Prof. Bryan Caplan

bcaplan@gmu.edu

http://www3.gmu.edu/departments/economics/bcaplan

Econ 311

Fall, 1999

HW#4 (Please type all answers)

  1. Fill in the blanks in the following table. If the equilibrium nominal wage falls, mark the row with a check.
    2.

    Change in Equilibrium

    Real Wage

    Inflation

    Change in Equilibrium Nominal Wage

    Nominal Fall?

    -3%

    -3%

    -6%

    Ö

    -3%

    0%

    -3%

    Ö

    -3%

    +3%

    0%

    		  

    -3%

    +10%

    +7%

    		  

    0%

    -3%

    -3%

    Ö

    0%

    0%

    0%

    		  

    0%

    +3%

    +3%

    		  

    0%

    +10%

    +10%

    		  

    +3%

    -3%

    0%

    		  

    +3%

    0%

    +3%

    		  

    +3%

    +3%

    +6%

    		  

    +3%

    +10%

    +13%

    		  
  2. Suppose that the equilibrium real wage for low-skill labor in 1999 is $3.00/hour, and the federal minimum wage is $5.15. Draw the consequences on a S&D diagram. Assuming real labor demand, real labor supply, and the official minimum wage do not change, show what this market will look like in 2009 if the annual rate of inflation for the decade was (i) 0%; (ii) 2%; (iii) 10%; (iv) 25%. In each case, what will the real wage be in 1999 dollars?

    3.  

     

     

     

     

     

     

    If the real minimum wage falls below $3.00, the minimum wage has no effect and the real minimum wage is $3.00. Otherwise, the minimum wage does matter. To check whether it does, we calculate:

    (i) $5.15/(1.0)10=$5.15/1=$5.15>$3.00

    (ii) $5.15/(1.02)10=$5.15/1.22=$4.22>$3.00

    (iii) $5.15/(1.1)10=$5.15/2.59=$1.98<$3.00

    (iv) $5.15/(1.25)10=$5.15/9.31=$.55<$3.00

     

     

  3. Draw two AS-AD diagrams, one with Classical AS, the other with Keynesian AS. Diagram the impact of an increase in AD in each case. How is the increase in output in the Keynesian case possible? Why is such an increase impossible in the Classical case?

    4. The Classical AS is vertical, the Keynesian is upward sloping. Output can increase in the Keynesian case because, by assumption, market prices are failing to clear markets. It cannot increase in the Classical case because, by assumption, market prices ARE clearing markets.

     

     

     

     

     

     

     

     

     

  4. On two separate AS-AD diagrams, show: (i) the short-run effect of a decrease in AD; (ii) the subsequent shift of SRAS.

    5. In the first diagram, the decline in AD moves along the SRAS curve; output and the price level fall. In the second diagram, SRAS shifts out until it equals LRAS at the new level of AD.

     

     

     

     

     

     

     

     

     

  5. Assume the price level is fixed at the initial intersection of money supply and money demand.
    1. Diagram the shortage that results from a reduction in the money supply.

      2. When money supply falls, the price of money (1/P) normally would rise (that is, P would fall!). If 1/P stays fixed, there is excess demand for money.

       

       

       

       

       

       

       

       

    2. Show how such a shortage of money affects the market for loanable funds.

      3. The supply of loanable funds decreases - fewer people make loans because there is a shortage of money. This raises the interest rate.

       

       

       

       

       

       

       

       

    3. On a third diagram, show how the changes in the market for loanable funds re-establish equilibrium in the market for money.

    As interest rates rise, the money demand curve keeps falling until money demand and money supply intersect at the original 1/P.

     

     

     

     

     

     

  6. Using AS-AD diagrams, show the short-run effects of the following:
    1. An increase in the money supply.

      2. AD increases since the money supply increases.

       

       

       

       

       

       

       

    2. A decrease in the money supply.

      3. AD falls since the money supply decreases.

       

       

       

       

       

       

       

    3. A tax on credit card purchases.

      4. AD falls since money demand increases (credit cards, a money substitute, are now more costly to use, so some people carry more cash instead).

