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Macro Question 2: Solutions

1. An increase in productivity shifts the IS curve outward in the short run, raising output and interest rates while prices are fixed. In the long run, it shifts the LRAS curve outward, decreasing prices and increasing output, while real money balances increase and interest rates decline. 2. Higher expected inflation shifts the IS curve outward by lowering the real interest rate, shifting aggregate demand. Lower expected inflation from increased productivity shifts the IS curve inward by raising the real interest rate, potentially offsetting the outward shift from higher investment. 3. Shocks to productivity or the IS curve reveal themselves as changes in prices in the long run. The Fed should maintain inflation near zero and adjust the money supply to push output toward its

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24 views

Macro Question 2: Solutions

1. An increase in productivity shifts the IS curve outward in the short run, raising output and interest rates while prices are fixed. In the long run, it shifts the LRAS curve outward, decreasing prices and increasing output, while real money balances increase and interest rates decline. 2. Higher expected inflation shifts the IS curve outward by lowering the real interest rate, shifting aggregate demand. Lower expected inflation from increased productivity shifts the IS curve inward by raising the real interest rate, potentially offsetting the outward shift from higher investment. 3. Shocks to productivity or the IS curve reveal themselves as changes in prices in the long run. The Fed should maintain inflation near zero and adjust the money supply to push output toward its

Uploaded by

ADITYA
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Macro Question 2

Solutions
1. In the short run, an increase in productivity raises investment demand and,
therefore, shifts the IS curve outward. It raises the interest rate, r , and output, Y .
The price level, P , is fixed by definition.

r
LM

r
r

IS
IS

In the long run, an inc rease in A raises the full employment level of output. Thus
it shifts the long-run aggregate supply curve outward. It decreases P and
increases Y . Since the real money balances, M P , increase, the interest rate
should decline.

LRAS

LRAS

P
P

AD

To accommodate the effects that occur in the short run and long run, in the
medium run Y must be increasing, r must be decreasing, and P must be
decreasing.
2. a) The higher expected inflation, e , the higher the level of investment, since the
real interest, r = i e , is lower. Therefore, an increase in expected inflation
shifts the IS curve outward and, consequently, the aggregate demand curve
outward.
b) From Part 1 we know that an increase in A will lead to a lower price level,
therefore the expected inflation is negative (we expect deflation). It will shift the
IS curve and the aggregate demand curve inward. It implies that an outward shift
in investment demand due to higher productivity may be offset by a rise of the
real interest rate. For this reason in the short run Y will either not change or
increase less than in Part 1. The behavior of the other macro variables will be
roughly the same as in Part 1.
3. From the Phillips Curve equatio n, shocks to productivity or the IS curve will
reveal themselves as changes in the price level, at least in the long run. Thus, the
Fed should maintain the level of inflation as close to zero as possible. If there is a
high inflation ( Y > Y f ), the Fed should reduce the money supply to push output
down toward its full-employment level. If inflation is low (or there is deflation),
then Y < Y f and the Fed should increase the money supply to push output up
toward its full-employment level.

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