Macroeconomics Papers IS LM model
Universitat Pompeu Fabra
Introducción a la Macroeconomía
r
Problem Set 6
IS
r0
1. Consider the effects of a decline in consumers’ confidence, that is, more pessimistic
expectations of future income. Is this a demand shock or a supply shock?r1
A demand shock (it affects C)
LM
a
b
1.1 First, look at the short-run effects (assuming that expectations of the price level Pe have not
changed). Show what happens in the AS-AD graph, indicating the new short-run equilibrium.
Y
Y
Show the short-run changes also in the IS-LM graph. Explain briefly what happens to all the
n
1
macro variables (and why): output, price level, interest rates, consumption, investment,
employment, nominal and real wages.
P
AD
AS
Pe
P1
b
Y1
a
Yn
Y
Error: Reference source not foundError: Reference
source not found
↓consumers confidence → ↓C for given Y → ↓goods demand for given r, that is IS shifts to the
left → ↓aggregate demand for given P, that is AD shifts to the left (expectation of price level Pe
Y
has not changed, so AS has not moved) → from a to b: ↓Y to Y1, ↓P to P1 (so rLM shifts down
ISa
bit, since ↓P→↑M/P); C is lower (both because of pessimistic expectations and lower Y); r is
lower, but current Y and expected future Y are also lower, so investment I not sure; employment
N is lower; nominal wages w are a bit lower (higher unemployment, lower r0
workers’ bargaining a
power), the real wage w/P is the same (if the PS is horizontal – P has decreased in proportion to
r1
b
w)
r2graph when price
1.2 Then, look at the medium-run effects. Show what happens in the AS-AD
c
level expectations are revised, indicating the final medium-run equilibrium. Show it also in the
IS-LM graph. Compare the final levels with the initial ones for all the macro variables: output, Y
Y
price level, interest rates, consumption, investment, employment, nominal and real wages.1
n
Explain briefly the adjustment process.
P
P0
P1
AD
AS
a
b
P2=
Pe
c
Y1
Yn
Y
Error: Reference source not foundError: Reference
source not found
Expectation of price level Pe is revised, now lower, so AS shifts down → from b to c: nominal
wages w decrease more (because of lower Pe), so ↓P to P2 and Y goes back to its natural level
Yn ; LM shifts down because ↓P, so ↓r → ↑I→ ↑goods demand back to Yn ; C is higher than in b
(for the recovery of Y), but not as high as it was in a (since consumers’ expectations of future
income are lower); I is higher and makes up for the lower C; employment N is back to its natural
level and the real wage w/P is the same (w and P have decreased in the same proportion).
Y
2. Consider an economy with the following price-setting relation:
P = (1+μ) w/A
where prices are set with a mark-up μ over the marginal cost of production w/A. A is a parameter
indicating the level of productivity: in the usual case it is equal to 1; an increase in productivity
means A>1, so firms’ marginal costs for the same wage are lower.
Now suppose that the economy experiences an increase in labor productivity A (due to a
technological or organizational improvement). Is this a demand shock or a supply shock?
A supply shock (it affects production costs, so the price-setting relation; and the production
function – the relation between output and labor employed)
2.1 First, look at the short-run effects (assuming that expectations of the price level Pe have not
changed). Show what happens in the AS-AD graph, indicating the new short-run equilibrium.
Show the short-run changes also in the IS-LM graph and in the labor market. Explain briefly
what happens to all the macro variables (and why): output, price level, interest rates,
consumption, investment, employment, nominal and real wages.
Price-setting relation P = (1+μ) w/A → w/P = A/(1+μ)
↑productivity A → ↓production costs → ↓P for given w → ↑w/P (PS shifts up) → ↑Nn (natural
level of employment), ↓un (natural level of unemployment) → ↑Yn (natural level of output) both
because of ↑Nn and of ↑A (labor more productive)
For the same expected price level Pe, the AS curve shifts down (lower costs → lower P at any Y),
as the natural level of output shifts to the right (to Y′n). Short-run movement from a to b: ↑Y to
Y1, ↓P to P1 (so LM shifts down, since ↓P→↑M/P); C is higher; ↓r → ↑I ; employment N is
higher (N1), but not as much as the new natural level N′n (price expectations have not changed
and nominal wages are too high); nominal wages w are a bit higher (lower unemployment,
higher workers’ bargaining power), the real wage w/P has increased (↑w and ↓P).
w/
P
(P
Introducción a la Macroeconomía
r
Problem Set 6
IS
r0
1. Consider the effects of a decline in consumers’ confidence, that is, more pessimistic
expectations of future income. Is this a demand shock or a supply shock?r1
A demand shock (it affects C)
LM
a
b
1.1 First, look at the short-run effects (assuming that expectations of the price level Pe have not
changed). Show what happens in the AS-AD graph, indicating the new short-run equilibrium.
