Problem Set I - 2011 - Solved

Problem Set I - 2011 - Solved - Lahore School of Economics...

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Unformatted text preview: Lahore School of Economics Macroeconomics II Spring 2011 BSC II - Problem Set 1 Suggested Solutions: Any queries can be emailed 1. How often does the price you pay for haircut change? What does your answer imply about the usefulness of market-clearing models for analyzing the market for haircuts? The price of haircuts changes rather infrequently. From casual observation, hairstylists tend to charge the same price over a one- or two-year period irrespective of the demand for haircuts or the supply of cutters. A market-clearing model for analyzing the market for haircuts has the unrealistic assumption of flexible prices. Such an assumption is unrealistic in the short run when we observe that prices are inflexible. Over the long run, however, the price of haircuts does tend to adjust; a market-clearing model is therefore appropriate. 2. Lets examine how the goals of the State Bank of Pakistan influence its response to shocks. Suppose SBP A cares only about keeping the price level stable, and SBP B cares only about keeping the output and employment at their natural rates. Explain how each SBP would respond to a. An exogenous decrease in the velocity of money b. An exogenous increase in the price of oil An exogenous decrease in the velocity of money causes the aggregate demand curve to shift downward, as in Figure 911. In the short run, prices are fixed, so output falls. If the SBP wants to keep output and employment at their natural-rate levels, it must increase aggregate demand to offset the decrease in velocity. By increasing the money supply, the SBP can shift the aggregate demand curve upward, restoring the economy to its original equilibrium at point A. Both the price level and output remain constant. If the SBP wants to keep prices stable, then it wants to avoid the long-run adjustment to a lower price level at point C in Figure 911. Therefore, it should increase the money supply and shift the aggregate demand curve upward, again restoring the original equilibrium at point A. Thus, both SBPs make the same choice of policy in response to this demand shock. b. An exogenous increase in the price of oil is an adverse supply shock that causes the short-run aggregate supply curve to shift upward, as in Figure 912. If the SBP cares about keeping output and employment at their natural-rate levels, then it should increase aggregate demand by increasing the money supply. This policy response shifts the aggregate demand curve upwards, as shown in the shift from AD 1 to AD 2 in Figure 912. In this case, the economy immediately reaches a new equilibrium at point C. Figure 912....
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Problem Set I - 2011 - Solved - Lahore School of Economics...

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