101

What variable in the equation would cause the multiplier to be higher or lower? Explain.

1/1−𝑥̅ is what determines the value of the multiplier, and therefore changes in 𝑥̅ will change the multiplier.

In what direction would the variable you mentioned in part 'a' have to move in order for the multiplier to be lower? Explain.

A higher value for 𝑥̅ would mean that the multiplier is larger and a lower value for 𝑥̅ would mean that the multiplier is lower. For instance, if 𝑥̅ =0.5, then the multiplier is 2, and if 𝑥̅ =0.33, then the multiplier is 1.5

What does A mean in y=AK^1/3

A is the total factory productivity

AD Curve, changes in inflation, greater b is flatter in AD curve

A movement along the AD curve

What happens to the AS-AD curve when there is a long period of oil price increases

AS curve shift up,, leading to stagflagtion (recession and inflation)

According to PC, the change in inflation is 0 when current output is equal to potential output, but inflation most likely above 0

According to PC, the change in inflation is 0 when current output is equal to potential output, but inflation most likely above 0

AD Curve, Changes in 𝒎̅, greater 𝒎̅ is flatter AD Cruve

Alters the slope of the AD curve

Using the IS-MP graph and the Phillips curve graph, explain what will happen if there is an increase in exports (𝒂̅𝒆𝒙). Show graphically and explain in words.

An increase in exports (𝑎̅𝑒𝑥) will lead to a shift to the right of the IS curve. This will cause an increase in short-run output (𝑌̃ 𝑡). The increase in short-run output will cause movement along the Phillips curve to a higher inflation rate.

Suppose that the stock of inventories in a country increased from $10 billion at the end of 2022 to $12 billion at the end of 2023. How would this alter the GDP calculation for 2023? What problem do we run into when we do not adjust for changes in inventories?

An increase in inventories at the end of the year compared to the beginning of the year means that a country has produced more than it has sold. The amount that is sold is counted as part of C, G, I, or EX, but there are $2 billion that are produced and not sold that need to be accounted for. Not accounting for an increase in inventories will lead to an understatement of GDP for that year.

Suppose there is an increase in housing prices, which increases people's wealth. Using both the IS-MP graph and the Phillips curve graph, display and explain what would happen in the economy.

An increase in people's wealth will increase consumption spending and therefore cause the IS curve to shift to the right. The economy will move from point A to point B on the graph depicting the IS-MP curves. This will increase short-run output 𝑌̃, so that it is above 0. By increasing short-run output, there is also an increase in the rate of inflation, which is depicted by a movement along the Phillips curve (from point A to point B).

What is the permanent income hypothesis, how related to diminishing marginal utility

Consumption is smooth over time, people smooth it out, spread out consumption

Why does the AS curve slope down?

Due to Phillips Curve

Why does AD curve slope down?

Due to response of policymakers to inflation

What happens if potential GDP is lower than it actualy is

Economy likely above potential and need to be cooled, if economy is at potential and not above and government cooling may lead to recession

What is the difference between ex ante and ex post

Ex Ante is nominal interest rate minus expected rate of inflation. Ex Post is nominal interest rate minus actual rate of inflation. (EX ante is used for investment decisions)

Your friend Steve says that whenever unemployment is negative, this will lead to an increase in real GDP. Why is your friend not precise in his assessment? Briefly explain.

First, unemployment cannot be negative. Second, the relationship he is referring to is known as Okun's law, which states that decreases in the unemployment rate (and not unemployment being negative) correspond to increases in real GDP.

What is the equation representing the relationship between fiscal policy and inflation, why is it the case that decrease in tax revenue may lead to inflation

G = T + ChangeB + ChangeM B = debt, M = Money supply Decreasing tax revenue may lead to printing money which can cause inflation

What happens if potential output is calculated as being higher than it actually is

GDP is more likely to be lower than potential, and need stimulus, but if GDP is close/at potential, then stimulating economy will lead to inflation

What is equation of IS curve,m and what does b(bar) represent

IS curve equation (given), b (bar) is the degree to which investment responds to changes in real interest rate, higher the B, more investment reacts to changes in real interst rate. higher b = flatter IS curve, because short run output is graphed on horizontal axis

Using the graph below, explain how not estimating potential real GDP (output)accurately can lead to enacting the wrong monetary policy.

