Econ132-001 Homework Four

Hakan TASCI Due: November 10th, 2006 in class

1.

Consider how unemployment would affect the Solow growth model. Suppose that output is produced according the production function Y = K[(1-u)L]1-, where K is capital, L is the labor force, and u is the unemployment rate. The national saving rate is s, the labor force grows at rate n, and capital depreciates at rate . a) What is the per worker production function? How does it depend on the unemployment rate?

b)

Calculate the steady-state level of capital per worker. How does an increase in the unemployment rate affect this value?

c)

Illustrate graphically the affects on the steady-state value of capital per worker of a positive unemployment (u2) rate as opposed to zero unemployment (u1).

d)

Suppose that some change in government policy reduces the unemployment rate from u1 to u2. Describe how this change affects output per worker in the steady state. Also, describe how this affects output per worker immediately. In other words, describe the path of output per worker as the economy transitions from one steady state to another.

2.

Mankiw, problem 2, page 277

If the Fed reduces the money supply, then the aggregate demand curve shifts down, as in Figure. This result is based on the quantity equation MV = PY, which tells us that a decrease in money M leads to a proportionate decrease in nominal output PY (assuming that velocity V is fixed). For any given price level P, the level of output Y is lower, and for any given Y, P is lower.

Recall from Chapter 4 that we can express the quantity equation in terms of percentage changes: % in M + % in V = % in P + % in Y. If we assume that velocity is constant, then the % in V = 0. Therefore, % in M = % in P + % in Y. We know that in the short run, the price level is fixed. This implies that the % in P = 0. Therefore, % in M = % in Y. Based on this equation, we conclude that in the short run a 5-percent reduction in the money supply leads to a 5-percent reduction in output. In the long run we know that prices are flexible and the economy returns to its natural rate of output. This implies that in the long run, the % in Y = 0. Therefore, % in M = % in P. Based on this equation, we conclude that in the long run a 5-percent reduction in the money supply leads to a 5-percent reduction in the price level, as shown in Figure.

Okuns law refers to the negative relationship that exists between unemployment and real GDP. Okuns law can be summarized by the equation: % in Real GDP = 3% 2 [ in Unemployment Rate]. That is, output moves in the opposite direction from unemployment, with a ratio of 2 to 1. In the short run, when Y falls 5 percent, unemployment increases 2-1/2 percent. In the long run, both output and unemployment return to their natural rate levels. Thus, there is no long-run change in unemployment.

The national income accounts identity tells us that saving S = Y C G. Thus, when Y falls, S falls. Next Figure shows that this causes the real interest rate to rise. When Y returns to its original equilibrium level, so does the real interest rate.

3.

3. a.

Consider a closed economy described by the following equations: Y = C + I +G C(Y T) = 170 + 0.6(Y T) I(r) = 100 4r (M/P)d = 0.75Y 6r T=200, G=350, M/P=735, a. Derive the IS curve i.e Y as a function of G, T, r. b. Derive the LM curve i.e Y as a function of M, P, r. c. Find the equilibrium level of output, interest rate, investment and consumption. d. Suppose G increases by 36 to 386. what will be the new interest rate and output levels. e. Derive the AD curve i.e Y as a function of M, P, G, T. (Hint: Eliminate r from IS&LM by solving them together) Y = 170 + 0.6(Y T) +100 4r + G

Y = 270 + 0.6Y 0.6T 4r + G 0.4Y = 270 0.6T 4r + G Y = 675 3/2T 10r + 5/2G b. M/P = 0.75Y 6r 0.75Y = M/P + 6r Y = 4/3M/P + 8r 675 3/2T 10r + 5/2G = 4/3M/P + 8r 675 300 + 875 - 980 = 18r 270 = 18r r = 15 and Y = 980 + 8*15 = 1100 M/P - 0.75Y = 6r => 1/6M/P-0.75/6Y Y = 675 3/2T 10*(1/6M/P-0.75/6Y) + 5/2G

c.

d.

Then solve for Y.

4.

Mankiw, problem 1, page 327

There is typo in this box. Output increases and T increases by the same amount. This means that disposable income Y-T stays same. It does not fall. Please keep this in mind.

5.

Mankiw, problem 4, page 328