# PS 7 with Answers - METU Department of Economics Econ 202...

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METU Department of Economics Econ 202 Macroeconomic Theory Instructors: Ebru Voyvoda - Şirin Saraçoğlu 2010-2011 Spring Semester Problem Set 7 Question 1: A new source of energy has been discovered in Macronesia. This new technology will reduce the costs of production of macronesian firms, and as a consequence will reduce the mark-up of price over wage charged by firms. (The change in the mark-up is the only way in which the new technology affects the economy.) As the finance minister of Macronesia, you would like to analyze the impact of this shock on the economy. a) In the AS-AD set up, the reduction in production costs shifts which curve, the AS or the AD? How? Explain in words. It affects the AS only. For any output level, now the AS curve will relate to a lower price level (AS shifts down in the Y-P diagram). b) What happens in the short-run? Show in a graph and describe the effect on the price and the level of output.

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c) What happens in the medium run? Prices decrease even further and output reaches a new higher natural level d) Describe the adjustment from the initial equilibrium towards the medium-run. Show in the graph. e) Compare the composition of spending (consumption, investment, and government spending) in the medium run with the initial pre-shock situation. Answer: Recall Y=C(Y-T)+I(i,Y)+G In the new equilibrium, G and T haven’t changed. Y is higher, so C has also to be higher. Now we need to see what happens to investment. In the IS-LM diagram, P is decreasing throughout the analysis, so M/P is increasing. The LM is then moving continuously to the right. This in turn implies that the interest rate is going down. In the medium run we are in equilibrium with a lower price level and a lower interest rate. So, as interest rates went down and output went up; investment went unambiguously up. So, in the medium run equilibrium, C is higher, I is higher and G is the same. The interest rate is lower. Suppose now that after the initial discovery, you as finance minister would like to accelerate the transition to the medium run by using fiscal or monetary policies. f) What kind of policies would you recommend? Can you stabilize the economy to its new medium run equilibrium level of output and keep prices constant at the initial level? Show in a graph. Answer: You would like to expand demand - this could be done with expansionary monetary policy (increasing M) or expansionary fiscal policy (increasing G or reducing T)
g) Suppose that you achieved the objective in part (f) by changing government spending. What can you say about the new composition of spending (consumption, investment and government spending)? Answer: Recall Y=C(Y-T)+I(i,Y)+G Comparison with pre-shock equilibrium Output is higher in the medium-run. Given that T is constant, consumption C is higher. Now in the IS-LM diagram, prices do not move (they are kept constant by the expansionary policy), and given that M is constant, the LM does not move. . However, G increased, so IS moves to the right. In equilibrium the interest rate is now higher than the pre-shock equilibrium. The effect in investment I is ambiguous

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## This note was uploaded on 03/22/2012 for the course ECON 202 taught by Professor Tunc during the Spring '10 term at Middle East Technical University.

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PS 7 with Answers - METU Department of Economics Econ 202...

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