Macroeconomics : aggregate demand curve

BA380SManagerial Economics (Macroeconomics)

Save Time On Research and Writing
Hire a Pro to Write You a 100% Plagiarism-Free Paper.
Get My Paper

Save Time On Research and Writing
Hire a Pro to Write You a 100% Plagiarism-Free Paper.
Get My Paper

Prof. Donangelo

Fall 2013

Problem Set 6

Question 1 (Aggregate Demand Curve)

You might want to review the construction of aggregate demand curve before answering

the questions below (slide pgs 287- 290).

a) What does the aggregate demand curve represent?

The Fed currently has a dual mandate of keeping both inflation and unemployment at

relatively low levels. We have been representing the dual mandate through the general

Monetary Policy rule (based on the Taylor rule) given by:

: , 2%

1
2

1
2

b) Suppose that the Fed reduces the weight on the mandate of keeping inflation low and

increases the weight on keeping unemployment low. For instance, suppose that the new

monetary policy rule is:

: , 2%

1
4

3
4


How does this policy change affect the aggregate demand (AD) curve?

c) Now consider the opposite case. Suppose that the Fed now increases the weight on

keeping inflation low and reduces the weight on keeping unemployment low. For

instance, suppose that the new monetary policy rule is:

: , 2%
3
4

1
4

How does this policy change affect the aggregate demand (AD) curve?

d) Based on your findings above: why is the AD curve downward sloping?

Question 2 (Oxidation and Inflation)

Suppose that there is a huge fire that completely destroys the Amazon forest. The

colossal fire greatly increases carbon dioxide and decreases oxygen levels. Answer the

following question from the point of view of a closed economy. Assume that the central

bank (Fed) has no credibility in fighting inflation. Assume that output is at potential

(Y=Y*) and that inflation is currently at the level targeted by the Fed ( ). You

should support your answers with the appropriate diagrams discussed in class.

Researchers from UCSD show that atmospheric oxygen levels are decreasing over time.

At the same time, carbon dioxide levels are increasing. Both changes tend to reduce

oxidation of iron (ie., rust).

a) Here we will make the naive assumption that the only effect of the development
is to reduce rust and thus depreciation rates. Analyze the short run and long run

effects of the economic development on inflation rates.

b) Now assume that oxygen deprivation negatively affects labor supply and reduces
potential output. Assume that this is a quick and permanent effect. For

simplicity, ignore the effect of the reduction in labor supply on the investment

demand (ID) curve. Compare the short run and long run inflation rates with

those in (a).

Question 3 (Zero Lower Bound)

a) Briefly explain why the Fed cannot set nominal interest rates below zero.

We saw in class that real interest rates (r) are the difference between nominal

interest rates (i) and inflation expectation (πe):

r = i – πe

Suppose that nominal interest rates are currently zero. Economists refer to this

situation as the “zero lower bound”. When the zero lower bound is reached, the Fed

can no longer directly control short term real interest rates.

b) Deflation is defined as negative inflation. Briefly explain why expected deflation
(i.e., πe < 0) would reduce GDP in the zero lower bound (relative to the case with expected inflation). Use a single IS-MP diagram to show how output is

affected by expected deflation.

c) Briefly discuss the role of Fed’s credibility in today’s macroeconomic
environment.

Still stressed from student homework?
Get quality assistance from academic writers!

Order your essay today and save 25% with the discount code LAVENDER