ECON5002 Tutorial 6
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ECON5002
Tutorial 6 (The AS-AD Model)
1. Suppose the interest rate has no effect on investment.
(a) Can you think of a situation where this may happen?
(b) What does this imply for the slope of the IS curve?
(c) What does this imply for the slope of the LM curve? unemployment? Explain the logic behind your answer.
(d) What does this imply for the slope of the AD curve?
2. Consider the following model of the economy (we ignore the role of G and T on aggregate demand; also, to simplify the algebra, we assume that output depends on the interest rate only):
AS: Pt = Pte + d(Yt − Yn)
IS: Yt = b − cit
Interest rate rule: it = in + a(Pt − PT)
where a, b, c, and d, are positive parameters.
(a) What is the AD relation in this economy?
(b) What are the medium-run values of P , Y and i?
Suppose PT = 1 and Yn = 100.
(c) What is the medium-run equilibrium value of the interest rate? Now assume Pte = Pt − 1 .
(d) Substitute the short-run equilibrium for Yt from the AD relation into the right-hand side of the AS relation. Write this as a relation between Pt and Pt − 1 . This is a difference equation. Show that the coefficient on Pt − 1 is less than 1.
Assume a = 1.25, b = 101, c = 0.1 and d = 2.
(e) Put these values into dynamic relation (difference equation) for the price level that you got in part (d).
(f) If the economy begins at time 0 with a value of P0 = 0.5, show that output begins at a value different from the natural rate. Using your difference equation for prices, show how the price will increase through time towards the price target. Explain in words.
3. Assume that the economy starts at the natural level of output. Now suppose there is a decline in business confidence, so that investment demand falls for any interest rate.
(a) In an AS–AD diagram, show what happens to output and the price level in the short run and the medium run.
(b) What happens to the unemployment rate in the short run? In the medium run?
Suppose that the RBA decides to respond immediately to the decline in business confidence in the short run. In particular, suppose that the RBA wants to prevent the unemployment rate from changing in the short run after the decline in business confidence.
(c) What should the RBA do? Show how the RBA’s action, combined with decline in business confidence, affects the AS–AD diagram in the short and medium run.
(d) How do short-run output and the short-run price level compare to your answers from part (a)?
(e) How do the short-run and medium-run unemployment rates compare to your answers from part (b)?
2022-09-21
The AS-AD Model