4. Money cannot be neutral in the short-run the neutrality of money is exclusively a medium run phenomenon.

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1 PART I TRUE/FALSE/UNCERTAIN (5 points ach) 1. Lik xpansionary montary policy, xpansionary fiscal policy rturns output in th mdium run to its natural lvl, and incrass prics. Thrfor, fiscal policy is also nutral. Fals. A policy is nutral if it only affcts nominal variabls (prics, nominal wags, nominal mony supply) in th mdium run, but dos not affct ral variabls (output, th componnts of output, intrst rats, tc.). Although fiscal policy dos not, in th mdium run, affct th natural lvl of output, it dos altr th composition of output (an xpansionary fiscal policy will, for instanc, dcras invstmnt in th mdium run). So it dos affct ral variabls, vn though a cursory xamination of th AS-AD diagram might giv th imprssion that it dos not. 2. If invstmnt is compltly insnsitiv to th intrst rat (i.. in th Invstmnt function I = ay bi, b is qual to zro), thn th AD curv will b vrtical. Tru. Th rason that th AD curv is usually downward sloping is that an incras in prics rducs th ral mony supply, which incrass intrst rats, which in turn rducs invstmnt and thrfor output. So if invstmnt is insnsitiv to changs in th intrst rat, thn on of th links in th abov argumnt is brokn, and changs in prics no longr affct th output lvl. So th AD curv will b vrtical. 3. A politician facd with a stpr AS curv is mor likly to mbark on a givn disinflation program than on facd with a flattr AS curv (assum that th stpr slop is du to a highr snsitivity of nominal wags to th unmploymnt rat). Tru. A stpr AS curv (rsulting from a highr snsitivity of nominal wags to th unmploymnt rat ) is quivalnt to a stpr Phillips curv. Th unmploymnt costs of a disinflation program will b lowr with a stpr Phillips curv than with a flattr Phillips curv. 4. Mony cannot b nutral in th short-run th nutrality of mony is xclusivly a mdium run phnomnon. Fals. If workrs hav rational xpctations, thn an incras in mony will lad th workrs to at onc rvis thir xpctd pric to b qual to th nw mdium run quilibrium pric (assuming that workrs can rvis thir xpctations as soon as th incras in mony taks plac). Th conomy will mrly jump from on mdium run quilibrium to anothr, with non of th usual gradual shifts in th AS curv. If workrs can only adjust xpctations aftr a lag, thn th conomy movs to a short run quilibrium, whr th nw AD curv intrscts th old AS curv, but thraftr it jumps to th nw mdium run quilibrium with non of th usual gradual shifts in th AS curv. Consquntly, mony will b nutral in both th short run and th mdium run.

2 PART II IS/LM and AS/AD A spcial cas (10 points ach) 1. Considr th following diagram for th mony markt i i* Mony Supply Mony Dmand M/P Not carfully what this mans. Mony dmand is compltly unrsponsiv to th intrst rat if intrst rat falls blow i*. In othr words, th intrst rat must ordinarily fall in ordr to convinc popl to hold mor mony, but onc it has falln to i*, no furthr drop is rquird for individuals to hold mor mony, rgardlss of what thir incom lvl is. Thy will b willing to hold any amount of mony at this intrst rat. Driv th LM curv graphically for this conomy (i.. considr changs in Y and what it dos to th Mony Dmand function, and translat this information into (i, Y) spac; show both th mony markt diagram and th IS-LM diagram whn you do this). Explain intuitivly its shap. (Hint : Changs in Y will NOT shift th ntir mony dmand curv up) Answr : i i i* i* M/P Y* Y

