Inflation and Aggregate Demand Curve Essay

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CH14, Problem 1 –
(a) Given that the interest rate has been 4 percent for the last ten quarters, then for IS curve I, real
GDP equals 8,800 − 25(4) − 25(4) − 25(4) − 25(4) − 20(4) − 20(4) − 20(4) − 15(4) − 15(4) −
10(4) = 8,000. For IS curve II, real GDP equals 8,400 − 5(4) − 5(4) − 5(4) − 5(4) − 10(4) −
15(4) − 15(4) − 15(4) − 20(4) = 8,000.
(b) For IS curve I, real GDP in the first quarter equals 8,800 − 25(3) − 25(4) − 25(4) − 25(4) −
20(4) − 20(4) − 20(4) − 15(4) − 15(4) − 10(4) = 8,025. Using the same IS curve, it is easy to show that for quarters two through ten, real GDP equals 8,050, 8,075, 8,100, 8,120, 8,140,
8,160, 8,175, 8,190, and 8,200, respectively. For IS curve II, real GDP in the first quarter equals
8,400 − 5(3) − 5(4) − 5(4) − 5(4) − 5(4) − 10(4) − 15(4) − 15(4) − 15(4) − 20(4) = 8,005. Using the same IS curve, it is easy to show that for quarters two through ten, real GDP equals 8,010,
8,015, 8,020, 8,025, 8,035, 8,050, 8,065, 8,080, and 8,100, respectively.
(c) Real GDP increases by 200 billion for IS curve I. The increase in real GDP for IS curve II equals
100 billion.
(d) For IS curve I, it takes four quarters, or twelve months, for real GDP to increase by 100 billion or one-half of the total increase in real GDP. For IS curve II, it takes seven quarters, or twentyone months, for real GDP to increase by 50 billion or one-half of the total increase in real GDP.
(e) IS curve I resembles the economy’s response prior to 1991. The increase in output in response to a decline in the interest rate is larger than for IS curve II and one-half of the total increase in output occurs much sooner with IS curve I as compared to IS curve II. IS curve II resembles the economy’s response to a change in the interest rate since 1991.
The reasons why IS curve I resembles the economy’s response prior to 1991 is that its interest rate parameters for the first six quarters are larger than those of IS curve II, and it is only for that last quarter that IS curve I has a smaller interest rate parameter than that of IS curve II. These parameters reflect the fact that since 1991, the monetary policy effectiveness lag has been longer and the interest-rate multiplier has been smaller.
(f) The answers to Parts b through d indicate that for IS curve II, real GDP rises less than it does for
IS curve I during any of the first seven time periods, for any given increase in the interest rate.
Therefore, the changes in the policy effectiveness lag and the interest-rate multipliers mean that monetary policymakers now have to change interest rates more in response to a given demand shock than they did previously.

CH17, Problem 3
(a) If the decline in the real exchange rate is only temporary, so that the aggregate demand curve returns to its original level, then given no change in the nominal money supply, the economy is long-run equilibrium when the expected price level and the actual price level at 1.0. On the other hand, if monetary policymakers change the nominal money supply so as to maintain a price level equal to 1.2 when aggregate demand returns to its original level, then they must change the nominal money supply to Ms′so that 12,000 = 9,000 + Ms′/1.2 or Ms′/1.2 =12,000 − 9,000 or Ms′ =1.20(3,000)
= 3,600. That is, monetary policymakers would have to increase the nominal money supply to 3,600 to keep the price level and expected price level equal to 1.2.

(b) If monetary policymakers do nothing in the sense of not changing the nominal money supply, then expected and actual price level rise if the decline in the real exchange rate persists. The reason both price levels rise is that firms and workers know it takes a higher price level to offset the increase in aggregate demand caused by the decline in the real exchange rate, given that they expect monetary policymakers to take no steps to offset that increase in aggregate demand. On the other hand, If firms and workers know that the decline in the real exchange rate is
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