Iowa State University

Department of Economics

Intermediate Macroeconomics

Fall 2006 Problem Set #4 Alexander

This problem set is due on Tuesday, December 5

1. Using IS/LM, the money market, and AD/AS, describe and graphically depict the effect of an increase in the marginal tax rate on the level of output, the interest rate, and the price level in the short-run (1 period) and the long-run.

We start at A in all three quadrants. The increase in t → ↓YD → ↓C → ↓TE → ↓Y: IS pivots left, AD shifts left. As output falls, costs of production for businesses decline, so they lower their prices. The decrease in their prices causes a decrease in the Price level (P). As P↓, M/P rises. This causes a ↓i → ↑I → ↑TE → ↑Y → ↑L → ↑i (soto↓i). The economy gets to point C in the first period. At the end of the period, workers renegotiate their wage contracts. They observe two things: ↓P and ↑u. Both of these cause workers to accept lower wages, so factor costs decline, so the AS shifts right. This process of wage renegotiation leading to decreased factor costs persists for many periods until workers expectations about the price level are consistent with business price setting behavior (i.e., what workers expect in terms of the price level is exactly what the price level ends up being): this occurs at Z, when the economy gets back to Y_F. The overall effect of this change in t is to cause no change in Y, a decrease in P and a decrease in i.

2. Using IS/LM, the money market, and AD/AS, describe and graphically depict the effect of a decrease in the money supply on the level of output, the interest rate, and the price level in the short-run (1 period) and the long-run.

We start at A in all three quadrants. The decrease in M causes an ↑i → ↓I → ↓TE →↓Y →↓L→↓i (soto↑i), LM shifts left, AD shifts left. As output falls, costs of production for businesses decline, so they lower their prices. The decrease in their prices causes a decrease in the Price level (P). As P↓, M/P rises. This causes a ↓i → ↑I → ↑TE → ↑Y → ↑L → ↑i (soto↓i). The economy gets to point C in the first period. At the end of the period, workers renegotiate their wage contracts. They observe two things: ↓P and ↑u. Both of these cause workers to accept lower wages, so factor costs decline, so the AS shifts right. This process of wage renegotiation leading to decreased factor costs persists for many periods until workers expectations about the price level are consistent with business price setting behavior (i.e., what workers expect in terms of the price level is exactly what the price level ends up being): this occurs at Z, when the economy gets back to Y_F. The overall effect of this change in M is to cause no change in Y, a decrease in P and no change in i.