer:

When inflation falls by 5%,

-0.05 = -0.5(u – 0.06)

u = 0.16

)06.0(5.0

05.0

1

1

u

π

π-1

π0

0.06 0.16 u

LRPC1

LRPC2

SRPC

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Numerical Questions

(continued)

Δu = 0.16 – 0.06 = 10%

According to Okun’s law: 1% change in u translates in to change of 2% in GDP.

Hence, Δu = 0.16 – 0.06 = 10% leading to fall in GDP of 20%.

The sacrifice ratio is 20/5 = 4.

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Numerical Questionsd. Inflation is running at 10%. The Fed wants to

reduce it to 5%. Give two scenarios that will achieve that goal.

Answer:1) Very high unemployment rate (e.g. 16%) for a

short period of time (e.g. 1 year).2) A small amount of cyclical unemployment (e.g.

8%) spread out over a long period of time (e.g. 5 years).

Both plans will achieve the goal but at different speed.

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178.200 06-6