Macroeconomics Term 1

Question 1

Keynesian consumption function

Answer 1

C = c0 + c1(1 - t)y

c1 is the marginal propensity to consume

Question 2

What part of the IS equation affects the slope and does the slope become flatter or steeper?

Answer 2

The greater a1 or k, the flatter the slope of the IS. They mill make individuals more sensitive to investment and consumer more at a given level respectively.

Question 3

Explain how much output would increase due to an increase in government spending, step by step.

Answer 3

G up, consumption increased by c1(1 - t) ∆G, demand increase by the same amount leading to higher output and income increasing consumption by c1(1 - t)^2 ∆G. Continues until equilibrium reach.

Question 4

IS curve and the last step before reaching it.

Answer 4

I = a0 - a1r

y = A - ar

Question 5

What will cause the IS to shift and by how much?

Answer 5

changes in a0, c0, or G and by ∆ x k

Question 6

What forward looking behaviour is there?

Answer 6

Consumption smoothing whereby households adjust their current spending
based on their expected income in the future.

Firms makes decisions based on forecasts about future demand and
input costs.

Question 7

Permanent income hypothesis?

Answer 7

individuals optimally choose to consume by
allocating their resources across their lifetimes.
Households borrow and save to smooth their consumption over their
lifetimes.

Question 8

How do we expect consumption to react when a change in income
occurs?

Answer 8

Anticipated changes should have no eect on consumption.
Unanticipated changes should affect consumption because they require
the recalculation of lifetime lifetime budget.
A permeant change will increase consumption by the change in income (MPC = 1)
A temporary change will change increase consumption by r/ (1=r) x change in lifetime wealth.

Question 9

What is observed regarding smoothing and sensitivity to lifetime income changes?

Answer 9

excess sensitivity to anticipated changes,
especially increases.
Also, it has been observed excess sensitivity to news about temporary
unanticipated changes and excess smoothness to news about permanent (unanticipated) changes.

Question 10

How is k affected by : 1. temporary/permanent
unanticipated changes transpire.
2. Credit constrained households and impatient households.
3. falsely perceiving changes in income as permanent

Answer 10

1. Temporary unanticipated, k=1,
   permanent, k > 1
2. k > 1 even for temporary shocks.
3. K > 1

Question 11

Real world factors that shift the IS?

Answer 11

Leftward shift if:
Unemployment up,
Fall in house prices,
Less access to credit.

Question 12

What does the supply side entail?

Answer 12

Supply side entails the supply of labour by workers and the demand
for labour by firms.

Question 13

Why doesn’t the labour market clear?

Answer 13

Efficiency wages

Question 14

What is efficiency wage settings and why does it occur?

Answer 14

Supply side entails the supply of labour by workers and the demand
for labour by rms.

Question 15

What does the WS curve show?

Answer 15

The wage to secure adequate worker effort at a given U. The supply of labour.

Question 16

What would happen if markets were competitive and contracts complete?

Answer 16

Only voluntary unemployment would occur, the welfare optimum

Question 17

What are the wage push factors?

Answer 17

WS shifts down when:
Unemployment benefits down,
Disutility of work down, union mark-up down,
Weaker unions,
Bargaining restraint.

Question 18

Perfectly competitive goods markets MPL

Answer 18

p = mc = W/MPL

So W/P = MPL

Question 19

What does the price setting curve show?

Answer 19

Demand for labour by firms.

Question 20

Imperfectly competitive markets prices?

Answer 20

Set MR = MC and profit depends on PED.

Question 21

Price setting equation?

Answer 21

W/P = (1 + mu)MPL

Question 22

Tax wedge?

Answer 22

The difference between the real consumption wage (W/Pc) and the real product wage (w gross/P).

Question 23

When will the PS curve shift up?

Answer 23

A fall in the tax wedge,
A fall in mark-up,
An increase in productivity.

Question 24

Reasons for wage rigidity (in case of a recession)?

Answer 24

wage cuts lead to a loss of productive workers, so layoffs are preferred.
Fairness issues so worker effort down.

Question 25

Reasons for price rigidities? and implications to model?

Answer 25

Firms can afford not to change price because P>MC.
Menu costs
Lose customers if other firms don’t follow suit.
Therefore, we assume that firms don’t change prices in response to demand, only due to changes in labour costs {P = 1+ mu)W/Lamda}

Question 26

Orate the process of a positive demand shock, i.e an increase in N and inflation

Answer 26

1. Change in y and N
2. Next wage round Change in W
3. Change in P immediately after wage round.

Question 27

What is the Phillips curve?

Answer 27

The relationship between inflation and unemployment.

Question 28

What are the two characteristics the PC is defined by?

Answer 28

1. Lagged inflation, which fixes the height of the PC on a vertical line above the level of output ye where U = ERU
2. the slope of the WS curve, which fixes its slope.

Question 29

ERU?

Answer 29

Equilibrium rate of unemployment = U/L.

Question 30

Output and inflation?

Answer 30

Output leads inflation as output changes before inflation.

Question 31

How do we ensure the real wage remains on the PS?

Answer 31

prices are adjusted immediately to wage changes.

Question 32

Supply side change vs demand side change?

Answer 32

AD change, IS curve shifts rightward.

SS change, WS curve shifts.

Question 33

Monetary rule?

Answer 33

determines the output gap the CB should set to stabilise the economy after a shock

Question 34

How to derive the MR curve?

Answer 34

1. define the CBs preferences in terms of utility (or loss) function to capture the costs it incurs of being away from the inflation target and from equilibrium output.
2. Define constraints faced by CB on supply side (PC).
3. Best response monetary rule in output-inflation space.
4. Once CB has decided where it wants to be using the MR curve, it uses the IS curve to implement the choice.

Question 35

Taylor rule?

Answer 35

CB minimies fluctuations from the inflation target and the size of the output gap;

Question 36

What is the MR curve?

Answer 36

The CBs preferred y-pi combination for any PC. It is the locus of points of tangency between the PCs and the indifference curves.

Question 37

What does the MR indicate?

Answer 37

The output gap the CB should choose when inflation isn’t equal to target inflation.

Question 38

Taylor rules?

Answer 38

Monetary policy rules often described as Taylor rules.. Taylor rules are expressed in terms of the r the CB should choose to implement its chosen output gap. In reality the central bank adjusts I in order to achieve a particular r on the IS.

Question 39

How the CB operates its monetary policy?

Answer 39

The CB chooses the best point along the PC curve that it faces, yt
is determined, r is set on the IS to achieve yt .

Question 40

Dynamic IS?

Answer 40

captures the idea that yt negatively responds to r with a one period lag.