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Department of Economics

Macroeconomics

BSc(B)/HA, 2nd

semester, Spring 2010

To be discussed at the 4th

tutorial

Relates mainly to Blanchard chapters 6 and 7

Problem set 4

Problem 1 (chapter 6 and 7)

Even after having read Blanchard most students appear to find it completely self-evident that

a lower price level in a closed economy cannot but stimulate economic activity. It appeared to

be taken for granted, for instance, by a huge majority of the students attending the recent

exam in Macroeconomics, Part 2, that took place in January 2009.

When asked the question

Discuss how such a disinflation [= declining inflation] contributes towards stimulating aggregate

demand (thus making unemployment decline …)

most of them argued along the following lines:

(1) lower inflation (lower rate of change of the price level) => lower price level=> higher

“purchasing power” (~ real income) => higher real demand (Z) => higher equilibrium

output => lower unemployment

or, somewhat similarly,

(2) lower inflation (lower rate of change of the price level) => lower price level=> higher

real wage (W/P) => higher real demand (Z) => higher equilibrium output =>lower

unemployment

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Please discuss the fallacies embedded in each of these “causal chains”

Problem 2 (chapters 7 and 5)

1) Derive the AD-curve from the IS-LM-model, using diagrams and/or algebra

2) Repeat – but now just in words – why the AD curve is negatively sloped

3) All students know, seemingly, that the AS curve is upward sloping. Experience shows,

however, that only a minority are able to explain why this is so. Therefore: Explain,

carefully, why the AS-curve (in Blanchard) is upward sloping

4) Along a certain AS curve, the expected price level Pe is given. What happens to a given

AS curve if, for some reason, the expected price level goes up by, say, 12%? Be sure

you understand the mechanism(s) behind your answer

5) Where, along a given AS curve, will the actual price level P be equal to the (given)

expected price level Pe?

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Problem 3 (chapters 6 and 7)

This problem appeared as Problem 2 in the paper set at the winterexamination 1999/2000

(BSc(B), Part 2) and was assigned the weight 1/3:

Years ago the chairmen (“vismændene”) of the Danish Economic Council wrote that

"there is a lack of efficient competition in parts of the economy where a number of sectors are

characterised by high prices and an extra-normal profit [...]. It is, therefore, necessary that

structural adjustments be made on the goods market." (Danish Economy - Autumn 1995, p.157)

In order to illustrate the beneficial effects to society of an increased degree of competition,

this report also included a calculation of how a reduction of the firms’ mark up would

influence a series of macroeconomic variables.

These analyses of the Economic Advisors are based on a macroeconomic model which

contains a specification of the price and wage setting which is similar to Blanchard’s PS-WS

model.

Let us assume that the wage and price setting relations can be described as:

1

1: W

PPS

WS F u zW

Pe: ,

1) Briefly explain the economic contents in the two relations

Assume that antitrust legislation is enforced more vigorously so that the competition on the

goods market increases. In the PS-WS model this can be modelled as a reduction of the mark

up factor, 2) Analyse and explain the effects this has on the natural rate of unemployment, the natural

level of production and real wages

3) Show and explain the adjustment to the new medium-run equilibrium in an AS-AD

graph

Problem 4 (chapters 7 and 6)

Use the WS-PS-and-AD-AS model to assess the short-run and medium-run consequences of a

reduction in unemployment benefits

caution!: this is not quite as simple as the analysis of, for instance, fiscal or monetary

policy. Why not? Because here we are once more considering a shock which does not,

according to chapter 6, leave uN and hence YN unaffected