ECON 3440 (Section M)
Summer 2024
Instructor: Sharif Khan
Active Learning Activities: ALA 4 -- Solutions
Due Date: August 2, 2024
[Note: Please PRINT (i.e., write in uppercase letters) your
name and sign below]
Last Name First Name Signature
Answer all of the following FIVE questions in the space provided after each question.
Question 1
“If prices and wages are perfectly flexible, then γ = 0 and changes in aggregate demand have a smaller
effect on output.” Is this statement true, false, or uncertain? Explain your answer.
False.
As prices and wages become more flexible, γ becomes larger, and the short-run aggregate supply curve
becomes steeper. (In the limit, with perfect flexibility, γ approaches infinity.) Thus, for a given aggregate
demand shock, as the short-run aggregate supply curve becomes steeper the effects on output are smaller.
Question 2
Using an aggregate demand and supply graph, show and describe the effects in both the short run and
the long run of the following:
a. A temporary negative supply shock
With a temporary negative supply shock, the short-run aggregate supply curve shifts up. In the short run,
output falls and inflation rises. This creates slack in the labour market, which puts downward pressure
on the inflation rate. As labour market slack continues and inflation expectations fall, the short-run
aggregate supply curve shifts back down. Over time, the inflation rate falls and output rises until the
economy returns to the long-run equilibrium.
b. A permanent negative supply shock
With a permanent negative supply shock, the long-run aggregate supply curve shifts to the left. This
creates a condition in which output is now above potential output, and the labour market tightens. As
inflation and inflation expectations rise, the short-run aggregate supply curve shifts upward to the new
long-run equilibrium. Eventually, output is lower and inflation is higher at the new long-run equilibrium.
Question 3
For each of the following situations, describe how (if at all) the IS, MP, and AD curves are affected.
a. A decrease in financial frictions
The IS curve shifts to the right; the MP curve does not shift; the AD curve shifts to the right.
b. An increase in taxes and an autonomous easing of monetary policy
The increase in taxes shifts the IS curve to the left, and the easing of monetary policy moves the
economy along the IS curve; the tax change does not affect the MP curve, but the monetary policy
change shifts the MP curve down; the monetary policy easing shifts the AD curve to the right, while the
tax increase shifts the AD curve to the left; the net effect on the AD curve cannot be determined without
knowing the relative shifts due to the tax and monetary easing effects.
c. An increase in the current inflation rate
An increase in the current inflation rate represents a movement along the MP curve, which increases the
real interest rate; the increase in the real interest rate due to the higher inflation represents a movement
along the IS curve to lower output (but does not shift the IS curve); the increase in inflation represents a
movement along the AD curve, reducing output, and does not shift the AD curve.
d. A decrease in autonomous consumption
A decrease in autonomous consumption shifts the IS curve to the left; the MP curve does not shift; the
AD curve shifts to the left.
e. Firms become more optimistic about the future of the economy.
Autonomous investment increases, which shifts the IS curve to the right; the MP curve does not shift;
the AD curve shifts to the right.
f. The new Bank of Canada governor begins to care more about fighting inflation.
This represents an increase in , which does not affect the IS curve; the MP curve becomes steeper; the
slope of the AD curve becomes flatter.
Question 4
Read each part of the question very carefully. Show all steps of your calculations to get full marks. Keep at least
4 digits after the decimal point, if applicable, in each step of your calculations. Write down the formula that you
are using to find the answers to each part of this question.
Consider an economy described by the following:
C = $4 trillion
I = $1.5 trillion
G = $3.0 trillion
T = $3.0 trillion
NX = $1.0 trillion
f =0
mpc = 0.8
d = 0.35
x = 0.15
= 0.5
r =2
a. Derive expressions for the MP curve and the AD curve.
The MP curve is given as r = 2 + 0.5. The AD curve is given as Y = 30.5 – 1.25.
b. Calculate the real interest rate and aggregate output when = 2 and = 4.
When = 2 and = 4, the real interest rate is r = 3% and 4%. Aggregate output is 28 and 25.5,
respectively.
c. Draw a graph of the MP curve and the AD curve, labelling the points given in part (b).
Graphs are shown below.
Question 5
“Autonomous monetary policy is more effective at changing output when is higher.” Is this statement
true, false, or uncertain? Explain your answer.
False.
Since is independent of the autonomous component of monetary policy r, any change in r will affect the
real interest rate the same regardless of the value of . Thus, for a given IS curve, any change in autonomous
monetary policy will have the same impact on output, independent of the value for .
