ECON 101 Tutorial: Week 18 Shane Murphy Office Hours: Monday 3:00-4:00 – LUMS C85

Outline Roll Call Problems Game

Chapter 30: Problem 3 Plot unemployment and inflation figures over the last 30 years. Is the trend stationary, nonstationary, or indeterminate?

Chapter 30: Problem 3 Plot unemployment and inflation figures over the last 30 years. Is the trend stationary, nonstationary, or indeterminate?

Chapter 30: Problem 5 Explain whether the comovements are procyclical or countercyclical: a)GDP and inflation b)GDP and employment c)GDP and unemployment d)GDP and the money supply (M1) When a variable is above trend when GDP is above trend the variable is said to be procyclical. If a variable is below trend when GDP is above trend the variable is described as countercyclical. In general then the results should be: a) Procyclical b) Procyclical c) Countercyclical d) Tends to be procyclical

Chapter 30: Problem 8 There is a fall in the price level which workers do not anticipate. Explain what effect such a scenario will have on output. The new classical model is based around the concept of anticipated and unanticipated price changes. If workers do not have perfect information they may not be aware of the impact of the fall in price level, workers continue to supply the same amount of labour, – So real wages do rise, firms demand less workers and output will fall.

Chapter 30: Problem 10 Which business cycle model do you find most compelling and why?

Chapter 31: Problem 3 Suppose economists observe that an increase in government spending of €10 billion raises the total demand for goods and services by €30 billion. a)Ignoring crowding out, what would the MPC be? b)Would crowding out raise or lower the estimate? Why? Crowding out would lower the estimate of MPC because the multiplier effect would be offset by higher interest rates

Chapter 31: Problem 4 Suppose the government reduces taxes by €2 billion, MPC is 0.75, and there is no crowding out. a) What is the initial effect of the tax reduction on AD? The initial effect is to increase aggregate demand by €1.5 billion (€2 billion x 0.75). b) What additional effects follow this initial effect? What is the total effect of the tax cut on AD? There will be additional induced changes in expenditure, i.e. a multiplier effect. The total effect is given by: €1.5 billion x k where k is the multiplier. The value of the multiplier is 1/(1-MPC), and MPC in this case is 0.75, so that k = 4. Therefore the total effect of the tax cut is to increase aggregate demand by €6 billion. c) How does the total effect of this €2 billion tax cut compare to the total effect of a €2 billion increase in government purchases? Why? The total effect of a €2 billion increase in government purchases will be to increase aggregate demand by €8 billion.

Chapter 31: Problem 6 What do the IS and LM curves show? The IS curve shows all combinations of interest rate and national income at which the goods market is in equilibrium. The LM curve shows all combinations of interest rate and national income at which the money market is in equilibrium.

Chapter 31: Problem 8 Use IS-LM to explain: a)The government institutes significant cuts in public expenditure. Significant cuts in government spending will shift the IS curve to the left. The extent of the fall in interest rates and national income that result will depend on the slope of the LM curve, and this depends on how responsive is the demand for money to changes in interest rates. Assuming that the LM curve has a positive slope and is not vertical, there will be some reduction in interest rates and the effect of reduced government spending on economic activity will be less than would otherwise have been the case.

Chapter 31: Problem 8 Use IS-LM to explain: b) The Central bank institutes an asset purchasing facility which expands money supply. Expanding the money supply will shift the LM curve to the right. The extent of the fall in interest rates and the rise in national income that result will depend on the slope of the IS curve, and this depends on how responsive is consumption and investment expenditure to changes in interest rates.

Chapter 31: Problem 8 Use IS-LM to explain: c) The central bank fears that inflationary pressures are rising and increases interest rates. If the central bank wishes to raise interest rates it must engage in open market operations to sell bonds and so reduce the money supply. This action is reflected in a leftward movement of the LM curve. This size of the reduction in money supply needed to raise interest rates to a particular level will depend on the slope of the IS curve – the flatter the IS curve the greater the shift the LM curve that will be needed, and the greater will be the associated reduction in national income.

Chapter 31: Problem 8 Use IS-LM to explain: d) The government increases taxation to try and reduce a large budget deficit. An increase in taxation will shift the IS curve to the left. The effect will thus be similar to that described in answer to question 10a - will shift the IS curve to the left. The extent of the fall in interest rates and national income that result will depend on the slope of the LM curve, and this depends on how responsive is the demand for money to changes in interest rates. Assuming that the LM curve has a positive slope and is not vertical, there will be some reduction in interest rates and the effect of reduced government spending on economic activity will be less than would otherwise have been the case.

Chapter 31: Problem 10 Do you think that Keynes’ ideas still have some relevance today?

Exam Notes 4 questions Memorize key terms and definitions Macroeconomics isn’t always as intuitive as microeconomics so make sure you study 16

Game 17