f01_ps7ans

# f01_ps7ans - 14.02 Fall 2001 Problem Set 7 Solutions Part...

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14.02 — Fall 2001 — Problem Set 7Solutions Part I: True, False or Uncertain? 1. False. The natural rate of unemployment depends on labor market insti- tutions and market structure. Therefore, policy changes such as a more stringent anti-trust legislation or a more generous Unemployment Insur- ance program will a f ect the natural unemployment rate. 2. False. If employment is increasing, but the labor force is increasing even faster, then we can have that the unemployment rate is rising. The state- ment would be true, however, if we assumed that the size of the labor force is constant. 3. True. All three will shift the Aggregate Demand curve —an increase in M will move the LM, while an increase in either T or G will move the IS, so for any given level of prices we will now have a new level of output as the equilibrium of the goods and f nancial markets. Hence, since the AD curve will have shifted, the economy will move to a new point along the Aggregate Supply curve. 4. True. All three a f ect the labor market conditions —an increase in P e or in z will move the Wage-Setting relation, whereas an increase in the markup μ will shift the Price-Setting relation. As a result, the Aggregate Supply relation between the price level and output will have shifted. 5. False. The correct argument works the other way round, as follows. When the economy is above its natural rate of output, f rms must be hiring more workers, so the unemployment rate is below its natural level —in plain En- glish, the labor market is tight. This increases the bargaining power of workers, and hence wages are higher than they would have been other- wise. This creates a pressure to increase prices, since these are set by f rms as a markup over wages. Therefore, the price level will be higher than expected. As wage-setters start revising their expectations up, the Aggregate Supply curve shifts up. So much for the labor market and Ag- gregate Supply —let us now look at the other two markets, represented in the IS-LM framework, and which determine Aggregate Demand. The increase in the price level (in F ation) will erode real money balances in the economy ( M/P ), so the interest rate will need to go up in order to restore equilibrium in the money market. This increase in the interest rate will depress demand for goods and therefore reduce output. In terms of the IS- LM framework, we will see the LM curve shift upwards due to the decline in , thus leading to a higher interest rate and a lower level of output as a result of simultaneous equilibrium in the goods and f nancial markets. Therefore, we will be moving along the Aggregate Demand curve as the Aggregate Supply shifts up. As that happens, this is, as the price level keeps increasing and the output level is reduced, f rms lay o f excess work- ers and the unemployment rate goes up. The aggregate supply curve will 1

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continue to shift up until, in the medium run, output and the unemploy- ment rate are equal to their natural levels.
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## This note was uploaded on 11/29/2009 for the course 14 14.02 taught by Professor Geurrieri during the Fall '09 term at MIT.

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f01_ps7ans - 14.02 Fall 2001 Problem Set 7 Solutions Part...

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