Final Exam Spring 2014 1 a UC graph As tao falls the user cost of capital falls with it Therefore the marginal benefit of K units of capital exceed the marginal cost This violates the profit maximizing condition and firms will increase K until they reach K where MR MC As tao falls Investment demand increases as firms want to invest into more capital S I graph This shifts the Id curve outward This increase in Id leads to an outward shift of the aggregate demand curve until Y Yb with prices held constant This increase in Y shifts the Sd curve and the money demand L curve outward as well At the same interest rate as ra real money demand exceeds real money supply so households sell bonds price of bonds drops and the interest rate on bonds increases if inflation expectations are held constant real interest rates will rise and investment and consumption fall As tao falls The increase in investment and savings shifts the IS curve outward IS LM graph while holding the LM curve constant because there is no change to real money supply real interest rates rise with Y until the IS curve intersects the LM curve at the Full employment line Aggregate demand Supply graph aggregate demand curve outward with the shift run aggregate supply curve horizontal because prices are sticky As tao falls Investment increases which shifts the b N and w will both increase As technology increases and capital becomes more efficient the production function will shift upwards along with the average productivity of workers increasing Because of the increase in production firms can afford to pay their workers more and hire more workers This is consistent with the business cycle facts especially the new economy where a new industry or a technological breakthough creates an upward shift of the production function and increase in employment and wages Output will increase because from the technology and capital shock the long run aggregate supply curve will shift outward and in a classical model labor markets always clear at full employment This will shift the aggregate demand outward until output equals potential Output c In the user cost of capital graph the marginal product of capital shifts outward from increased productivity Therefore the marginal benefit of K units of capital exceed the marginal cost This violates the profit maximizing condition and firms will increase K until they reach K where MR MC In the desired savings and investment graph the savings curve shifts outward due to an increase in output The desired investment curve shifts further outward because of the technological shock The real interest rate rises further due to at rb money demand exceeds money supply and households sell bonds which lowers the price on bonds which raises the yield on bonds If inflation expectation is held constant then the real interest rate rises In the IS LM graph The IS curve shifts further outward due to the technological shock and the LM curve stays the same The full employment line shifts to the right as well due to the capital and technological shock The LRAS shifts to the right due to the technological and capital shocks The increase in MPK raises investment which shifts the AD curve to right until y Yp d Bread workers and firm problem workers real wage W P 100 100 1 firms real wage W Pb 100 1 1 expected inflation 2 actual inflation Pb increases to 1 10 workers receive 5 increase in wage change in W change in P real wage goes up workers real wage W P 105 102 1 03 firms real wage W Pb 105 1 10 95 45 workers are fooled into working harder and firms are happy because firms real wage drops Only unanticipated monetary policy affects output Solid basis for conducting countercyclical monetary policy Prudent for C B to fight inflation because if they keep prices stable Pa Pe y a y B Pa Pe y a y Not relevant anymore Unanticipated money is no loonger a concern due to the internet no longer on an island prices are easily computed and retrieved e As you can see from the diagram from above real wages are pro cyclical meaning that wages increase as output increases After the technology shock The marginal product of labor exceeds the real wage This violates the profit maximizing condition of MPN w Firms will hire more labor and raise wages until w MPN You can notice as LRAS shifts right due to positive shocks the potential output increases thus wages are increasing along with output making real wages pro cyclical Point C Is not Graphed Hint fiscal shock such as increase in G leads to Ns shifting right and wages falling but output rising making wages counter cyclical due to fiscal shocks Variations in unemployment are due to variations in the natural rate of unemployment leading to a matching problem were Ns shifts around a lot f Use efficiency wage theory to describe how people workharder at any given wage during a recession Real wages are pro cyclical working harder at a given wage during recession y decreases w decreases As you can see above when there is a negative aggregate demand shock output falls from A to B This is because the effective demand for labor falls as output falls firms don t need as many workers to produce less output This shows how as output drops so does employment proving employment as pro cyclical Keynes would prescribe fiscal or monetary policy to get back to full employment However Keynes himself thought that monetary policy was unreliable due to animal spirits and would suggest either and increase in government spending or a decrease in taxes Keynes thought that if peoples outlook on the economy was dim that increasing the money supply would have little effect on stimulating the economy