Q1: Price flexibility plays a key role in the classical model by ensuring that the markets

reach equilibrium.
a) Explain which price adjusts to bring equilibrium in the labor market. Describe how
the price adjusts when the demand exceeds supply in this market.
In the labor market the wage is the price that adjusts to bring the labor market into equilibrium.
The wages are believed to induce workers to enter sectors where their services are in greatest
demand and to leave sectors with labor surpluses. Wage level is a major determinant of the
supply of and demand for labor. The labor market will reach equilibrium as the amount of
workers willing to work for a certain price equals the amount of workers employers are willing
to hire for that wage. On a supply and demand curve the employees represent the supply curve
while the employers represent the demand curve.
It is possible to find the wage rate that clears the labor market, the equilibrium wage rate, by
combining the labor demand curve and the labor supply curve. This is done in Fig a.1. The
equilibrium wage rate (W0) is the rate at which the quantity of labor demanded (D L0) is equal to
the quantity of labor supplied (SL0). The equilibrium wage rate is equal to the marginal revenue
product of the last worker hired.
Figure a.1

Fig a.2 illustrates the effect of increase in the demand for labor. Suppose the labor market begins
at the intersection of DL0 and SL0 so that the equilibrium wage rate is W0. An increase in the
demand for labor will shift the labor demand curve outward from DL0 to DL1 and cause the
equilibrium wage to rise to W1, assuming that all other factors are held constant.

Figure a.2

b) Explain which price adjusts to bring equilibrium in the loanable funds market.
Describe how the price adjusts when supply exceeds demand in this market.
The special price in this model is the cost of credit - the interest rate, represented by the variable
r. Loanable Funds Model assumes only one interest rate, which can be thought of as a proxy
average for the entire structure of interest rates.

The demand and supply curves in this model have a special meaning. The demand curve
represents the demand for credit by borrowers and the supply curve represents the supply of
credit by lenders.
An example of this is seen in Figure b.1, which shows the impact of a decline in consumer
borrowing. Suppose consumers thought that current consumer debt levels were too high and

they react by cutting back on their use of credit. This would be shown as a shift to the left of the
demand for credit. This by itself would result in a decline in interest rates and a lower volume of
credit, as shown. It should be remembered in this model as in any comparative statics model, the
analysis of cause and effect that comes from consideration of a change in a single variable
assumes no change in the other variables in the model - the relationship is considered in
isolation. Therefore, in this example, we might conclude that a contraction of consumer demand
for credit has the tendency of lowering interest rates, or considered in isolation from other
factors, would lower interest rates.
Figure b.1

Q2: If the demand for money depends positively on real income and depends inversely on
the nominal interest rate, what will happen to the price level today, if the central bank
announces (and people believe) that it will decrease the money growth rate in the future,
but it does not change the money supply today?
The quantity theory of money says that todays money supply determines todays price level. The
conclusion remains partly true: if the nominal interest rate and the level of output are held
constant, the price level moves proportionately with the money supply. Yet the nominal interest
rate is not constant; it depends on expected inflation, which in turn depends on growth in the
money supply. The presence of the nominal interest rate in the money demand function yields an
additional channel through which money supply affects the price level.

This general money demand equation implies that the price level depends not only on todays
money supply but also on the money supply expected in the future. To see why, suppose the Fed
announces that it will decrease the money supply in the future, but it doesnt change the money
supply today. This announcement causes people to expect lower money growth and lower
inflation. Through the Fisher effect, this decrease in expected inflation rate decreases the nominal
interest rate. The lower nominal interest rate increases the demand for real money balances.
Because the quantity of money has not changed, the increased demand for real money balances
leads to a lower price level today.
The effect of money on prices is complex. The conclusion is that the price level depends on a
weighted average of the current money supply and the money supply expected to prevail in the
future.

Q3: You are given the information about the following leading indicators. For each
indicator explain whether the information suggests that a recession or expansion should be
expected in the future.
a) Average initial weekly claims for unemployment insurance rises.
The average number of initial weekly claims for unemployment insurance is a significant
indicator of the labor market condition, and since the employment rate is a leading indicator of
economic wellbeing, an increase in the number of people making new claims for unemployment
insurance suggests an economic recession.
b) New building permits issued increase.
A raise in new building permits indicates an increase in real estate demand, which usually is
caused by such determinants as reduction in real interest rate, raise in credit availability, or/and
increase in the national income. All of these indicators are associated with economic expansion.
c) The interest rate spread between the 10-year Treasury note and the 3-month
Treasury bill narrows.
This spread also known as the slope of the yield curve reflects the expected future interest rate.
The real interest rate requires an adjustment to inflation, thus the expected future interest rate
factors in future inflation, which consequently reflects the condition of the economy. Narrowing
down this spread means that the interest rates are expected to decrease, which typically occurs
when economic activity decreases signaling for a recession.
d) The Index of Supplier Deliveries falls.

The Index of Supplier Deliveries also known as vendor performance measures the number of
companies receiving slower deliveries from suppliers. This index is a leading indicator of
economic activity because typically delivery rate decreases when suppliers experience increased
demand for their goods. Hence, a fall in this index indicates an increase in economic activity,
which leads to economic expansion.
Q4: During a recession, consumers may want to save money more to provide themselves
with a reserve to cushion possible job losses. Use the Keynesian model to describe the
impact of an exogenous decrease in consumption (a decrease in C) on the equilibrium level
of income in the economy. Will aggregate national saving increase?
Q5: If inflation is bad, why isnt deflation good? Use the IS-LM model to explain how
deflation could result in a contraction of output.
Deflation is a decrease in the general price level over a period of time. Deflation is the opposite
of inflation. During deflation the demand for liquidity goes up, in preference to goods or interest.
During deflation the purchasing power of money increases.
In economic theory deflation is a general reduction in the level of prices, or of the prices of an
entire kind of asset or commodity. Deflation should not be confused with temporarily falling
prices; instead, it is a sustained fall in general prices. In the IS-LM model this is caused by a shift
in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of
demand. That is, there is a fall in how much the whole economy is willing to buy and the going
price for goods. Since this idles capacity, investment also falls, leading to further reductions
in aggregate demand. This is the deflationary spiral. The solution to falling aggregate demand is
stimulus either from the central bank, by expanding the money supply, or by the fiscal authority
to increase demand, and borrow at interest rates which are below those available to private
entities.
The "bad" deflation occurs when aggregate demand falls in the economy, leading to a decrease in
output (meaning more unemployment) and a falling average price level (deflation). See the
graph below: