BA380SManagerial Economics (Macroeconomics)
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.