In this case, the central bank thinks the economy is in an expansion because actual output is above the perceived potential output (what the central bank estimates). However, the true potential output is above actual output, so the economy is actually in a recession. The central bank raising interest rates because it thinks the economy is in an expansion, when it is actually in a recession, will make the recession worse

How will the AS curve shiftt?

Inflation rate changing over time, Change in the inflation shock paramter

How do differences between real interest rate and the marginal product of capital lead to changes in short run output, what is reason for discrepancy?

Marginal product of capital = real interest rate in long run, short run, pries take time to adjust, and the real interest rate deviates from Marginal product of capital. There fore the central bank can influence real interest rate

What is the difference between nominal GDP and real GDP? Does nominal GDP decreasing necessarily mean that real GDP is decreasing as well?

Nominal GDP is measured using prices and quantities of a particular year. Real GDP measures quantities and prices keeping prices constant at base year prices. Nominal GDP decreasing does not mean real GDP is decreasing, if prices are decreasing, then real GDP may increase even though nominal GDP is decreasing.

If Okun's law represents the relationship between unemployment and output, why are there years where the values are not on the line representing Okun's law? Is the law wrong? Briefly explain.

Output may increase/decrease due to factors unrelated to unemployment and unemployment may increase/decrease due to factors unrelated to output. This would make the points deviate from the line, which represents a linear relationship between unemployment and output.

How would a higher value for b affect response to bank decreasing interest rate

Phillips curve, increase in inflation, increase in short-run output

real interest rate is

Rt

What happens if there is a positive shock to imports (a im)

Shift IS curve to the left

What happens if theres a positive shock to exports (a ex)

Shift IS curve to the right

What is the difference between short-run output (𝒀̃) and potential output (𝒀̅)? How are they different that actual GDP (Y)? Briefly explain.

Short-run output is defined as the percentage deviation from potential output, where potential output is the level of output that could be produced if all inputs were utilized fully: Actual GDP (Y) is used to measure short-run deviations from potential GDP

The AD curve shows that there is a negative relationship between inflation and short-run output. Does this contradict the AS curve? Explain the concept behind the slope of each of these curves.

The AD and AS curves are graphed with 𝑌̃ on the horizontal axis and π on the vertical axis. The AD curve embodies the monetary policy rule, which states that the central bank will change interest rates when inflation is not at its target. For example, a rise in inflation (y-axis) will cause the central bank to raise interest rates. The rise in interest rates will decrease investment spending and decrease short-run output (x-axis). 𝑌̃ and π are negatively correlated. The AS curve is based on the Phillips curve, which represents the idea that when 𝑌̃ increases, there is increased demand for goods and services, which allows firms to raise prices, therefore leading to an increase in inflation (π). 𝑌̃ and π are positively correlated.

The aggregate demand (AD) curve looks a lot like a regular demand curve.However, the reason it slopes down from left to right is different. What is the reasonthat the AD curve slopes down? Explain.

The AD curve slopes down from left to right because of the monetary policy rule. Whenthe inflation rate increases above its target, the central bank will raise interest rates. Therise in interest rates will decrease short-run output. The opposite will occur when theinflation rate is below its target. This is why there is a negative relationship between the inflation rate and short-run output, which is what is depicted with the AD curve.

What might be a reason why there are outliers like 1974 (well above the line) and 1981 (well below the line)? Briefly explain using the equation used to derive the Phillips curve.

The Phillips curve displays the relationship between short-run output 𝑌̃ and the change in inflation. A change in short run output (the horizontal axis) will lead to a change in the inflation rate (vertical axis). However, there are other factors, like changes in production costs, that can also affect inflation, and these will be depicted by deviations from the Phillips curve. These are incorporated into the variable 𝜃̅ in the Phillips curve. So outliers are usually called by shocks to prices (like oil price shocks).

