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Unformatted text preview: ECMA06
Tutorial #7 - Week 7
Answers 1. First we need to derive the AD curve. Yd = T + TR — TA = 140 + 0.7Y
C =14 + 0.9Yd +(1004P)=140 + 0.63Y + (100—P)
I =130, G = 300, X = 330, M = 0.23Y
AE=C+I+G+X—IM=900+0.4Y+(100—P) Set AB = Y: 900 + 0.4Y +(100—P)= Y, so P = 1000 — 0.6Y which is AD Now set AS = AD: —200 + 0.2Y = 1000 — 0.6Y so 0.8Y = 1200, Y = 1500 and P = 100 GBB = TA 4 TR - G = 375 — 65 — 300 = 10, so there is a government surplus of 10 The level of Y at full employment (called YF) is 1500, because we are in long run equilibrium. 2a) Increasing G by 32 increases AE to 932 + 0.4Y + (100—P), so the new AD curve is P = 1032 — 0.6Y
Again set AS = AD: —200 + 0.2Y = 1032 — 0.6Y so 0.8Y = 1232, Y = 1540 and P = 108
GBB = TA — TR — G = 385 — 63 — 332 = —10, so there is a government deﬁcit of 10
Here the multiplier on G is AY/AG = 40/32 = 1.25
If prices had not changed, we would have used the multiplier deﬁned by 1/(1—Cy) = 1/(I—.4) = 1.67
The multipliers differ because the rise in P moves us up the AD curve and reduces the impact on Y.
b) In the short run run, Y = 1540 is above YF = 1500, which means that unemployment is below the full
employment level of unemployment. In the long run, the shortage of workers causes w to rise, shifting
the AS curve up and returning Y to 1500. Plug Y = 1500 into the AD curve: P = 1032 — 0.6Y = 132
Now plug Y = 1500, P = 132 into the AS curve: P = [—200 + 0.2Y][w/20], 132 = 100[w/20]
This gives us w = 26.4: The adjustment mechanism is the rise in wages caused by
unemployment rates below full-employment unemployment.
c) See next page [to emphasize the shifts, we have drawn the diagram so that it is not to scale] 3a) Reducing X by 24 reduces AE to 876 + 0.4Y +(1004P), so the new AD curve is P = 976 — 0.6Y Again set AS = AD: —-200 + 0.2Y = 976 — 0.6Y so 0.8Y = 1176, Y = 1470 and P = 94 GBB = TA — TR — G = 367.5 — 66.5 — 300 = 1, so there is a government surplus of 1 b) In the short run run, Y = 1470 is below YF = 1500, which means that unemployment is above the full employment level of unemployment. In the long run, the extra unemployment causes w to fall, shifting the AS curve down and returning Y to 1500. Plug Y = 1500 into the AD curve: P = 976 — 0.6Y = 76
Now plug Y = 1500, P = 76 into the AS curve: P = [—200 + 0.2Y][w/20], 76 = 100[w/20]
This gives us w = 15.2: The adjustment mechanism is the fall in wages caused by
unemployment rates above full-employment unemployment. c) See next page [again, remember that the diagram is not to scale] 4. The two adjustment mechanisms are not equally likely. We know that wages can easily move
upwards, but that workers are unusually resistant to wage reductions, so that wages are sticky downwards.
This means that wages in question 2 will move upwards very quickly, returning us quickly to long run
equilibrium (and in fact, wages may overshoot, causing a situation of stagﬂation). Meanwhile, wages in
question 3 will fall very slowly, if at all, leaving us stuck in a situation of higher unemployment for an
extended period of time. mévw 0F. he; ...
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