University of Michigan

Econ 102: Principles of Macroeconomics

Spring 2024
Instructor: Oleg Zamulin

Problem set 6
Suggested answers

1. Explain which curve will shift in each of the following cases in the aggregate demand –
aggregate supply diagram:
a. Inefficient business regulation makes employees spend an extra hour a day on filling out
new bureaucratic forms at work

Answer: LRAS shifts to the left because of fall in productivity

b. Increase in life expectancy prompts people to save more for retirement

Answer: Increase in saving means a drop in consumption, which causes AD to shift to the
left

c. Depletion of oil fields leads to an increase in world oil prices

Answer: SRAS shifts upward because of rising costs of production

d. The “Buy American” campaign makes people want to switch from foreign to US-made
products

Answer: Although this is a shift in preferences, AD goes up because this is an increase in

demand for US products. Consumption does not go up, but NX increases for each price
level.

e. The anti-global warming campaign prompts people to switch from gasoline to electric
cars

Answer: This is a change in preferences, nothing shifts

f. There is an influx of immigrants into the country

Answer: LRAS goes up, as labor force increases.

2. Suppose the economy is in the log-run equilibrium on the aggregate demand and aggerate
supply diagram
a. Is there unemployment at this point? Explain

Answer: Yes, there is frictional and structural unemployment. This corresponds to full
employment level of GDP
 b. Suppose the central bank wants to decrease the unemployment rate and raises the
money supply. Show what happens on the aggregate demand – aggregate supply
diagram immediately after this action

Answer: The AD curve shifts to the right and the economy now is at point 2, on the
intersection of the new AD with the old SRAS.

AS
ncrease in

S AS
A

c. Did the unemployment rate drop after this action? If so, where did extra workers come
from?

Answer: Yes, unemployment had to fall, as extra workers had to be hired to produce the
greater GDP. The extra workers came from the frictional and structural unemployment
above. For example, there could be unemployed because of the efficiency wages, now
firms are hiring them.

d. Describe what happens in the long run on this graph. What curve will shift next and
where will the graph eventually settle? Provide intuition

Answer: As economy operates above potential, workers demand higher wages and firms
eventually increase them. Prices have to be increased as well, so SRAS shifts up until the
new intersection of AD and SRAS happens precisely at the level of LRAS.

AS
ncrease in
rice
a ustment

S AS
A

3. Let us analyze the causes and consequences of the recent inflation spike in the US.
a. In 2021-22, inflation went up significantly in the US. The peak occurred in the summer of
2022, when 12-month CPI inflation exceeded 9%. First, demonstrate two possible
explanations for this inflation surge on the AS-AD graph:
i. Inflation surge is caused by increase in costs of production because of growth in
world commodity prices and prices of semiconductors
ii. Inflation surge is a consequence of a fiscal and monetary stimulus done during
the pandemic

Answer: If the inflation surge was caused by costs of production, this means a leftward
shift in SRAS. If it was cause by excessive stimulus, this means a rightward shift in AD. In
both cases prices go up in point 2.

ncrease in AS
AS costs

S mulus

S AS S AS
A
A

b. Suppose the Fed does nothing in response to this inflation surge, keeping money supply
unchanged. For each of the two explanations above, demonstrate on the graph what
happens to inflation next. How does your answer correspond to the view that inflation
spike was “transitory”?

Answer: In case this is a shift is SRAS, economy below potential, which makes wages fall
and SRAS will eventually shift back, so that the economy will return to point 1. If this is
an AD shift, then economy is above potential and wages will grow, shifting SRAS to the
left, and economy will end up at point 3. Thus, in the first case inflation will reverse
completely, while in the second, prices will grow to a new level and stay there. In both
cases inflation is transitory as long as there are no further shifts.
 urther price
ncrease in AS a ustment
costs S mulus
AS

rices
a ust
ask

S AS S AS
A
A

c. Now suppose that the surge in inflation generates additional inflation expectations for
the next years. How would this affect your answer to (b)?

