ECON 4710 Aggregate Economic Analysis

Instructor: Fang Yang

Homework Assignment 6
Answer Key
1. (20 points) A firm believes that the relationship between the real wage it pays and the effort exerted by its
workers is given by the following table.

(a.) (15 points) If the firm can pay only one of the 4 real wage levels shown in the table, what real wage
will it pay? How many workers will it employ?
Real Wage Effort (E) E/W
10 20 2
11 25 2.27
12 27 2.25
13 29 2.23

The firm will pay a real wage of 11, since that is the real wage that maximizes E/W.

At a real wage of 11, the effort level will be 25, so the marginal product of labor will be

MPN = 25(100 – N)/10 = (100 – N)*2.5

Setting w = MPN gives 11 = (100 – N)*2.5 which can be solved for N = 95.6.

(b) (5 points) Suppose that a big influx of workers enters the town, willing to work at a real wage of 10. How
would that change your answer above?

It would not change the answer at all. It would not be cost efficient for firms to pay 10, because they would
actually be paying more per unit of effort.

2.(30 points, 15 points each) Use the Keynesian model to analyze the effects of each of the following events
on output, the real interest rate, employment and the price level in the short run and in the long run. Include
appropriate graphs (IS-LM-FE) in your answer.

(a) Expected inflation rises.

(b) Wealth increases.

Answer:
(a) Short run: An increase in the expected inflation will cause a downward shift in the LM
curve. This will cause output to increase. Employment N increases; r falls; P is unchanged.
To restore equilibrium, the price level must rise, shifting the LM curve to the left. Long run:
P rises; Y, r, and N are unchanged.
 FE
r LM1
LM0

LR

E0
r0
ES
rS

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(b) Short run: An increase in wealth will cause an upward shift in the IS curve. This will cause
output to increase beyond the full-employment level. r and N increase; P is unchanged. To
restore equilibrium, the price level must rise, shifting the LM curve to the left. Long run: r
and P rise; Y and N are unchanged.

FE LM1
r

E1 LM0
r1

rS ES

r0
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3. (35 points) A Keynesian economy is described by the following equations.

Cd = 250 + 0.5(Y – T) – 250r

Id = 275 – 250r

G = 300

T = 300

L = 0.5Y – 500r + πe

M = 3000

Y = 1300

πe = 0
(a) Calculate the values of the real interest rate, the price level, consumption, and investment for the
economy in general equilibrium. (15 points)
(b) Now suppose government purchases increase to 325 with no change in taxes. What will be the real
interest rate, the price level, output, consumption, and investment in the short run? What will be
the real interest rate, the price level, output, consumption, and investment in the long run? (10
points each)

Answer:
(a) Calculate the values of the real interest rate, the price level, consumption, and investment for the
economy in general equilibrium.
r = 0.05, P = 4.8, Y = 1300, C = 737.5, I = 287.5 (please change steps below)

Sd = 1300 – (250 +.5(1300 - 300) –250r) – 300

= 250 + 250r.

Id = 275 - 250r

Using goods market equilibrium condition set Sd = Id and solve for r:

250 + 250r = 275 - 250r or 500r = 25 or r =.05.

Substitute Y = 1300 and r = .10 into the consumption function to get C:

Cd = 250 + 0.5(1300 – 300) -250(.05) = 737.5.

Substitute r =.10 into the investment function to get I:

Id = 275– 250r = 275– 250(.05) = 262.5.

Set real money supply equal to real money demand to get P:

3000/P = (.5)(1300) – 500(.05) = 625, so P = 3000/625 = 4.8.

 (b) Now suppose government purchases increase to 325 with no change in taxes. What will be the real
interest rate, the price level, output, consumption, and investment in the short run?

Since this is a Keynesian model, the price level is fixed in the short run, but output can vary. The level
of output is given by the level of aggregate demand. So get the level of aggregate demand, we need
to solve the IS and LM curves simultaneously for Y and r.

IS Curve: Sd = Y – (250 +.5(Y - 300) –250r) – 325

= .5Y – 500 + 250r.

Id = 275 - 250r

Set desired saving equal to desired investment and solve for r.

.5Y – 425 + 250r = 275 - 250r, or 500r = 700 -.5Y.

LM Curve: 3000/4.8 = .5Y -500r, or 500r = -625 +.5Y.

Since the left-hand side if the IS equation is 500r and the left-hand side of the LM equation is 500r, we
can set the two right-hand sides equal to each other and solve for Y.

700 - .5Y = -625 +.5Y, or Y = 1325.

Substituting Y = 1325 into either the IS or the LM curve yields r = .075

Cd = 250 + 0.5(1325 – 300) -250(.075) = 743.75.

Substitute r =.2 into the investment function to get I:

Id = 275 – 250r = 275 – 250(.075) = 256.25.

Obviously, since P is fixed, P is still equal to 4.8.

(c). What will be the real interest rate, the price level, output, consumption, and investment in the long
run?

In the long-run Y = 1300.

Substituting Y = 1300 into the IS curve gives

500r = 700 –(.5)(1300) = 50, so r = .1.

For the price level, set real money supply equal to real money demand:

3000/P = (.5)(1300) – (500)(.1) and solve for P = 5.

C = 250 + .5(1300 – 300) – (250)(.1) = 725.

I = 275 – (250)(.1) = 250.

4. (15 points) You are the chairperson of the Board of Governors of the Federal Reserve. You believe
in a Keynesian model of the economy, and your goal is to keep the economy at the full-employment
level of output. How would you respond (tightening or easing policy) in each of the following
cases? Include appropriate graphs (IS-LM-FE) in your answer.

(a) Government purchases increase

Answer: An increase in government purchases will cause an upward shift in the IS curve. This will
cause output to increase beyond the full-employment level. In order to bring output back to the full-
employment level, the Federal Reserve should use a tightening policy. This will cause the LM curve
to shift upward, bringing output back to the full-employment level at a higher interest rate.

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r

E1 LM0
r1

rS ES

r0
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