Lecture Note #8

Question 1

What are the assumptions of the IS-LM curve?

Answer 1

1. Closed economy
2. Fixed Prices
3. Aggregate demand-driven (no supply side modeling)

Question 2

What are the three reasons why the AD curve is downward sloping?

Answer 2

1. Wealth Effect
2. Interest Rate Effect
3. Real Exchange Rate Effect

Question 3

In the aggregate demand and aggregate supply model, considering its assumption, what is the only fixed variable in the short-run?

Answer 3

Physical capital (K) is assumed to be fixed in the short run

Question 4

How is MPL and nominal W related to the AS curve?

Answer 4

At each point along the AS curve, equilibrium in the labor market ensures that firms are producing the corresponding level of output efficiently:

P x MPL = W

Question 5

What is the labor market equilibrium formula?

Answer 5

P x MPL = W

or

MPL = W / P

Question 6

What determines the slope of the AS curve?

Answer 6

1. If P and W are directly proportional (rise by same percentage) output doesn’t change [AS is vertical]
2. If P goes up but W goes up by a smaller percentage, then output goes up. [AS is upward-sloping]
3. If P goes up but W stays the same, then output increases the most [AS is horizontal]

Question 7

How does a lower initial unemployment rate affect wage increases?

Answer 7

low employment = more bargaining power for workers which would incur higher wage increases

Question 8

What are characteristics of Phillips curve graph?

Answer 8

1. Inverse relationship between inflation and unemployment
2. short-run, tradeoff between inflation and unemployment
3. long-run, vertical at the natural rate of unemployment
4. Non-linear

Question 9

What are characteristics of Okun’s Law graph?

Answer 9

1. short-run relationship
2. trade-off between output growth and changes in unemployment rate
3. When GDP rises, unemployment drops