Problem Sets on “Introductory Macroeconomics” 4

2 Problem Set 2 [due on December 13 (Fri)]

2.1 Consumer pessimism vs. investor pessismism
This question is taken from Problem Set 1, and tries to examine the macro e¤ects of pessis-
mism that were left unanswered in your 1st homework assignment. Recall, in particular, that
you were asked to explain how investor pessimism (or loss of investor con…dence) may a¤ect
AD and thus the equilibrium value of each of the macro variables in the various markets— in
both the long run and and the short run. [Note: By “investor,”we mean those who invest
in physical capital (e.g., machines and equipment) rather than in …nancial securities (e.g.,
bonds). In other words, we are talking about “real” (rather than “…nancial”) investors
here.] The suggested answer to this particular question is outlined in the Appendix below.
Now, you are left to analyze the macro e¤ects of consumer pessismism and to compare the
e¤ects of these 2 types of pessismism.

1. Explain how consumer pessimism (or loss of consumer con…dence) may a¤ect AD and
the macro equilibrium— viz., the equilibrium value of each of the macro variables in
the tables below, in both the long and short runs.

2. Apparently both investor pessimism and consumer pessimism would a¤ect the macro-
economy via a reduction in aggregate demand. Explain whether and why

(a) there are any di¤erences at all in their e¤ects on prices and quantities in the
various (incl. labor, capital-input, goods, loanable-funds, and money) markets;
and
(b) there are any di¤erences at all in their policy implications— i.e., stabilization
(…scal and monetary) policies that are required to close output gaps created by
these 2 alternative types of pessimism.

Long run (LR)

prices no change rise fall ambiguous quantities no change rise fall ambiguous
w =W P
N
W K
rk = RPk y
Rk C
r S
R = r + gpe I
P NX
m =M P

Chi-Wa Yuen November 27, 2019

Problem Sets on “Introductory Macroeconomics” 5

Short run (SR)

prices no change rise fall ambiguous quantities no change rise fall ambiguous
w =W P
N
W K
rk = RPk y
Rk C
r S
R = r + gpe I
P NX
m =M P

*** Appendix: Macro e¤ects of investor pessismism ***

2.1.1 Direct e¤ect on AD

Investor pessimism would reduce investment demand.
Intuitive reasoning: Since investment expenditure is a component of aggregate expen-
diture, I (:). =) AD. :
Formal reasoning

– The left/down-ward shift in the I-curve would lower rcredit in the loanable-funds
market below rmoney = Rmoney gpe in the money market.
– To close this interest-rate gap, we require a downward adjustment in either P or
y d (or both)
P -adjustment

Ms
P #=) ms " = =) Rmoney #=) rmoney # (given gpe )
P#

y d -adjustment

md -curve .=) Rmoney #=) rmoney # (given gpe )

y d # =)
S-curve - & (I+) N X-curve %=) rcredit "

– Since P # at any given y d OR y d# at any given P; the AD-curve shifts to the left.

Investor pessimism may reduce import demand for capital goods as well. In that case,
N X (:)% , which would o¤set the above I-e¤ect on AD: But since imports are normally
smaller in volume than domestic investment in most countries, we would expect the
N X-e¤ect to be dominated by the I-e¤ect— so that AD would still end up falling.1
Here, let us ignore this N X-e¤ect for simplicity.

1
Even in the case of a small open economy that is resource-scarce and cannot survive without imports
from abroad, the N X-e¤ect of investor pessimism would be negligible— because of its super low (price- and
income-) elasticities of demand for imports.

Chi-Wa Yuen November 27, 2019

Problem Sets on “Introductory Macroeconomics” 6

2.1.2 Long run (LR) e¤ects

LRAS AD.. =) P # ; y

labor market: N s (:) N d (:) =) w; N ; W # = w P#

capital market: K s K d (:) =) rk ; K ; Rk# = rk P#

loanable-funds market: S (:) I (:).. + N X (:) =) r# ; S # = (I + N X)#

goods market: y = C " + I # + G + N X; where

– C " = C( r# ; y ; :::) due to the (indirect) r-e¤ect;

( ) (+)

– I# = I# r# ; ::: ; because the 1st -round down/left-ward shift in I (:) [direct