Answer: In this case, SRAS will be shifting further out to the left. In the first graph, this
means that the economy will go further to the left than point 2, while in the second, this
means that SRAS will not stop at point 3 but instead will shift further and the economy
will end up below potential. This will mean a more severe recession and harsher
response from the Fed.

d. Now go back to (a) and suppose the Fed does want to respond to this inflation. What
would be the options and trade-offs for the Fed for each of the explanations for the
inflation spike? Show on the AS-AD diagram. Does a fight against inflation necessarily
imply a recession?

Answer: The only thing the Fed can do to fight inflation is decrease the money supply
(raise the interest rate) and thus shift the AD curve to the left. If it does so in response to
an increase in cost, this will mean making a recession even worse and creating extra
unemployment (point 3 on the left graph). This unemployment will cause downward
pressure on wages and counterbalance the original increase in cost. If this is done in
response to excessive stimulus, however, then the AD curve will simply be returned to
the original position (point 1 on the right graph) without any recession (in the sense of a
negative output gap).
 ncrease in AS
AS costs

S mulus

S AS

onetary
contrac on
S AS
A
onetary A
contrac on

4. For each of the following show what happens on the money market graph and on the AS-AD
graph for i) the case when the Fed controls the money supply and ii) for the case when it
controls the interest rate:

a. Traders on Wall Street flee to safe assets by selling stocks in exchange for cash

Answer: This means that the money demand curve shifts to the right. If the Fed fixes
money supply, then the interest rate will go up, and this will cause a reduction in
consumption and investment, so AD will shift to the left. If the Fed fixes the interest rate,
then it will have to shift the MS curve to the right on the money market graph, while
nothing will happen on the AS-AD graph.

i)

r
S AS

S AS
A

ii)

r
S AS

S AS
A
 b. Consumer sentiment drops and people start to buy less goods and services

Answer: This means that the AD curve shifts to the left and economy will go below
potential. Then the MD curve will also shift to the left, as the economy needs less money
for transactions. If the money supply is unchanged, this will lead to a drop of the interest
rate, which will dampen the effect on output. If the interest rate is fixed, then the Fed
will need to reduce the money supply in correspondence with the drop in money
demand, shifting MS to the left.

i)

r
AS
S

S AS
A

ii)

r
AS
S

S AS
A

5. Suppose that the central bank conducts its policy by adjusting the interest rate in accordance to
the Taylor rule r = 2.5% + 1.5(π – π*) + 0.5((Y – Y*)/Y*)×100%

a. Where does the coefficient 2.5% comes from?

Answer: This is the neutral rate, corresponding to economy at potential and inflation at
target level. The nominal neutral rate equals the long-run real rate determined in the
market for loanable funds (now believed to be 0.5% for short-term bonds) plus the
inflation target (now 2% in the US). This gives 2.5%
b. Suppose that the US economy is currently at potential, but we know that inflation is
now running at 3.5%, while the official target for inflation is π* = 2%. What should the
interest rate be now, according to the rule? How does this correspond to the actual
current Federal Funds Rate? Based on this finding, what do you expect the Fed to do
with the interest rate in the near future?

Answer: According to this rule, the needed rate is r = 2.5+1.5(3.5-2) + 0.5*0 = 4.75%. This
is somewhat below the current Federal Funds Rate target, which is 5.25-5.50, so we
should expect the Fed to start cutting the rate soon according to this rule.

c. Explain why, according to this rule, inflation caused by a surge in demand would call for
a bigger increase in the interest rate than identical inflation caused by increase in costs
of production. Use the AS-AD graph.

Answer: An increase in demand shifts AD to the right, causing (Y – Y*)/Y*>0 and (π – π*)
> 0. An increase in costs shifts SRAS to the left causing (Y – Y*)/Y*<0 and (π – π*) > 0. So
in the first case the output term will work to increase the interest rate yet further, while
in the second case it will work to reduce the needed hike.