Economics 359 Assignment #1 Your future employer will judge a response to her questions as being acceptable

University of Calgary

Department of Economics

Economics 359

R. Kneebone Assignment #1 Due: October 17, 2013 (at beginning of class)

Hints for Getting Good Grades on Assignments, Tests and Exams:

(a) Your future employer will judge a response to her questions as being acceptable only if it is concise, well-organized and well-explained. To get you use to that fact, I will judge responses

to my questions as being acceptable only if they are concise, well-organized and well-

explained.

(b) Economists use models to clarify arguments and highlight important assumptions. Unless you are told otherwise, you should answer questions in the context of economic models.

(c) You will often be asked, or simply find it useful, to use a diagram to prove or illustrate your answer. Keep in mind that a diagram presented without an explanation of shifts and movements

in the diagram will receive no marks. Similarly, should you use mathematical manipulations to

answer a question you must show and explain each step in your derivation.

Question One: (10 marks)

The sticky-wage and the worker-misperception models of aggregate supply both suggest an upward

sloping short-run aggregate supply (SRAS) curve. The SRAS curve will be steeper under one of

these theories than it will be under the other. Which is it? Prove your answer by deriving the SRAS

curve implied by each of these theories. Explain all shifts and movements in your diagram(s).

Question Two: (10 marks)

Consider an economy which can be reasonably described by an IS/LM model. Assume the

economy is in equilibrium and assume that the interest rate (r) and the level of real income (Y) are

endogenous variables. Finally, assume the IS and LM curves have the usual slopes. Now suppose

the government of this economy announces it plans to reduce the level of government spending (G).

You are an economist working for a large corporation. The president of the corporation asks you to

provide an economic forecast detailing the effect the government's forthcoming policy will have on

the economy. With the aid of an IS/LM diagram, describe the resulting disequilibrium (what

markets are out of equilibrium and what is the nature of this disequilibrium) and the economic

forces at work moving these markets back into equilibrium. Your answer should include a

description of what would we expect to happen to inventory investment, the price of bonds, the

interest rate, the level of investment, and the level of real income.

2

Question Three: (20 marks)

Both the sticky-wage and worker-misperception models of aggregate supply make an assumption

that results in a vertical long-run aggregate supply curve (vertical when graphed in P, Y space).

That is, they both assume that in the long-run, when misperceptions have been resolved and the

nominal contracts that produce wage and price stickiness have been renegotiated, labour demand

and labour supply curves adjust in such a way that employment returns to its natural level.

This assumption implies that, should the price level (P) increase, then in the long-run the nominal

wage (W) will increase too. In fact, W will increase by the same amount as P and in this way keep

the real wage (W/P) constant. This seems like a sensible story. However, think about what is

assumed to happen should the price level fall. The assumption is that in the long-run the nominal

wage (W) will fall too. The nominal wage will fall by the same amount as the price level and in this

way the real wage (W/P) will be unaffected. The vertical long-run AS curve thus results from an

assumption that the nominal wage is, in the long-run, perfectly flexible both up and down.

Many economists question whether in fact nominal wages will adjust downward in response to a

fall in the price level. After all, this requires people to take a pay cut and there might be a strong

aversion to doing so. These economists suggest that in fact, nominal wages are downward rigid in

the sense that although prices might fall, nominal wages will not, even in the long-run.

Using an appropriate number of well-labeled and carefully drawn diagrams, derive the LRAS curve

relevant for the case where nominal wages are downward rigid but upward flexible. Explain each

step in your derivation.

***