( )
e¤ect] dominates the 2nd -round downward movement along the new I (:) schedule
[indirect r-e¤ect]
!
– NX = NX r# ; y ; ::: ; summing small open economy (SOE) so we can ignore
( ) ( )

the (indirect) r-e¤ect

money market: P # =) ms" md (:) =) m" = M =P # ; R# = r# + gpe

prices no change rise fall ambiguous quantities no change rise fall ambiguous
w X N X
W X K X
rk X y X
Rk X C X
r X S X
R X I X
P X NX X
m X

2.1.3 Short run (SR) e¤ects

SRAS AD.. =) P # ; y #

labor market: W ; w" = W =P # ; N # (upward movement along N d -curve)

capital market: K s K d (:). (due to factor complementarity) =) K; rk# ; Rk# = rk# P#

loanable-funds market: y # =) S (:)- N X (:)% =) r# ; S # = S( r# ; y # ; :::) =

(+) (+)
#
(I + N X) because

Chi-Wa Yuen November 27, 2019

Problem Sets on “Introductory Macroeconomics” 7

– the 1st -round down/left-ward shift of I (:) [direct e¤ect] dominates the 2nd -round
up/left-ward shift of S (:) [indirect y-e¤ect]

goods market: y # = C ?(#) + I # + G + N X " ; where

– C ?(#) = C( r# ; y # ; :::); because the (intertemporal substitution) r-e¤ect on con-

( )
(+)
sumption is empirically small relative to the (income/wealth) y-e¤ect;

– I# = I# r# ; ::: ; because the 1st -round down/left-ward shift of I (:) [direct

( )
e¤ect] dominates the 2nd -round downward movement along the new I (:) schedule
[indirect r-e¤ect];
!
– N X" = N X r# ; y # ; ::: ; assuming small open economy (SOE) so we can ignore
( ) ( )

the (indirect) r-e¤ect

money market: P # ; y # =) ms" md (:). =) m" = M =P # ; R# = r# + gpe

prices no change rise fall ambiguous quantities no change rise fall ambiguous
w X N X
W X K X
rk X y X
Rk X C likely X
r X S X
R X I X
P X NX X
m X

Chi-Wa Yuen November 27, 2019

Problem Sets on “Introductory Macroeconomics” 8

2.2 Productivity shocks [NOT to be handed in]

[Hint: This is the exact opposite of the case of positive productivity shock
analyzed in Section 3.4 of the lecture notes]
Suppose a natural disaster (such as an earthquake) destroys a newly installed technol-
ogy, forcing producers to fall back on an old and inferior one. The purpose of this question
is to examine the macro e¤ects of such adverse productivity shock— viz., its e¤ects on prices
fw; W ; rk ; Rk ; P ; ; Rg and allocations fN; K; y; C; I; G; N X; S; mg— in the short run and the
long run. Let us analyze this problem in 2 stages.

(1) The immediate impact of this negative shock to the production function is to lower
the marginal productivities of both labor (M P N ) and capital (M P K) : Explain how
this would a¤ect the macro equilibrium via possible shifts in the production function
and input demands.

(2) If the shock is persistent (rather than transitory), it would also lower the expected
future marginal productivities of both labor M P N f and capital M P K f as well as
people’s expected future income y f : Explain how these expectations e¤ects would al-
ter the macro equilibrium via possible shifts in credit supply (S) and demand (I + N X)
as well as labor supply (N s ) :

(3) In my note on “Keynesian Economics”(published in the SAGE Encyclopedia of Polit-

ical Behavior), I argue that, relative to adverse demand shocks, adverse supply shocks
are not as strong an explanation for cyclical unemployment and output gaps. Could
you use your results above to justify my argument?

2.3 Economic growth [NOT to be handed in]

Some people have argued that the wartime destruction of capital goods stimulated the post-
war economic growth in Japan and (the former West) Germany.

(1) Is this argument consistent with the growth predictions discussed in my video lectures?
Does it follow that losing a war is an economic bene…t?

(2) What about the loss of lives in the war? In terms of their e¤ects on capital accumulation
and growth, in what ways are casualties di¤erent from capital losses?

Chi-Wa Yuen November 27, 2019