ECON 102 Tutorial: Week 23

Ayesha Aliwww.lancaster.ac.uk/postgrad/alia10/econ102.html

a.ali11@lancaster.ac.ukoffice hours: 8:00AM – 8:50AM tuesdays LUMS C85

Today’s Outline

Week 23 worksheet – Revision of ISLM and Aggregate Demand/Aggregate Supply

Additional Slides at the end contain material from past exams – these might be helpful for your revision, so I’ve included them.

If you have not picked up Exam 3, you may pick up from my office.

Question 1 Consider a fall in the general level of prices from PA to PB, which results in a movement along an aggregate demand curve. Use the geometry of ISLM, the Liquidity Preference schedule and the Investment Demand schedule, to explain the increase in output from YA to YB.

1. With a fall in the general level of prices (P), real balances (M/P) rise.

By Keynes’s liquidity preference theory of interest rate determination, excess real balances force up bond prices so that interest rates fall.

2. & 3.This stimulates investment expenditure and real income (Y) rises.

4. From this, we can understand that the relationship between P and Y is an inverse relationship.

1. Liquidity Preference schedule 2. Investment Demand Schedule

3. IS-LM Model

4. Aggregate Demand Curve

Question 2 Now, let’s look at the impact on Aggregate Supply of an increase in money wages:

If money wages increase, that shifts AD to the right, so that output is at Q2.

If labour is not involuntarily unemployed (meaning if Q2 is not Q*), then the rise in the general level of prices will be countered by a rise money wages (the AS schedule swings upwards).

Question 3 What would be the locus of the Aggregate Supply schedule, if money wages and prices always changed by the same proportionate rate? The AS Schedule would be vertical at the point of: (i) ‘full-employment’ income/output; (ii) (ii) the ‘natural rate of unemployment’.

Question 4(a)Consider a shift to the right of the aggregate demand curve. What might happen to the general level of prices and to the level of employment?Prices or Employment or Both may increase, depending on the slope of the AS Curve.

only Prices ↑: only Employment ↑:

Both↑:

Which is more likely and when? Short-Run:

(AS is horizontal – a very deep recession)

Long-Run:– fiscal deficit spending increases the volume of bonds/currency in

circulation which is (potentially) inflationary.

Question 4(b)

only Prices ↑: only Employment ↑:

Both↑:

Both Output & Prices ↑ (when AS is upward-sloping)

Only Prices ↑

Only Output ↑

Question 4 ctd.

Consider a shift to the right of the aggregate demand curve.c) Explain the relevance of aggregate supply determined to your

answer to b).If, as retail prices begin the rise, there is no price/wage spiral,

then inflation is unlikely; but, by the experience of the UK in the 1970s, neither high unemployment nor ‘incomes policy’ inhibit a price/wages spiral.

d) Which variable remains constant along a given aggregate supply curve? Explain the relevance of that constancy.

Money wages stay constant in the AS curve. If we assume that money supply is constant then, this implies that if prices rise, in order to compensate either wages would go up or unemployment would go down. Additionally, if we assume that money wages stay constant then the rise in the general level of prices is assumed to NOT trigger a price/wage spiral.

Question 4(e)

How would you represent a price/wage spiral within the geometry of aggregate demand and aggregate supply?

Note: This is what we look at in Question 2, as well.

Question 5(a)

Which circumstances are represented by an Aggregate Supply schedule that is vertical?This is the Long-run equilibrium (LRAS), if we were at full employment or the natural rate of unemployment (Q = Q*).In this case, ‘expansionary’ macroeconomic policy generates inflation only.

Note: This is what we look at in Question 4(b).

Question 5(b)Which circumstances are represented by an Aggregate Supply schedule that is horizontal?This would occur in a deep recession or when there is excess capacity.Unit costs of production are unchanged as income/output rises

Note: This is what we look at in Question 4(b).

Question 5(c)Which circumstances are represented by an Aggregate Supply schedule that is upward sloping (left to right)?The case that Keynes addresses in TGT: ‘expansionary’ macroeconomic policy raises both output and unit costs which, passed on as higher prices, reduces real wages and eliminates involuntary unemployment.

Note: This is what we look at in Question 4(b).

Question 6 The following passage is from Keynes’s General Theory: ‘Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods, relative to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of unemployment.’ Using modern terminology and vocabulary, rewrite the passage and define words in bold.