       

       

       

       

       

       

    4. A 20% increase in the income tax (assuming spending and the money supply do not change).

      5. AD stays the same. As per the notes, if spending and the money supply stay the same, this just means that the government borrows less. That makes more loanable funds available to non-government borrowers, balancing out the fall in after-tax income.

       

       

       

       

       

       

    5. A decrease in government spending (assuming taxation and the deficit do not change).

    AD stays the same. As per the notes, if taxation and the money supply stay the same, this just means that the government borrows less. That makes more loanable funds available to non-government borrowers, balancing out the fall in government spending.

     

     

     

     

     

     

  7. Using an AS-AD diagram and a S&D diagram for the market for loanable funds, show the effect of a reduction in deficit spending assuming the Fed targets a nominal interest rate of 7%.
    8.

    If the government borrows less, the demand for loanable funds falls. Interest rates thus tend to fall. For the Fed to prevent this fall, it must reduce the money supply. The reduction of the money supply in turn makes AD fall.

     

     

     

     

     

     

     

     

  8. The Korean War began in 1950 and ended in 1953. Calculate the growth rate of the monetary base for each of the years from 1948-1955, using the data at the following web site: http://www.stls.frb.org/fred/data/reserves/ambns. Was monetary growth higher during the Korean War than before and after?

    9. (Calculate January-to-January).

     

    Year

    Base

    % Change

    War?

    1947

    33.612

    --

    1948

    34.056

    1.3

    1949

    33.257

    -2.35

    1950

    32.991

    -0.80

    Ö

    1951

    32.282

    -2.15

    Ö

    1952

    35.12

    8.79

    Ö

    1953

    36.362

    3.54

    Ö

    1954

    36.982

    1.71

    1955

    36.982

    0

    Average growth during war years=2.35%; average growth during peace years=.17%.

     

  9. Using AS-AD diagrams, show what happens when:
    1. The public does not expect monetary policy will change, but it actually becomes more expansionary.

      2. AD shifts out along a fixed SRAS curve.

       

       

       

       

       

       

       

    2. The public expects monetary policy to become more expansionary, while actual policy stays fixed.

      3. SRAS shifts back, AD stays unchanged.

       

       

       

       

       

       

       

    3. The public expects monetary policy to become less expansionary, while actual policy stays fixed.

      4. SRAS shifts out, AD stays unchanged.

       

       

       

    4. The public expects monetary policy to become more expansionary, but actual policy becomes even more expansionary than expected.

      5. SRAS shifts back, AD shifts out even more.

       

       

       

       

       

       

       

    5. The public expects monetary policy to become less expansionary, but actual policy becomes more expansionary.

    SRAS shifts out, AD shifts out.

     

     

     

     

     

     

     

     

  10. Using Phillips curve diagrams, show what happens when:
    1. The public does not expect monetary policy will change, but it actually becomes more expansionary.
      2.

      The economy moves to a lower-unemployment, higher-inflation point on a fixed short-run Phillips curve.

       

       

       

       

       

       

       

       

    2. The public expects monetary policy to become more expansionary, while actual policy stays fixed.

      3. The short-run Phillips curve shifts up; both unemployment and inflation increase.

       

       

       

       

       

       

       

    3. The public expects monetary policy to become less expansionary, while actual policy stays fixed.
      4.

      The short-run Phillips curve shifts down; both unemployment and inflation decrease.

       

       

       

       

       

       

    4. The public expects monetary policy to become more expansionary, but actual policy becomes even more expansionary than expected.
      5.

      The short-run Phillips curve shifts up; unemployment falls, while inflation increases.

       

       

       

       

       

       

       

    5. The public expects monetary policy to become less expansionary, but actual policy becomes more expansionary.

    The short-run Phillips curve shifts down; unemployment falls, while inflation increases.

     

     

     

     

     

  11. Suppose you are the head of the central bank of Russia. What could you do to permanently regain the confidence of the Russian public? What could you do to temporarily regain their confidence, then trick them one last time?

One thing you could do is: freeze the monetary base, redefine a "new ruble" equal in value to exactly one dollar, and legalize dollar-denominated bank accounts. Then stick to your guns - it will be a difficult task, but backing out will only make the problem worse. Of course, if you want to trick the public one last time, you could carry out these steps, wait a while, and then reverse policy.