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Problem Set 5 Macroeconomics I - Paul Pichler

1. Consider an economy with the following wage and price setting behavior:

W = P e [B + f (u)], P = W (1 + τ ).

B denotes unemployment benefits and f is an arbitrary function that is decreasing in the unemployment rate
u. Finally, τ denotes a payroll tax that has to be paid by the employers. Marginal costs of production are
thus given by (1 + τ )W . Note that firms do not charge any markup.
(a) What are the effects of an increase in unemployment benefits on the real wage? Explain the intuition
behind this relationship.
(b) Show graphically how an increase in unemployment benefits affects real wages and unemployment in the
medium run.
(c) Show graphically how an increase in payroll taxes affects real wages and unemployment in the medium
2. Consider an economy that is on its natural level. Then there is a decrease in investor confidence, that is,
investment is now lower for any given interest rate.
(a) Show graphically how this decrease in investor confidence affects the economy in the short and medium
run. In particular, discuss the effects on prices, output and unemployment.
(b) Assume that the central bank responds immediately to the decrease in investor confidence. In particular,
assume that the central bank implements a policy that prevents the unemployment rate from changing
in the short run.
i. Explain the policy that is implemented by the central bank. Analyze the effects of this policy
ii. What are the medium run effects on unemployment?
iii. Do you think that the central bank’s policy is good for the economy?
3. Consider a closed economy that can be described by an AS-AD model. Assume that initially this economy is
in a recession, i.e. output is below its natural level. Assume that expectations are adaptive, i.e. Pte = Pt−1 .
(a) Illustrate the situation graphically.
(b) Show how the economy will evolve over time (assuming that there are no policy interventions).
(c) Do you think that fiscal and/or monetary policy should be employed to improve the situation? Explain!