Y
Y
Show the short-run changes also in the IS-LM graph. Explain briefly what happens to all the
n
1
macro variables (and why): output, price level, interest rates, consumption, investment,
employment, nominal and real wages.
P
AD
AS
Pe
P1
b
Y1
a
Yn
Y
Error: Reference source not foundError: Reference
source not found
↓consumers confidence → ↓C for given Y → ↓goods demand for given r, that is IS shifts to the
left → ↓aggregate demand for given P, that is AD shifts to the left (expectation of price level Pe
Y
has not changed, so AS has not moved) → from a to b: ↓Y to Y1, ↓P to P1 (so rLM shifts down
ISa
bit, since ↓P→↑M/P); C is lower (both because of pessimistic expectations and lower Y); r is
lower, but current Y and expected future Y are also lower, so investment I not sure; employment
N is lower; nominal wages w are a bit lower (higher unemployment, lower r0
workers’ bargaining a
power), the real wage w/P is the same (if the PS is horizontal – P has decreased in proportion to
r1
b
w)
r2graph when price
1.2 Then, look at the medium-run effects. Show what happens in the AS-AD
c
level expectations are revised, indicating the final medium-run equilibrium. Show it also in the
IS-LM graph. Compare the final levels with the initial ones for all the macro variables: output, Y
Y
price level, interest rates, consumption, investment, employment, nominal and real wages.1
n
Explain briefly the adjustment process.
P
P0
P1
AD
AS
a
b
P2=
Pe
c
Y1
Yn
Y
Error: Reference source not foundError: Reference
source not found
Expectation of price level Pe is revised, now lower, so AS shifts down → from b to c: nominal
wages w decrease more (because of lower Pe), so ↓P to P2 and Y goes back to its natural level
Yn ; LM shifts down because ↓P, so ↓r → ↑I→ ↑goods demand back to Yn ; C is higher than in b
(for the recovery of Y), but not as high as it was in a (since consumers’ expectations of future
income are lower); I is higher and makes up for the lower C; employment N is back to its natural
level and the real wage w/P is the same (w and P have decreased in the same proportion).
Y
2. Consider an economy with the following price-setting relation:
P = (1+μ) w/A
where prices are set with a mark-up μ over the marginal cost of production w/A. A is a parameter
indicating the level of productivity: in the usual case it is equal to 1; an increase in productivity
means A>1, so firms’ marginal costs for the same wage are lower.
Now suppose that the economy experiences an increase in labor productivity A (due to a
technological or organizational improvement). Is this a demand shock or a supply shock?
A supply shock (it affects production costs, so the price-setting relation; and the production
function – the relation between output and labor employed)
2.1 First, look at the short-run effects (assuming that expectations of the price level Pe have not
changed). Show what happens in the AS-AD graph, indicating the new short-run equilibrium.
Show the short-run changes also in the IS-LM graph and in the labor market. Explain briefly
what happens to all the macro variables (and why): output, price level, interest rates,
consumption, investment, employment, nominal and real wages.
Price-setting relation P = (1+μ) w/A → w/P = A/(1+μ)
↑productivity A → ↓production costs → ↓P for given w → ↑w/P (PS shifts up) → ↑Nn (natural
level of employment), ↓un (natural level of unemployment) → ↑Yn (natural level of output) both
because of ↑Nn and of ↑A (labor more productive)
For the same expected price level Pe, the AS curve shifts down (lower costs → lower P at any Y),
as the natural level of output shifts to the right (to Y′n). Short-run movement from a to b: ↑Y to
Y1, ↓P to P1 (so LM shifts down, since ↓P→↑M/P); C is higher; ↓r → ↑I ; employment N is
higher (N1), but not as much as the new natural level N′n (price expectations have not changed
and nominal wages are too high); nominal wages w are a bit higher (lower unemployment,
higher workers’ bargaining power), the real wage w/P has increased (↑w and ↓P).
w/
P
(P