Ec 10 Spring 2007 Pset 6

Tarun Singh TF: Andres Zahler Ec 10 Problem Set #6 1. The fact that 43% of consumers planned to spend the extra disposable income even though their long-term income expectations were unchanged suggests that consumers may only loosely follow the permanent income hypothesis. However, there may be other factors at play here. For example, suppose consumers expect price levels to rise and real interest rates are low, it would make sense for consumers to spend more of the extra disposable income today rather than tomorrow. 2. a) The Aggregate Demand curve has a downward slope because as price level rises, nominal GDP rises. The increase in nominal GDP causes an increase in money demand because people need more money for everyday transactions at higher prices. The rise in money demand causes an increase in the interest rate since we assume MS is unchanged. Higher nominal interest rate means real interest rate is also higher. Higher real interest rate causes a decrease in consumption demand since people substitute away from spending and towards saving. NX also decreases since higher real interest rate increases the real exchange rate. It also reduces investment demand because the net present value of investment opportunities is reduced. Thus, at higher price levels, aggregate expenditure is reduced and so the AD curve slopes downward. b) The SRAS curve slopes upward for three main reasons. First, lower price levels cause misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied (misperceptions theory). Second, because wages do not adjust immediately to the price level, a lower price level makes employment and production less profitable, which induces firms to reduce the quantity of goods and services supplied (sticky-wage theory). Finally, because not all prices adjust instantly to changing conditions due to menu costs, an unexpected fall in the price level leaves some firms with higher than desired prices. These high prices depress sales and induce firms to reduce the quantity of goods and services they produce. c) The LRAS curve is vertical because in the long run, an economy’s production of goods and services depends on its supplies of labor, capital, natural resources, and available

technology used to turn the factors of production into goods and services. Changes in price level do not affect these long run determinants of real GDP; thus, LRAS curve is vertical. 3. a) The AD curve would be more elastic. If, as Keynes suggests, businesses respond less to changes in real interest rate, than the investment demand component of aggregate expenditure will respond less to the initial increase in price and thus the slope of the AD curve will be closer to zero. b) Monetary policy is used to either increase or decrease the supply of money. A shift in the money supply curve to the right would lower the equilibrium interest rate which would in turn increase the consumption, investment demand, and net exports and hence aggregate demand. If Keynes considers interest rate to a weaker influence on investment demand, then lower interest rates will not necessarily spur an increase in aggregate demand. 4. High interest rate elasticity of money demand, high interest rate elasticity of investment demand, and a low percentage of firms with sticky prices is the combination that would make monetary policy most effective at influencing real output in the short run. When the Fed either decreases or increases the money supply through open market operations, a high interest rate elasticity of money demand would result in the greatest change in interest rate. This change in interest rate will spur the greatest change in aggregate expenditure if the interest rate elasticity of investment demand is high. Real output is determined by the intersection of the SRAS and AD curve. A shift in the AD curve would have the greatest effect on Real output when the SRAS curve is more elastic. This occurs when a low percentage of firms have sticky prices. Thus, this combination would make monetary policy most effective at influencing real output in the short run. 5. a) See graph b) See graph c) In the short run, some firms respond to the increase in AD by increasing prices while others just adjust their output. As we transition to the long run, because of this partial increase in the price levels, agents adjust their expectations of inflation upwards. This change in expectations is one component of the AS curve shifting back to the left.

d) Nominal wages are sticky in the short run. Thus, nominal wages at points A and B are the same. At point C, nominal wages are higher. e) Real wages at point B are lower than at point A. Real wages at point C are the same as at point A. f) Yes this is consistent with money neutrality since though real wages are altered in the short run, they are unchanged in the long run.

6. a) The housing market, in terms of levels of new construction and real estate prices, have performed well in the last five to six years. Much of this growth has been spurred by low mortgage rates. According to the Bernanke article, the expansion of US housing wealth has kept the U.S. national saving rate low and increased the current account deficit. This is due to the expansion of housing wealth, accessible through cash-out refinancing and home equity lines of credit. This housing wealth made homeowners feel effectively richer because according to the permanent income hypothesis a consumers income is more than just his/her disposable income, but includes both physical and human assets such as property. Thus, when the increased value of their home is factored into their consumption decisions, consumers are likely to consume more and save less. b) The US macroeconomy could suffer as a result of the subprime lending crisis. Defaults on loans and foreclosures will result in an increased supply in an already saturated housing market, causing home prices to go down and leaving homeowners with negative equity. The construction industry will suffer since building new houses would not be profitable and consumers would feel poorer as a result of the value of their homes depreciating causing them to spend less. Thus, the real GDP will suffer (both consumption and investment go down). This particular housing slowdown is different from previous housing

slowdowns because the meltdown in the market for subprime loans, made to homeowners with poor credit and carrying interest rates 2-3% higher than normal loans. The default rates of these loans have soared as the housing bubble has deflated and some mortgage originators, such as New Century Financial, are going bankrupt.