Topic # 01 – AD-AS model components

1   Problem

Fill in the gaps.

When the Federal Reserve autonomously tightens monetary policy, it                                  the autonomous component of the real interest rate, , that is unrelated to the current level of the inflation rate. The                                  real interest rate at any given inflation rate leads to a                                  real interest rate for financing investment projects, which leads to a                                  in investment spending and planned expenditure.                                   real interest rates also lead to                                   consumption spending and net exports.  Therefore the equilibrium level of aggregate output                                  at any given inflation rate and the aggregate demand curve shifts to the                                 .

2   Problem

1.     What is the difference between the short run AS and the LRAS?

2.     What are the factors behind the LRAS?

3.     List the factors that can change the position of the short run AS.

Topic # 02 – Equilibrium and adjustment

3   Problem

In the short run (in 2028) the aggregate demand of a closed economy can be described by the following function Y = 6960 − 40T

The aggregate supply curve takes the following form

T = Te + 0.012(Y − YP )

where the expected inflation is 6.4 and the potential GDP is 7000.

1.     Determine the equilibrium output and inflation.

2.     On the following graph illustrate the short run AD and AS and mark the equilibrium.

3.     What happens to the equilibrium output and inflation if the economic agents form their inflation expectations based on the previous period inflation Tt(e)  = Tt − 1 .

4.     Illustrate the AD and AS for 2029 on the graph above and mark the new equilibrium.

4   Problem

Suppose that the following set of equations describes the behavior of the economic agents in a closed economy

C = 536.98 + 0, 72(Y − T) − 130 · r

I = 6382.4 − 810(r + f)

G = 1104

T = 1214

where the financial frictions variable takes the value of 3.83 percentage points.

The monetary policy maker uses the following rule while taking actions

r = 2.3540 + 1.9 · π

The pricing policy of producers can be described by the following supply function

π = π e + 0.000397(Y − YP )

The expected inflation is 0.1963 and the potential output is 4190.

1.     Calculate the output gap in equilibrium.

2.     On an appropriate graph show how the economy adjusts to the long run equilibrium.

5   Problem

Suppose that the economy started in the long run equilibrium but an exogenous change in the aggregate demand has caused the output to increase. On the graph below show how the economy adjust to the long run equilibrium.

6   Problem

Suppose that the economy started in the long run equilibrium but an exogenous change in the aggregate demand has caused the output to decline. On the graph below show how the economy adjust to the long run equilibrium.

Topic # 03 – Policy interventions and economic events

7   Problem

The following graph illustrate the current state of an economy. Show what happens to this economy if there is an increase in government spending.

8   Problem

The following graph illustrate the current state of an economy. Show what happens to this economy if the monetary policy decision maker carries out an autonomous monetary tightening.

9   Problem

When Paul Volcker became the chairman of the Federal Reserve in August 1979, inflation had spun out of control and the inflation rate exceeded 10%. Volcker was determined to get inflation down.

After the monetary policy tightening the inflation and unemployment in the US looked like this:

Using an appropriate graph explain what has happened to the US during the period between 1980 and 1986.