Now consider what happens to the interest rate when the level of income increases from Y1 to Y2. The increase in income shifts the money demand curve upward. At the old interest rate r1, the demand for real money balances now exceeds the supply. The interest rate must rise to equilibrate supply and demand. Therefore, as shown in Figure 10–5(B), a higher level of income leads to a higher interest rate: The LM curve slopes upward.
Chapter 11
QUESTIONS FOR REVIEW:1
1.Explain why the aggregate demand curve slopes downward.
The aggregate demand curve represents the negative relationship between the price level and the level of national income. In Chapter 9, we looked at a simplified theory of aggregate demand based on the quantity theory. In this chapter, we explore how the IS–LM model provides a more complete theory of aggregate demand. We can see why the aggregate demand curve slopes downward by considering what happens in the IS–LM model when the price level changes. As Figure 11–1(A) illustrates, for a given money supply, an increase in the price level from P1 to P2 shifts the LM curve upward because real balances decline; this reduces income from Y1 to Y2. The aggregate demand curve in Figure 11–1(B) summarizes this relationship between the price level and income that results from the IS–LM model.
Chapter 13
QUESTIONS FOR REVIEW:4,5,6
4.Explain the differences between demand-pull inflation and cost-push inflation.
Demand-pull inflation results from high aggregate demand: the increase in demand ―pulls‖ prices and output up. Cost-push inflation comes from adverse supply shocks that push up the cost of
production—for example, the increases in oil prices in the midand late-1970s. The Phillips curve tells us that inflation depends on expected inflation, the difference between unemployment and its natural rate, and a shock v:
Π= EΠ?–?(u – un) + v.
n
The term ― –?(u –u)‖ is the demand-pull inflation, since if unemployment is below its
n
natural rate (u < u), inflation rises. The supply shock v is the cost-push inflation.
5.Under what circumstances might it be possible to reduce inflation without causing a recession?
The Phillips curve relates the inflation rate to the expected inflation rate and to the difference between unemployment and its natural rate. So one way to reduce inflation is to have a recession, raising unemployment above its natural rate. It is possible to bring inflation down without a recession, however, if we can costlessly reduce expected inflation.
According to the rational-expectations approach, people optimally use all of the information available to them in forming their expectations. So to reduce expected inflation, we require, first, that the plan to reduce inflation be announced before people form expectations (e.g., before they form wage agreements and price contracts); and second, that those setting wages and prices believe that the announced plan will be carried out. If both requirements are met, then expected inflation will fall immediately and without cost, and this in turn will bring down actual inflation.
6.Explain two ways in which a recession might raise the natural rate of unemployment.
One way in which a recession might raise the natural rate of unemployment is by affecting the process of job search, increasing the amount of frictional unemployment. For example, workers who are unemployed lose valuable job skills. This reduces their ability to find jobs after the recession ends because they are less desirable to firms. Also, after a long period of unemployment, individuals may lose some of their desire to work, and hence search less hard.
Second, a recession may affect the process that determines wages, increasing wait unemployment. Wage negotiations may give a greater voice to ―insiders,‖ those who actually have jobs. Those who become unemployed become ―outsiders.‖ If the smaller group of insiders cares more about high real wages and less about high employment, then the recession may permanently push real wages above the equilibrium level and raise the amount of wait unemployment.
This permanent impact of a recession on the natural rate of unemployment is called hysteresis.
4、Calculation Questions (2×10, 20 points) Chapter 2
PROBLEMS AND APPLICATION:2
2.A farmer grows a bushel of wheat and sells it to a miller for $1.00. The miller turns the wheat into flour and then sells the flour to a baker for $3.00. The baker uses the flour to make bread and sells the bread to an engineer for $6.00. The engineer eats the bread. What is the value added by each person? What is GDP?
Value added by each person is the value of the good produced minus the amount the person paid for the materials needed to make the good. Therefore, the value added by the farmer is $1.00 ($1 – 0 = $1). The value added by the miller is $2: she sells the flour to the baker for $3 but paid $1 for the flour. The value added by the baker is $3: she sells the bread to the engineer for $6 but paid the miller $3 for the flour. GDP is the total value added, or $1 + $2 + $3 = $6. Note that GDP equals the value of the final good (the bread).
Chapter 3
PROBLEMS AND APPLICATION:7,9
7.The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6, what happens to the following? Do they rise or fall? By what amounts? a. Public saving. b. Private saving. c. National saving. d. Investment.
The effect of a government tax increase of $100 billion on (a) public saving, (b) private saving, and (c)
national saving can be analyzed by using the following relationships: National Saving = [Private Saving] + [Public Saving] = [Y – T – C(Y – T)] + [T – G] = Y – C(Y – T) – G.
a. Public Saving—The tax increase causes a 1-for-1 increase in public saving. T increases by $100 billion and, therefore, public saving increases by $100 billion. b. Private Saving—The increase in taxes decreases disposable income, Y – T, by $100 billion. Since the marginal propensity to consume (MPC) is 0.6, consumption falls by 0.6 ??$100 billion, or $60 billion. Hence, ?Private Saving = – $100b – 0.6 ( – $100b) = – $40b. Private saving falls $40 billion. c. National Saving—Because national saving is the sum of private and public saving, we can conclude that the $100 billion tax increase leads to a $60 billion increase in national saving. Another way to see this is by using the third equation for national saving expressed above, that national saving equals Y –
C(Y – T) – G. The $100 billion tax increase reduces disposable income and causes consumption to fall by $60 billion. Since neither G nor Y changes, national saving thus rises by $60 billion.
d. Investment—To determine the effect of the tax increase on investment, recall the national accounts identity:
Y = C(Y – T) + I(r) + G.
Rearranging, we find
Y – C(Y – T) – G = I(r).
The left-hand side of this equation is national saving, so the equation just says that national saving equals investment. Since national saving increases by $60 billion, investment must also increase by $60 billion.
How does this increase in investment take place? We know that investment depends on the real interest rate. For investment to rise, the real interest rate must fall. Figure 3–1 illustrates saving and investment as a function of the real interest rate.
The tax increase causes national saving to rise, so the supply curve for loanable funds shifts to the right. The equilibrium real interest rate falls, and investment rises.
9.Consider an economy described by the following equations: Y = C + I + G Y = 5,000 G = 1,000 T = 1,000
C = 250 + 0.75(Y ? T) I = 1,000 ? 50 r.
a. In this economy, compute private saving, public saving, and national saving. b. Find the equilibrium interest rate.
c. Now suppose that G rises to 1,250. Compute private saving, public saving, and national saving.
d. Find the new equilibrium interest rate.
a. Private saving is the amount of disposable income, Y – T, that is not consumed: Sprivate = Y – T – C = 5,000 – 1,000 – (250 + 0.75(5,000 – 1,000)) = 750.
Public saving is the amount of taxes the government has left over after it makes its purchases:
Spublic = T – G = 1,000 – 1,000 = 0.
Total saving is the sum of private saving and public saving:
S = Sprivate + Spublic
= 750 + 0 = 750.
b. The equilibrium interest rate is the value of r that clears the market for loanable funds. We already