ps4_answers - 14.02 Principles of Macroeconomics Problem...

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14.02 Principles of Macroeconomics Problem Set #4 - Answers October 23, 2002 1 PART I. TRUE/FALSE/UNCERTAIN 1. As in microeconomics, the AD-curve is downward sloping since consumers buy less goods when they are expensive. False: the AD-curve is downward sloping because higher a price level re- duces the real supply of money (M/P). To restore the equilibrium in the money market the interest rate has to increase, so the amount of money demanded in equilibrium is equal to the amount of real money -now lower-. A higher interest rate reduces the level of investment, which implies a lower aggregate demand. 2. Even with the unemployment rate in its natural level, in fl ation rate can increase due to higher expected in fl ation. True: if wage setters expect a higher level of in fl ation (higher expected in fl ation is equivalent to a higher expected price when current price level is given), they set a higher nominal wage, which leads to a higher price level. Given last period’s price level, a future higher price implies a higher in fl ation rate. 3. Wage indexation decreases the impact of changes in unemploy- ment rate on the in fl ation rate. False: The extreme case of in fl ation forecast is the wage indexation. In that case, an increase in prices leads to a further increase in wages within the year, which leads to a further increase in prices, and so on. So the e ff ect of unemployment on in fl ation within the year is higher. 4. Expansionary fi scal policy has a positive e ff ect on output, con- sumption and investment in the short run. However, it has no e ff ect in the medium run since all the components of aggregate demand go back to its previous level. 1
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False: Investment in the medium run is unambiguously lower. In the short run, a budget expansion leads to an increase in output. In order to restore the equilibrium in the fi nancial market, an increase in the interest rate is needed to neutralize the positive e ff ect of higher income in the demand of money. Consumption only depends on output, so it increases in the short run. Investment may be lower or higher depending on how sensitive it is to the increase in output versus the increase in the interest rate. However, as long as the output is above its natural level the price level in- creases (expected price level increases shifting the AS-curve up). In the medium run, the prices settle down when output is equal to its natural level. Output goes back to its previous level as well as consumption. So, the increase in govern- ment expenditure crowds out investment. The contraction in the real amount of money leads to an increase in the interest rate, which -having output constant- ends up in a lower level of investment. 5. Expansionary monetary policy has a positive e ff ect on output, consumption and investment in the short run. However, it has no e ff ect in the medium run since all the components of the aggregate demand go back to its previous level.
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