Problem Set 6 Solutions

Problem Set 6 Solutions - Economics 3213 Answers to Problem...

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Economics 3213 Answers to Problem Set 6: The Hunchback of Notre Dame Prof. Xavier Sala-i-Martin 1. The King of Fools I. A temporary increase in productivity (an increase in A 1 only) directly increases this period's aggregate supply (from AS 0 to AS 1 in Diagram 1) and income. Since workers have become more productive today relative to subsequent periods, their wages are higher today relative to tomorrow. As an indirect effect, workers increase their supply of labor, thereby shifting aggregate supply further to the right (from AS 1 to AS 2 ). Since the increase in income is temporary, the demand for consumption C d today increases less than today's income because of consumption smoothing motif. Remember that MPC out of temporary income is less than one. Hence, aggregate demand shifts to the right less than aggregate supply (from AD 0 to AD 1 ). As a result, equilibrium interest rate goes down, and equilibrium income and consumption go up. Diagram 1 Notice a very important difference between aggregate supply and demand on one hand and equilibrium income and consumption on the other. Aggregate supply is a functional relationship that tells you how much output is produced for a given interest rate. Similarly,
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aggregate demand tells you how much consumption is desired for a given interest rate. These curves can shift in opposite directions, like in Diagram 3, for example. In equilibrium, however, the actual amounts produced and consumed are always equal. II. A permanent increase in productivity (an increase in A 1 , A 2 , etc.) directly increases today's supply (from AS 0 to AS 1 in Diagram 2). There is no indirect effect through labor supply because relative productivity A 1 / A 2 and hence relative wages are unchanged. The demand for consumption today increases by the same amount as income (from AD 0 to AD 1 ) because a permanent increase in productivity implies a permanent increase in output. Notice that MPC out of permanent income is one. Hence, equilibrium interest rate is unchanged, but equilibrium income and consumption go up. Diagram 2 III. An anticipated increase in productivity (an increase in A 2 , A 3 , etc., with A 1 constant) has no direct effect on period 1 aggregate supply. However, if A 2 will increase, relative productivity A 1 / A 2 decreases. Workers will be paid more tomorrow relative to today.
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Problem Set 6 Solutions - Economics 3213 Answers to Problem...

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