What is the intuition (non-technical reason) behind the positive correlation between the amount of capital in the economy and the marginal product of labor?

The idea is that the more capital is available in the economy, the more capital there is for an additional unit of labor to work with

Using the AS/AD model, explain with a graph and in words what would happen in the economy if there is a decrease in oil prices (𝜽̅).

The initial change in the AS/AD model will be depicted by a downward shift of the AS curve (prices are decreasing). Graphically, we move from point A to point B. With inflation below its target, this will lead the central bank to lower interest rates, leading to an increase in output (𝑌̃). Even after the shock is over and prices return to normal (𝜃̅= 0), inflation is going to be below its target rate because expected inflation has decreased. Inflation is sticky and only as expected inflation increases, does the AS curve shift back to its original position. This will be gradual as expectations take time to adjust. Eventually, the economy will return to point A.

The IS curve is steeper as 𝒃̅ decreases

The lower the value of 𝑏̅, the less short-run output (𝑌̃) is going to be affected by changes in the real interest rate (R). Because the IS curve is graphed with 𝑌̃ on the horizontal axis and R on the vertical axis, a weaker reaction of 𝑌̃ to changes in R is depicted by a steeper IS curve. Therefore, answer d is correct.

When we graph the IS curve, we plot short-run output (𝒀̃) on the horizontal axis and the real interest rate (R) on the vertical axis. What does the point where 𝒀̃ =𝟎 and R = 𝒓̅ represent? Briefly explain.

The point where 𝑌̃ =0 and 𝑅 =𝑟̅ represents the economy being on its long run trend (at potential output). Regarding output, short-run output (𝑌̃) is equal to potential output (𝑌̅). The values of R (real interest rate) and 𝑟̅ (marginal product of capital) determine whether firms can earn more from investing relative to the cost of borrowing (𝑟̅ >𝑅), or vice versa (𝑟̅ <𝑅). When they are equal, then there is no additional incentive or disincentive to invest.

What would happen to the real wage (w) in the economy described in this question if the amount of capital decreased? Briefly explain.

The real wage in the economy is equal to MPL. A decrease in the amount of capital will decrease the MPL and therefore decrease the real wage at equilibrium

What is the rationale behind sometimes assuming that the multiplier is equal to 1 and at other times assuming that it is greater than 1? Briefly explain.

The variable 𝑥̅ has to do with the effect of short-run output/income (𝑌̃) on consumption. If we assume that short-run output/income changes do impact consumption, then 𝑥̅ would be positive, and if we believe that short-run output/income changes do not impact consumption, then 𝑥̅ would be 0. We sometimes assume 𝑥̅ is equal to 0 due to the permanent-income hypothesis, which states that individuals tend to smooth their consumption over time. This leads to consumption decisions not being affected by changes in 𝑌̃. Mathematically, this means that 𝑥̅ =0.

What are the two adjustments that need to be made to the real GDP of one country when comparing its GDP to that of another country?

Two adjustments are different currency and cost of living

How is it possible that there are negative values on x axis (short-run output) and y axis (unemployement)

Unemployement is just deviation from natural rate, and short-runoutput is just below long-run trend

Graph the aggregate demand curve. Is the statement "A higher value for 𝒎̅ leads toa smaller decrease in output when inflation increases" true or false? If it is true,explain why. If it is false, explain how it needs to change to be true.

Whenever inflation is above or below its target, then 𝑚̅ is going to dictate by how muchthe central bank is going to change interest rates as a response. A higher value for 𝑚̅indicates that the central bank will change the interest rate to a greater degree wheninflation is above its target, which leads to a larger decrease in output. Therefore, thestatement is false. It should say 'larger decrease' instead of 'smaller decrease'.

Is the following statement true or false? "If the marginal product of capital is equal to the real interest rate, then investment spending is equal to 0". Briefly explain.

While the real interest rate affects investment spending, we also assume that there is a fraction of potential output (𝑎̅𝑖 ) that will go to investment, irrespective of the interest rate. So investment will not be equal to 0 even if the real interest rate equals the marginal product of capital.

