1. Office Hours: Monday 3:00-4:00 – LUMS C85
ECON 101 Tutorial: Week 20
Shane Murphy
Office Hours: Monday 3:00-4:00 – LUMS C85

2. Outline
Roll Call
Problems

3. Chapter 33: Problem 3
The economy is in a recession with high unemployment and low output. a) Use a graph of AD-AS to illustrate the current situation.

4. Chapter 33: Problem 3
The economy is in a recession with high unemployment and low output. b) Identify an open-market operation that would restore the economy to its natural rate.
The central bank will want to stimulate aggregate demand. Thus, it will need to lower the interest rate by increasing the money supply. This could be achieved if the central bank purchases government bonds from the public.

5. Chapter 33: Problem 3
c) Use a graph of the money market to illustrate the effect of this open-market operation. the central bank’s purchase of government bonds shifts the supply of money to the right, lowering the interest rate.

6. Chapter 33: Problem 3
The economy is in a recession with high unemployment and low output. d) Use a graph similar to the one in part (a) to show the effect of the open-market operation on output and the price level.
The central bank’s purchase of government bonds will increase aggregate demand as consumers and firms respond to lower interest rates. Output and the price level will rise.

7. Chapter 33: Problem 7
Assume the economy is in a recession. Explain how each of the following would affect consumption and investment.
An increase in government spending.
An increase in government spending would shift the aggregate demand curve to the right, increasing output. The rise in output would raise consumption spending, since people would have higher incomes, and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, as people would save more, and reduce investment, since the cost of investing would be higher. Overall, the changes in both consumption and investment are ambiguous.

8. Chapter 33: Problem 7
b) A reduction in taxes. A reduction in taxes would directly increase consumption spending, since people would have higher after-tax incomes. Also, since the reduction in taxes increases consumption spending, aggregate demand increases, so total output increases. The rise in output would raise consumption spending further, since people would have higher incomes, and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, as people would save more, and reduce investment, since the cost of investing would be higher. Overall, consumption must increase (otherwise aggregate demand would not have increased at all) while the change in investment is ambiguous.

9. Chapter 34: Problem 7
c) An expansion in the money supply An expansion in the money supply reduces the interest rate, thus increasing aggregate demand and output. The rise in output would raise consumption spending, since people would have higher incomes, and raise investment spending through the accelerator. The lower interest rate would increase consumption, as people would save less, and increase investment, since the cost of investing would be lower. Overall, both consumption and investment would increase.

10. Chapter 34: Problem 9
Recently some members of the legislature have proposed a law that would make price stability the sole goal of monetary policy.
How would the central bank respond to an event that contracted aggregate demand?
If there were a contraction in aggregate demand, the central bank would need to increase the money supply to increase aggregate demand and stabilize the price level, as shown in the figure. By increasing the money supply, the Fed is able to shift the aggregate demand curve back to AD1 from AD2. This policy stabilizes output as well as the price level.

11. Chapter 34: Problem 9
Recently some members of the legislature have proposed a law that would make price stability the sole goal of monetary policy. b) How would the central bank respond to an event that cause an adverse sift in SR-AS
If there were an adverse shift in short-run aggregate supply, the central bank would need to decrease the money supply to stabilize the price level, shifting the aggregate demand curve to the left from AD1 to AD2, as shown in the figure. This worsens the recession caused by the shift in aggregate supply. To stabilize output instead of the price level, the central bank would need to increase the money supply, shifting the aggregate demand curve from AD1 to AD3, but this action would raise the price level.

12. Chapter 34: Problem 3 Suppose that a fall in consumer
Spending causes a recession.
Illustrate the changes in the
economy using AS-AD and Phillips curve diagram.
In both diagrams, the economy begins at full employment at point A. The decline in consumer spending reduces aggregate demand, shifting the aggregate demand curve to the left, from AD1 to AD2. The economy initially remains on the short-run aggregate supply curve SRAS1, so the new equilibrium occurs at point B. The movement of the aggregate demand curve along the short-run aggregate supply curve leads to a movement along short-run Phillips curve SRPC1, from point A to point B. The lower price level in the aggregate supply/aggregate demand diagram corresponds to the lower inflation rate in the Phillips curve diagram. The lower level of output in the aggregate supply/aggregate demand diagram corresponds to the higher unemployment rate in the Phillips curve diagram.

13. Chapter 34: Problem 3
b) Now suppose over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the short run Phillips curve? After the recession, is inflation-unemployment worse than before? As expected inflation falls over time, the short-run aggregate supply curve shifts down from AS1 to AS2, and the short-run Phillips curve shifts down from SRPC1 to SRPC2. In both diagrams, the economy eventually gets to point C, which is back on the long-run aggregate supply curve and long-run Phillips curve. After the recession is over, the economy faces a better set of inflation-unemployment combinations.

14. Chapter 34: Problem 3
b) Now suppose over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the short run Phillips curve? After the recession, is inflation-unemployment worse than before?

15. Chapter 34: Problem 4 Suppose the economy is in LR equilibrium.
Draw the economy’s SR and LR Phillips curve

16. Chapter 34: Problem 4
b) Suppose a wave of pessimism reduces AD. If the central bank expands MS, can it return the economy to the original inflation and unemployment
A wave of business pessimism reduces aggregate demand, moving the economy to point b in the figure. The unemployment rate rises and the inflation rate declines. If the central bank undertakes expansionary monetary policy, it can increase aggregate demand, offsetting the pessimism and returning the economy to point a, with the initial inflation rate and unemployment rate.

17. Chapter 34: Problem 4
b) Suppose the price of oil rises. If the central bank expands MS, can it return the economy to the original inflation and unemployment. If it contracts MS?
The higher price of imported oil shifts the short-run Phillips curve up from SRPC1 to SRPC2. The economy moves from point a to point c, with a higher inflation rate and higher unemployment rate. Now if the central bank engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point d, but the inflation rate will be higher. If the central bank engages in contractionary monetary policy, it can return the economy to its original inflation rate at point e, but the unemployment rate will be higher. This situation differs from that in part (b) because in part (b) the economy stayed on the same short-run Phillips curve, but in part (c) the economy moved to a higher short-run Phillips curve, which gives policy makers a less favourable trade-off between inflation and unemployment.

18. Chapter 34: Problem 8
Imagine an economy in which all wages are set in three-year contracts. In this world, the central bank announces a disinflationary change in monetary policy to begin immediately. Everyone in the economy believes the central bank’s announcement. Would this disinflation be costless? What might the central bank do to reduce the cost of disinflation? If the central bank announces a disinflation, but nominal wages have been set in three-year contracts, then the lower rate of inflation will mean real wages are too high until the contracts can be renegotiated in three years. As a result, firms will not hire as much labour and the unemployment rate will exceed the natural rate, so the disinflation would be costly. To reduce the cost of disinflation, the central bank could announce that it would reduce inflation three years from now, so contracts could be adjusted. Alternatively, the central bank could reduce inflation very slowly, so real wages wouldn't be too high for quite as long, and the costs of disinflation would be lower.