This document contains 4 problems from a macroeconomics tutorial relating to Blanchard chapters 6 and 7 on price and wage setting models. Problem 1 asks students to discuss the fallacies in arguments that a lower price level can stimulate economic activity in a closed economy. Problem 2 involves deriving the AD curve from the IS-LM model and explaining why the AD and AS curves are downward and upward sloping respectively. Problem 3 analyzes the effects of increased competition lowering markups in a PS-WS model. Problem 4 asks students to use the WS-PS-AD-AS model to assess the short and medium-run effects of reducing unemployment benefits.

1. Department of Economics Macroeconomics
BSc(B)/HA, 2nd semester, Spring 2010
To be discussed at the 4th tutorial
Relates mainly to Blanchard chapters 6 and 7
Problem set 4
Problem 1 (chapter 6 and 7)
Even after having read Blanchard most students appear to find it completely self-evident that
a lower price level in a closed economy cannot but stimulate economic activity. It appeared to
be taken for granted, for instance, by a huge majority of the students attending the recent
exam in Macroeconomics, Part 2, that took place in January 2009.
When asked the question
Discuss how such a disinflation [= declining inflation] contributes towards stimulating aggregate
demand (thus making unemployment decline …)
most of them argued along the following lines:
(1) lower inflation (lower rate of change of the price level) => lower price level=> higher
“purchasing power” (~ real income) => higher real demand (Z) => higher equilibrium
output => lower unemployment
or, somewhat similarly,
(2) lower inflation (lower rate of change of the price level) => lower price level=> higher
real wage (W/P) => higher real demand (Z) => higher equilibrium output =>lower
unemployment
-------------------------------------
Please discuss the fallacies embedded in each of these “causal chains”
Problem 2 (chapters 7 and 5)
1) Derive the AD-curve from the IS-LM-model, using diagrams and/or algebra
2) Repeat – but now just in words – why the AD curve is negatively sloped
3) All students know, seemingly, that the AS curve is upward sloping. Experience shows,
however, that only a minority are able to explain why this is so. Therefore: Explain,
carefully, why the AS-curve (in Blanchard) is upward sloping
4) Along a certain AS curve, the expected price level Pe is given. What happens to a given
AS curve if, for some reason, the expected price level goes up by, say, 12%? Be sure
you understand the mechanism(s) behind your answer
5) Where, along a given AS curve, will the actual price level P be equal to the (given)
expected price level Pe?
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2. Problem 3 (chapters 6 and 7)
This problem appeared as Problem 2 in the paper set at the winterexamination 1999/2000
(BSc(B), Part 2) and was assigned the weight 1/3:
Years ago the chairmen (“vismændene”) of the Danish Economic Council wrote that
"there is a lack of efficient competition in parts of the economy where a number of sectors are
characterised by high prices and an extra-normal profit [...]. It is, therefore, necessary that
structural adjustments be made on the goods market." (Danish Economy - Autumn 1995, p.157)
In order to illustrate the beneficial effects to society of an increased degree of competition,
this report also included a calculation of how a reduction of the firms’ mark up would
influence a series of macroeconomic variables.
These analyses of the Economic Advisors are based on a macroeconomic model which
contains a specification of the price and wage setting which is similar to Blanchard’s PS-WS
model.
Let us assume that the wage and price setting relations can be described as:
PS : W  1 
P
1
WS: We  F u, z 
P
1) Briefly explain the economic contents in the two relations
Assume that antitrust legislation is enforced more vigorously so that the competition on the
goods market increases. In the PS-WS model this can be modelled as a reduction of the mark
up factor, 
2) Analyse and explain the effects this has on the natural rate of unemployment, the natural
level of production and real wages
3) Show and explain the adjustment to the new medium-run equilibrium in an AS-AD
graph
Problem 4 (chapters 7 and 6)
Use the WS-PS-and-AD-AS model to assess the short-run and medium-run consequences of a
reduction in unemployment benefits
caution!: this is not quite as simple as the analysis of, for instance, fiscal or monetary
policy. Why not? Because here we are once more considering a shock which does not,
according to chapter 6, leave uN and hence YN unaffected
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