Problem Set 3 Solution

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ECON112 Macroeconomics Problem Set 3 *Solution* Fall 2010 (Instructor: Li, Yao; TA: Fok Pik Lin, Astor) -----------------------------------------------------------------------------------------------------------------------------------Posted: Monday, November 1, 2010 Due: 5:30 PM Monday, November 8, 2010 40 marks total

Part I: True/False/Uncertain Please justify your answer with a short argument for each question and draw a diagram if necessary. (15 marks, 3 marks each: 1 mark for correct judgment and 2 marks for correct argument)

1. Suppose that workers in the Republic of Communia are highly unionized, while workers in the Republic of Individuela are not. In all other respects, the two countries are exactly the same. Then Communia is likely to have a higher natural level of output than Individuela. False. In our model of the labor market, the level of unionization is captured by the

Communia is likely to have a higher natural rate of unemployment than Individuela. Hence Communia is likely to have a lower natural level of output than Individuela.

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2. Suppose there is a decrease in the price level from P to P’. Given the stock of nominal money, M, this leads to an increase in the real money stock, M/P, which shifts the LM curve down. This implies that the AD curve shifts to the right.

3. When output is below the natural level of output, the actual price level is lower than the expected price level. True. The actual price level equals the expected price level when output is equal to the natural level of output. Because the AS curve is upward-sloping, if output is below its natural level, the actual price level is lower than expected. See diagram:

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4. In terms of changing output, monetary policy is relatively more effective when the AS curve is relatively flat, while fiscal policy is more effective when the AS curve is relatively steep. False. Monetary and fiscal policies affect the AD curve, not the AS curve. Monetary and fiscal policies...
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