HW 8 Solution - Econ 201 HW 8 1 Inflation in an economy...

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Econ 201 HW 8 1. Inflation in an economy rises by 3%. A worker’s wages rise by 3%. Assume the worker is fooled by the “money illusion.” Complete the following: (5) What has happened to the worker’s nominal wage? As stated in the problem, the nominal wage increases by 3%. What has happened to the worker’s real wage? Nominal wage has increased at the same rate as prices. This means that real wage remains the same. How will the worker feel about her new wage? The worker will be pleased by her wage increase. Explain why this is the case. The “money illusion” refers to our tendency to focus on nominal wages rather than real wages. Since nominal wage increased, she is happy. Is this response more closely related to classical or Keynesian economics? Keynesian economics; according to classical theory people are not fooled by the money illusion. 2. Say’s law suggests that, in the overall economy, the production of goods will generate the income necessary to buy the goods produced by the economy. How can we explain recessions in a way that is consistent with Say’s Law? What will happen to investment spending as a result of recession if we believe in Say’s Law? How will this return the economy to full employment, again in accordance with Say’s Law? (3) There can be structural gaps in the economy. This generally occurs because the goods produced are not always the same goods that consumers want to buy. This means we will sometimes have a glut of some goods, and inadequate spending to maintain full employment while the economy shifts resources from the undesirable good to the desirable one. Inadequate spending should drive down interest rates, increase investment spending, and return the economy to full employment as greater investment facilitates the shift in production to higher demand goods.
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