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Unformatted text preview: Homework 12 Solutions ECON 010, Fall 2011 Question 1: AD-AS Model and Money Market Analyze the credit card revolution in the 1980s. Suppose the demand for money goes down, because agents now have credit cards to carry out market transactions. a. Start in the money market and illustrate what happens to money demand and the quantity of money and interest rates in equilibrium. Answer: Introduction of credit cards will decrease the demand for money at any given interest rate and thus the Money Demand curve will shift in. As a result, the equilibrium interest rates will decline. However, the equilibrium quantity of money will stay the same (since MS is constant). b. Suppose that the economy is currently operating at potential GDP. Trace the development in the money market further into the AD-SRAS-LRAS diagram, assuming there is no long-run growth. Describe what happens to equilibrium GDP and prices. Answer: Since the equilibrium interest rates decline, Investment and Consumption will increase. There- fore, the Aggregate Demand curve will shift. In the short-run the economy will be producing at a level above Potential GDP (and thus, the unemployment will be be below the natural unemployment level) and the price level will be higher. c. Describe what will happen in the long-run to equilibrium level of GDP and prices. Answer: Since the prices are now higher, real wages are lower. Therefore, workers will demand higher wages and the supply for workers will shift in. The demand for workers will also shift up since demand depends on the price of the goods which the workers produce and the price is now higher. In equilibrium, the nominal wages will increase and employment will stay the same. Therefore, in the L-R in the AD-SRAS graph, SRAS will shift in to the point where the economy is now producing back at Potential GDP, but now the price level is higher. Question 2: AD-AS Model and Fiscal Policy Suppose that the economy is currently operating below potential GDP. The government has decided to cut taxes in an effort to increase output. Suppose that the government can calculate the exact amount by which it will need to cut taxes by in order to close the deflationary gap. 1 a. Describe what happens initially to Aggregate Expenditure when the government decreases taxes. Answer: When the government decreases taxes, the initial effect is an increase in Aggregate Expendi- ture. b. Describe what initially happens in the AD-AS model when the government decreases taxes....
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This note was uploaded on 04/04/2012 for the course ECON 010 taught by Professor Stein during the Fall '07 term at UPenn.
- Fall '07