Gerry’s re-write:a Suppose price inflation erodes the purchasing power of existing earnings. If the effect were to increase (beyond the current level of employment) both (1) the number of individuals willing to work at those earnings levels, and (2) the number of jobs that are available at those earnings levels, then involuntary unemployment could be said to exist.

b the price of wage-goods:‘cost of living’ the money-wage‘retail prices’; ‘earnings’

Question 7(a) Search the internet with the string Keynesian “fixed price model” then, in your own words, explain the essential assumption of such models The assumption of a Keynesian Fixed Price Model:

The impact of aggregate demand management policies is based on factors other than the general level of prices. (Gerry suggests that this assumption is highly dubious.)

Some points that Gerry makes: a model delivers results determined by its assumptions; all causation originates from exogenous changes (about which

we know nothing!)

Question 7(b) Comment on the plausibility of that assumption. By Keynes’s General Theory, an economy in recession should have no fear of inflation. However, once full employment is reached, inflation sets in. Two key passages are: ‘ .. an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment, and that employment will increase in exact proportion to any increase in effective demand brought about by an increase in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand’ (TGT: 295) ‘When a further increase in the quantity of effective demand produces no increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation’ (‘ .. an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment, and that unemployment will increase in exact proportion to any increase in effective demand brought about by an increase in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand’ (TGT: 303) Keynesians argue that short-term measures (i.e., raising public expenditure) to lift an economy from recession, no inflationary consequences because of spare productive capacity and unemployed labour. Their argument is that short-term solutions have no long-term adverse consequences: The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again. (Keynes 1923)‘Are we not told that ‘since in the long run we are all dead’, policy should be guided entirely by short-run considerations? I fear that these believers in the principle of après nous le déluge may get what they have bargained for sooner than they wish’ (Hayek, 1941)

Next Class

Last Class! Week 24 Worksheet

Practice Past Exam Questions

Please Note: Solutions are not given to tutors for these questions. The solutions I’ve prepared here are my best

guess – I cannot guarantee they are correct.

Note: View in slideshow mode for suggested solutions.

Fiscal monetarists argue that inflation is a consequence of excessive growth in:

a) revenue from taxation b) sovereign debt c) the money supply d) national output

2013 Exam Q36

As defined in Keynes’s General Theory, ‘involuntary unemployment’ relates to individuals whose employment prospects would be raised bya) a rise in the price of wage goods (i.e., a rise in

the cost of living)b) a fall in the price of wage goods (i.e., a fall in

the cost of living) c) greater trade union participation d) a shift to capital-intensive production methods

2013 Exam Q30

MPL

‘Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods (P2 > P1) relative to the money-wage (W), both the aggregate supply of labour willing to work (L2) for the current money-wage and the aggregate demand for it at that wage (E2) would be greater than the existing volume of employment (E1)’ (Keynes, 1936)

E1 L1

Labour Market:

W/P1

real wage (W/P)

2013 Exam Q30

Assuming national income is at the full employment level, which one of the following policies would be most likely to lead to inflation?a) A fall in taxation with unchanged

Government spending b) A reduction in investment by firms c) A fall in exports d) An increase in labour productivity with no

corresponding increase in wages

2014 Exam Q27

In the IS-LM model, a fall in the money supply will:

a) Shift the LM curve downwards b) Cause the interest rate to rise and so raise

investment c) Cause the interest rate to fall and so raise

investment d) Cause national income to fall and the interest

rate to rise

2014 Exam Q30

Causation is determined in Keynesian macroeconomic models by

a) consumers’ behaviour b) changes in exogenous variables c) investors’ behaviour d) changes in endogenous variables

2014 Exam Q40

Keynes’s analysis of the demand to hold money (i.e., ‘liquidity preference’) assumes that asset holders speculate in regard toa) the exchange rate b) prices of consumption goods c) prices of capital goods d) bond prices

2014 Exam Q34

Money illusion is people failing to distinguish between

a) Real and money wages b) Real and nominal interest rate c) Real and nominal money balances d) All of the above

2014 Exam Q33

Which aggregate demand curve indicates a situation of inflationary demand?

2014 Exam Q33

The diagram below refers to questions 31 and 32 and shows aggregate demand (D) curves and an aggregate supply curve (S) for an economy.

a)D1 b)D2 c) D3 d)D4

An increase in aggregate demand above D3 will lead to:

2014 Exam Q34

The diagram below shows aggregate demand (D) curves and an aggregate supply curve (S) for an economy.

a) More goods and services being produced

b) Fewer goods and services being produced

c) The same amount of goods and services being produced

d) It is impossible to tell