3 Considr th curv labld 1 as th initial mony dmand curv. As Y is incrasd, th mony dmand curv shifts out to th right (as indicatd by 2,3,4,5 tc), but only th downward sloping part of th mony dmand curv is sn to shift out. At i*, ach of th nw curvs must bcom flat, so th horizontal portions of th mony dmand curvs do not shift out. Dnot th incom lvl for which curv 4 is drawn as Y*. Thn as long as Y<Y*, th shifts in th mony dmand curv do not chang th quilibrium intrst rat. So th LM curv is flat in this rang. Incrass in Y do not incras th intrst rat. But for Y>Y*, th downward sloping parts of th mony dmand curvs intrsct th mony supply curv, so w gt a rgular upward sloping LM curv for Y>Y*. 2. Suppos th IS curv has th usual ngativ slop. Driv graphically th AD curv in this conomy (i, considr changs in P and how it affcts th IS-LM diagram and translat this information into a diagram in (Y,P) spac; show both th IS-LM diagram and th AS-AD diagram whn you do this). Explain intuitivly why it has th slop it dos. Answr : i P P* i* IS Y Y* Y* Y Considr th LM curv 2 as th initial LM curv. Dnot th pric lvl corrsponding to this LM curv as P*. Now incras prics. Th ral mony supply falls and th LM curv starts shifting to th lft (to a position such as 3). But only th upward sloping part of th LM curv shifts to th lft, sinc th curv flattns out at i*. With vry incras in prics abov P*, th nw LM curv intrscts th IS curv at a lowr output and a highr intrst rat. Translatd into (Y,P) spac, this corrsponds to th rgularly downward slopd AD curv sn abov P* on th right hand sid diagram abov. But now considr dcrass in P blow P*. Starting from curv 2, th LM now bgins to shift to th right, but bcaus with ach shift, th IS curv always intrscts th flat portion of th LM curv, th output lvl rmains at Y*. This corrsponds to th vrtical sction of th AD curv on th right hand sid. Th intuitiv xplanation for th downward sloping part of th AD curv is th rgular xplanation. Th intuitiv xplanation for th vrtical part of th AD curv is that as prics fall blow P*, mony supply incrass, but bcaus

4 individuals ar willing to hold any mony at th intrst rat i*, this incras in mony supply is willingly hld by individuals without ncssitating a fall in th intrst rat, and if th intrst rat dos not fall, thn invstmnt cannot incras and nithr can output. So output rmains at Y* vn as prics fall blow P*. 3. Suppos th AS curv has its rgular upward slop, and it intrscts th AD curv you just drivd at som initial point. Th govrnmnt thn incrass th mony supply. Dos th AD curv shift? Is montary policy ffctiv, at last in th short run? Answr : Th vrtical part of th AD curv will not shift, but th downward sloping part will shift up, so th pric at which th curv bcoms vrtical incrass from P* to som highr lvl of P. With th vrtical part not having shiftd, quilibrium output rmains at Y*. Montary policy is usually ffctiv in th short run sinc an incras in mony rducs intrst rats, and this incrass invstmnt and thrfor output. But if th conomy is at quilibrium along th vrtical part of th AD curv to start with, it is, in th IS-LM diagram, alrady at th intrst rat i*. Any incras in mony will not rduc th intrst rat and so thr is no incras in output vn in th short run. If, howvr, th conomy is at quilibrium along th downward sloping part of th AD curv to start with, thn montary policy will b ffctiv in th short run for th usual rasons. PART III THE PHILLIPS CURVE (10 points ach) Considr th following st of quations : Phillips Curv : π t = t-1 π t + 5 u t Okun s Law : u t u t-1 = - g yt Aggrgat Dmand (in trms of growth rats) : g yt = g mt - π t W hav usd th following notation : t a tim subscript dnoting yar π t th inflation rat in yar t (th rat of chang of prics btwn t-1 and t) t-1π t th inflation xpctd by workrs for yar t formd at th nd of yar t-1 u t th unmploymnt rat in yar t g yt th growth rat of output btwn yar t and yar t-1 g mt th growth rat of nominal mony btwn yar t and yar t-1 Assum that u t, g yt, and π t ar all dtrmind in th middl of th yar, whil g mt is st at th bginning of th yar by th govrnmnt. As dscribd abov, workrs form xpctations about nxt yar s inflation rat at th nd of th currnt yar, i, aftr th currnt yar s inflation rat, unmploymnt rat and output growth hav all bn dtrmind.

5 1. What is th natural rat of unmploymnt in this conomy? Answr : Stting π t qual to t-1 π t in th Phillips curv rlation, w gt u n to b qual to 5%. 2. Suppos w start in th yar 1990 with th govrnmnt having st th growth rat of mony at 6% for all yars. Suppos also that th conomy is in a mdium run quilibrium. What is g yt and π t? Answr : In th mdium run, w know that u t =u n and that th growth rat of output is qual to its normal growth rat. As is vidnt from th Okun s Law rlation providd abov, th normal growth rat is 0. So g yt =0. Th AD rlation thn tlls us what th inflation rat should b. With g yt = 0 and g mt = 6%, π t must qual 6% as wll. 3. Draw a Phillips curv in (u, π) spac to dscrib th information providd so far. In your diagram, show th natural rat of unmploymnt and th corrsponding inflation rat. Answr : π t 6% 5% Phillips Curv u t 4. Suppos th govrnmnt maintains th growth rat of mony at 6% ach yar till But in 1995, th govrnmnt incrass this growth rat to 10% vry yar from thn on. Suppos also that workrs us adaptiv xpctations, and xpct th nxt yar s inflation rat to b qual to th inflation rat in th currnt yar. Calculat th valus of th unmploymnt rat and th inflation rat for Show ths valus on th diagram you drw for part 3.

