ECON 2123: Macroeconomics    Problem Set 4  Instructor: Fei DING 

Problem Set 4
Macroeconomics, ECON 2123
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100 marks total

Part I: True/False/Uncertain Please justify your answer with a short argument for each question and
draw a diagram if necessary. (25 marks, 5 marks each: 2 marks for correct judgment and 3 marks for correct
argument)

1. Suppose that workers in the Republic of Communia are highly unionized, while workers in the
Republic of Individuela are not. In all other respects, the two countries are exactly the same. Then
Communia is likely to have a higher natural level of output than Individuela.

2. Suppose there is a decrease in the price level from P to P’. Given the stock of nominal money, M, this
leads to an increase in the real money stock, M/P, which shifts the LM curve down. This implies that the
AD curve shifts to the right.

3. When output is below the natural level of output, the actual price level is lower than the expected price
level.

4. In terms of changing output, monetary policy is relatively more effective when the AS curve is
relatively flat, while fiscal policy is more effective when the AS curve is relatively steep.

5. The aggregate demand relation slopes down because at a higher price level, consumers wish to
purchase fewer goods.

Part II: The Labor Market (Chapter 6) (10 marks)

1. The existence of unemployment

(a) Suppose previously the unemployment rate was relatively high. But now things change: the
unemployment rate becomes very low this year. What change happens in terms of the relative bargaining
power of workers and firms when the unemployment rate becomes very low? What do your answers
imply about the average wage as the unemployment rate gets very low, given expected price and actual
price constant?
(b) Given your answer to part (a), why is there unemployment in the economy? (What would happen to

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ECON 2123: Macroeconomics    Problem Set 4  Instructor: Fei DING 

real wages if the unemployment rate approached zero? Suppose expected price and actual price remain
constant.)

Part III: The IS-LM Model and the AS-AD Model (Chapter 5 and Chapter 7) (32 marks)

1. The Republic of Keynesia is a closed economy and obeys our short-run IS-LM model. Assume it starts
out in equilibrium in both the goods market and the money market. Keynesia’s economy is described by
the following set of equations:
Goods market:
 C = c0 + c1 (1-t)Y, where C is consumption; Y is income; t represents a proportional tax; and c0 and
c1 are positive constants.
 I = b0 – b1 i, where I is investment; i is the interest rate; and b0 and b1 are positive constants.
 G = G , where G is a positive constant.

Money market:
d d
 M = P (m0 + m1Y – m2 i), where M is nominal money demand; P is the price level; m0 (a positive
d
constant) represents exogenous changes to M ; and m1 and m2 are also positive constants.
 Let Ms represent nominal money supply.

(a) Derive the IS relation and the LM relation equations. (2 marks)

(b) Now let ≡ 1/[1-c1(1-t)] for simplicity of notations. Derive the expression for aggregate demand
using your answer to part (a). (Hint: To derive the AD curve, just substitute in for i into the IS
equation from the LM equation. You will obtain an equation of Y as a function of P. In the
right-hand-side of AD equation, you still keep those parameters, such as , Ms, etc.) (3 marks)

(c) Now let:

c0=200 c1=0.5 b0=300 b1=0.4
m0=400 m1=1 m2=0.8 Ms=200
G=100 t=0 Yn=550
Derive the AD equation using these figures. (All figures are in millions of HK dollars.) (3 marks)

(d) Use the same conditions in part (c). Suppose the aggregate supply takes the following form:
P = Pe + (1/50)( Y − Yn ) and P=1. Assume we are in the short-run for now. What is the short run
equilibrium output, Y*? What is the expected price level, Pe? Draw and label the AS-AD diagram
for this case and denote the short run equilibrium in this economy as point A. Also denote the
natural level of output in the diagram. (4 marks)

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ECON 2123: Macroeconomics    Problem Set 4  Instructor: Fei DING 

(e) If Y happened to be equal to the natural level of output Yn, what must be the relation between P and
Pe? (2 marks)

(f) The Keynesian government is up for re-election soon, so it wants to achieve the natural level of
output. (We are still in the short run now.) Propose two different policy options (fiscal and
monetary) that would do the job. For each policy option, draw the AS-AD and the IS-LM diagrams,
and show how the two diagrams are related to each other. Calculate by how much the government
must increase/decrease government spending to achieve the natural level of output. For monetary
policy, you don’t need to do any calculations. What is the difference between the effects of the two
policy options? (10 marks)
 
(g) The Keynesian government decides not to listen to you, and raises government spending by more
than what’s required to achieve the natural level of output. Its argument is that higher output is
better. The voters apparently think so too, and the government gets re-elected. What happens as time
passes and we get to the “medium run” equilibrium? (You do not have to do any calculations, just
draw diagrams and give some intuition/explanations.) (8 marks)
 
2. Closed Economy AS-AD (33 marks)
Price Setting Relation: W = Pe F(u, z)
Wage Setting Relation: P = (1 + m) W
Goods Market: Y = C(Y, T) + I(Y, i) + G
Financial Market: Ms /P = Md (Y, i)

(a) Find the aggregate supply relation. Describe the channel through which the AS curve slopes up/down.
(3 marks)

(b) Assume that the economy is at a point such that the unemployment rate is equal to the natural rate of
unemployment. What does this imply about the price level and output? Explain. (2 marks)

(c) If the Fed carries out a monetary contraction, what happens in the short-run (SR) and the
medium-run (MR)? Start from point A where P = Pe. Label the following: all curves including IS0,
ISSR, ISMR, LM0, LMSR, LMMR, ADSR, ADMR, ASSR, ASMR, where the subscript 0 denotes initial
status, the short-run equilibrium as point B, the medium-run equilibrium as point C, and output
associated with natural rate of unemployment. (10 points)

(d) What does neutrality of money imply about the effectiveness of contractionary monetary policy in
affecting output and interest rate in the short- and medium-run? (2 marks)

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ECON 2123: Macroeconomics    Problem Set 4  Instructor: Fei DING 

(e) If the price of oil increases sharply, what happens in the short-run (SR) and the medium-run (MR)?
Start from point A where P = Pe. Label the following: all curves including IS0, ISSR, ISMR, LM0,
LMSR, LMMR, ADSR, ADMR, ASSR, ASMR, where the subscript 0 denotes initial status, the short-run
equilibrium as point B, the medium-run equilibrium as point C, and output associated with natural
rate of unemployment. (10 marks)

(f) Indicate whether these variables increase, decrease or remain the same when the price of oil rises
sharply. (You may use arrows.) (6 marks)
Y Yn P I Investment Pe
SR
MR

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