Econ 302
Fall 2006
C. Engel
Answers to Homework #7
2. a. The aggregate demand curve shifts down to the left:
b. In the short run, output falls and the price stays constant.
In the long run, the price level falls and output is back to the full-employment
level.
c. In the short run, for every 1 percentage point drop in the annual growth rate of
output, the unemployment rate rises by 0.5 percentage points. (That is, a 1 percentage point
increase in the unemployment rate goes along with a two percentage point drop in annual output
growth.)
d. In the short run, because output falls, then total saving falls. (The model of
Chapter 3 assumed saving is related to income or output.) This is a decline in the supply of
loanable funds. According to the model of Chapter 3 (see Figure 3-9), this leads to an increase in
the real interest rate.
In the long run, output is back to its full employment level, so saving returns to its
initial level, and the real interest rate falls back to its initial level.
3. a. A decrease in the velocity of money shifts the aggregate demand curve to the
right. Without any change in Fed monetary policy, output rises in the short run, but then prices
would rise over time.
Fed A, which wants to keep the price level stable, would do nothing the moment that
velocity falls, since prices do not change in the short run. But as there is pressure for prices to
begin to rise, Fed A would begin to reduce the money supply, and shift the aggregate demand
curve back to the left. They reduce the money supply gradually over time to offset the pressure
for prices to increase.
Fed B does not want output to rise. The decline in velocity would tend to increase
aggregate demand and output in the short run. Fed B immediately decreases the money supply
so much that it offsets the decline in velocity. They keep MV constant, and the aggregate
demand curve does not shift.
b. When there is a temporary increase in the price of oil, the price level shifts up (the
SRAS shifts up.) Output falls in the short run. If the Fed does nothing, then over time, as the
price of oil declines, prices fall, and the economy returns to its initial price level and to the full-
employment level of output.
Fed A does not want the price level to rise. But with a supply shock, it cannot prevent
the short run increase in the price level. It can keep the money supply constant, and let prices
adjust downward to their initial level.
Fed B, which does not want output to change, immediately increases aggregate demand
in response to the increase in oil prices, as in Figure 9-15.