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  wellexplained.
(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 man ipulations 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.
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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.
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