6 Answr : So g mt = 10% for all t from 1995 onwards To gt u 1995 and π 1995, w hav to solv th thr quations providd simultanously for Ths 3 quations ar Phillips Curv for 1995 : π 1995 = 1994 π u 1995 Okun s Law : u 1995 u 1994 = - g y1995 Aggrgat Dmand (in trms of growth rats) : g y1995 = 10% - π 1995 W know that in 1994, th conomy is still at th old mdium run quilibrium (th on w calculatd in part 1). And sinc th valus of th inflation rat, unmploymnt rat and growth rat of output ar dtrmind in th middl of th yar, bfor xpctations hav had a chanc to adjust to th nw growth rat of mony, w hav 1994π 1995 = π 1994 = 6% u 1994 = 5% Putting ths valus into th abov quations and solving w gt π 1995 = 8% u 1995 = 3% g y1995 = 2% So unmploymnt falls blow th natural rat and inflation incrass. Not carfully that th 1995 Phillips curv for th conomy is th sam as th 1994 Phillips curv. So th conomy movs along this Phillips curv from a to b. π t 8% b 6% a 3% 5% Phillips Curv, 1995 u t

7 5. What ar th unmploymnt and inflation rats in 1996? Show on th diagram whr th conomy is in th middl of At th nd of 1995, workrs hav a chanc to rvis thir xpctations. Thy had xpctd th 1995 inflation rat to b 6% but it turnd out to b 8%. Sinc thy hav adaptiv xpctations thy thrfor st th xpctd inflation rat for 1996 to b 8%. This has th ffct of shifting up th Phillips curv. Th nw Phillips curv is π 1996 = 1995 π u 1996 = u 1996 Okun s Law is : u = - g y1996 And th AD rlation is th sam as bfor. Solving ths thr quations simultanously, w gt π 1996 = 10% u 1996 = 3% g y1996 = 0% So th inflation rat incrass but th unmploymnt rat stays at its 1995 lvl. In th diagram blow, th point (3,10) lis on a nw Phillips curv. This nw Phillips curv passs through (5,8) sinc if actual inflation is qual to xpctd inflation (which is 8% along this curv), thn th corrsponding unmploymnt rat must b th natural rat. Earlir th conomy had movd from a to b. In 1996 it movs from b to c. π t 10% c 8% b 6% Phillips Curv,1996 3% 5% Phillips Curv, 1995 u t

8 6. (No math is rquird for this part just provid word answrs) If you trac th volution of th conomy, you will find that th valus (u t, π t ) trac out th following approximat path from 1995 onwards. π t d 10% c a b 6% a u n Phillips Curv u t Th conomy starts at a and movs along th path abcda. Th nw mdium run quilibrium is at a (a) Considr th path abc. Along this path u t is falling whil π t is rising. Intuitivly why is u t following this path? (b) Considr th path cd. Along this path u t is rising whil π t is first rising and thn falling. Why dos u t continu to ris along this path? Why dos π t first ris and thn fall? (Hint : Think about what is happning to th ral mony supply along ths paths)

9 Answr : Th rason th conomy follows th path shown is that ovr tim th Phillips curv kps shifting, somtims up and somtims down, dpnding on what th actual inflation rat is, rlativ to th xpctd inflation rat. (a) Along th path abc, th inflation rat is always lss than th mony growth rat which is 10% aftr th chang. Thrfor along abc, th ral mony supply is growing. Thrfor output is growing (by th AD rlations), and thrfor th unmploymnt rat is falling (by Okun s law). As th unmploymnt rat falls, th inflation rat riss du to th Phillips curv rlation but stays blow 10% till th conomy rachs point c. (b) At point c, th inflation rat is qual to th mony growth rat, but unmploymnt is still blow its natural rat, so th inflation rat continus to ris. But now th inflation rat outstrips th mony growth rat, so th ral mony supply is falling. Along cd, th ral mony supply falls, thrfor output growth falls (by th AD rlation), and th unmploymnt rat incrass (by Okun s Law). At d, th unmploymnt rat is back to th natural rat, but inflation continus to b highr than th mony growth rat. So th ral mony supply continus to fall, output growth continus to fall, and th unmploymnt rat continus to incras. But as soon as w ar past d, th unmploymnt rat is gratr than th natural rat, so now th inflation rat starts falling as wll, and along th path d, th inflation rat, though falling, continus to b highr than th mony growth rat, so output growth continus to fall, and th unmploymnt rat continus to incras.

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