Economics 219

Solutions to Problem Set #6

1.    Note that for this question, you should always get the same result using IS-LM-FE analysis or the approach we used earlier in the class (capital market, labor market, money market). It would be good practice for the final to work out these examples using both methods!
    1. An increase in productivity raises the level of output produced by any combination of labor and capital as well as increases employment (demand for labor increases). Therefore, the FE curve shifts to the right. The increased demand for capital as well as the higher wealth (reducing savings) shifts the IS curve to the right. The overall effect on interest rates is therefore ambiguous, but output is definitely higher. Higher output implies lower prices. Given a fixed money stock, real balances fall and the LM curve also shifts to the right.
    2. Assuming prices are fully flexible, a 10% increase in the money stock causes a 10% rise in the price level. Therefore, real balances are unaffected and the LM curve doesn’t move. Nothing real in the economy (employment, productivity, etc.) has been affected, so the IS and FE curve also don’t move.
    3. A drop in consumer confidence will lower consumer spending (raise savings) and therefore shift the IS curve to the left. Productivity and employment are unaffected so the FE curve doesn’t move. Therefore, output remains constant and interest rates fall. Lower interest rates raise the demand for money causing prices to fall. A drop in prices increases real balances which shifts the LM curve to the right.
2.    This question is, admittedly, a bit difficult!
    1. The key to comparative statics is to figure out what the primary effect of an exogenous event is and work out from there. In this case, deregulation increases the productivity of capital. This should raise investment demand. Therefore, IS shifts to the right. Note that this increase in productivity is immediate and impacts all capital. Therefore, FE shifts right as well. The presumption is that IS increases by more the FE thus raising interest rates. Output, consumption, and investment all rise. In the labor market, nothing has changed except that everybody’s wealth has increased. Therefore, labor supply shifts left - real wages rise and employment falls.
    2. With an increase in the capital stock, workers are now more productive, so the demand for labor increases – this pushes up the real wage even higher than it was in the short run, but the effect on employment is ambiguous. Now that all the new capital goods have been purchased, investment demand can return to its initial levels (actually, investment demand will be a little higher than before the policy change because now there is a larger capital stock to maintain). Therefore FE shifts right, IS shifts left, and interest rates fall relative to the short run.
3.    A freeze on prices along with an increase in the supply of money raises real balances and shifts the LM curve to the right. Output rises and interest rates fall. The explanation behind this is as follows. The increased money supply (with prices fixed) raises demand for goods and services. As firms temporarily raise their output to satisfy demand, they must hire some extra labor, which drives up the real wage, raises employment and increases output. Note that this temporarily increases national income. With higher income, consumers increase their savings. With an increased supply of loanable funds, the interest rate falls. Once prices are allowed to rise (which we know will happen at some point due to the higher money supply), the above process reverses itself and the economy returns to its initial level of output, employment, and interest rates, but with a higher price level.

4.    A monetary contraction under "sticky" wages.

    1. With nominal wages fixed, a monetary contraction raises prices and drives up the real wage. With the real cost of labor higher, firms reduce the quantity of labor hired. This lowers employment and output. With national income temporarily lower, consumers dip into their saving, lowering the supply of loanable funds and driving up the interest rate.
    2. In the long run, labor contracts can be renegotiated at a lower nominal wage and the effects in part (a) reverse themselves.