Constant returns to scale

Y= AK^a L^b, if a and b add up to exactly 1

Increasing returns to scale

Y= AK^a L^b, if a and b add up to greater than 1

Decreasing returns to scale

Y= AK^a L^b, if a and b add up to less than 1

Suppose you take out a loan from a bank at a certain nominal interest rate, inflation increase who benefits

You benefits, because you pay less

a (im) is

a (bar)

a (bar) = 0, any deviation is a marcoeconomic shock

a (bar) = 0, any deviation is a marcoeconomic shock

What role did changes in interest rates by the federal reserve, first the decrease from 2000 to 2004, then increase from 2004- 2007 play in Great Recession

fed decreased interest rate to respond to 2001 recession and making purchasing houses easier = increase in housing prices, then fed increase interest rate, which made people unable to pay for their house and default.

What happens to graph of the IS curve if the Fed raises interest rates

increase in nominal interest rate/real interest rate, decrease in short run output

Combined, Okun's law and the Phillips curve imply that there is a ______ relationship between _______ and unemployment.

negative, inflation Because there is a negative relationship between unemployment and short-run output, and a positive relationship between short-run output and inflation, there will be a negative relationship between inflation and unemployment (b is correct).

What would happen to the inflation rate and short-run output if the central bank decreases interest rates

nominal interest rate decrease, increase in short run output

real interest rate is less than marginal product of capital, then firms will increase their investment spending

real interest rate is less than marginal product of capital, then firms will increase their investment spending

The formula below represents a possible monetary policy rule: 𝑹𝒕 − 𝒓̅ = 𝒎̅ (𝝅𝒕 − 𝝅̅)

𝑅𝑡 represents the real interest rate 𝑟̅ represents the marginal product of capital 𝑚̅ represents how strongly the central bank reacts (in terms of interest rates) to inflation being above or below its target 𝜋𝑡 represents the inflation rate 𝜋̅ represents the inflation rate target The right-hand side of the equation represents how strongly the central bank is going toreact to actual inflation deviating from the target inflation rate.The left-hand side represents how much the real interest rate deviates from the marginalproduct of capital. In other words, the relationship between the cost of borrowing (𝑅𝑡) tothe return on that borrowing (𝑟̅ ).

Suppose that GDP grew at 3% last year. Does this mean that 𝒀̃ is 3%? Briefly explain using the formula for how 𝒀̃ is calculated.

𝑌̃ represents the percentage deviation of actual (short-run) GDP from the long-run trend and can be calculated with the following equation: 𝑌̃𝑡 =𝑌𝑡 −𝑌̅𝑡/𝑌̅𝑡 If 𝑌̃ = 3%, this means that GDP was 3% above 𝑌̅𝑡 which is potential GDP/output. This means that GDP had to have increased by more than 3%.

What role does the marginal product of capital play in the equation representing the IS curve? Why is 𝒂̅ equal to in the equation representing the IS curve?

𝑌̃ 𝑡 = 𝑎̅ − 𝑏̅(𝑅𝑡 − 𝑟̅), equation for IS curve. The marginal product of capital is measured against the real interest rate. When the real interest rate is higher than the marginal product of capital, then investment will decrease because the cost of borrowing is greater than the return to borrowing, and vice versa. 𝑎̅ represents all of the shares of potential output of the different components of GDP: Consumption (𝑎̅𝑐 ), Investment (𝑎̅𝑖 ), Government purchases (𝑎̅𝑔), Exports (𝑎̅𝑒𝑥), and Imports (𝑎̅𝑖𝑚). Technically, we also need to subtract '1' from the different shares in order to be able to graph the IS curve with 𝑌̃ 𝑡 on the horizontal axis.

If federal reserves only control nominal interest rate, how does it influence output if we assume that only real interest rates drive investment decision of firms

𝑖 =𝑅+𝜋→𝑅 =𝑖−𝜋 Because inflation is 'sticky' (takes time to adjust), then in the immediate term, a change in the nominal interest rate will also change the real interest rate.