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MACROECONOMIC NOTES

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MACROECONOMIC NOTES
_____________________________________________________________________

By
Claremont Graduate University
Mustapha Akintona
Ahmed Oweis (Ph.D)

Abstract

By standards of economic efficiency which you will elaborate, what is wrong with
inflation? What is wrong with unemployment? What is the inter-relationship between
inflation and unemployment? Is there any important short-run versus long-run distinction
here? What can national economic policy do to solve these problems? Is the effect of such
policy sustainable? At each state of the argument, show what costs are associated with
what benefits.

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Notes on the circular flow of income

The Basic sectors in any economy are the household sector, the business sector,
the government sector, and the foreign sector (the rest of the world). To be more
accurate, a fifth sector should be added to this list, namely the financial sector
(financial markets).
The Circular Flow of Income:
Factors of Production (Labor, Land, Capital, Entrepreneurship)

Incomes (wages, rent, interest and profits

T
S G Business I
Household Government
Sector TR Sector
X
M

Spending on goods & services

Production of goods & services

 This diagram represents the basic relationships between the major sectors
in an economy.
 The inner flow is a “monetary flow”, while the outer flow is a “real flow”,
as money is not involved in this flow.
 Dividing this diagram horizontally into two parts, we can see the
exchanges that take place in two major markets. The upper part represents the
exchanges that take place in the input market (or factor market). Similarly, the
lower part represents transactions that take place in the goods market.
 This circular flow of income requires leakages (in the form of savings,
taxes, or imports) to be fully offset by injections (in the form of investment,
government expenditure, or exports).
 The government collects income taxes (T) from the households. These
taxes are used to make transfer payments (TR) and also to purchase goods and
services from the business sector. Remember, only government purchases are
included in the government expenditure (G). Transfer payments are usually

2
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subtracted from taxes to get net taxes. From now on, when we talk about taxes
we actually mean “net taxes”. Accordingly, we are not interested in TR
anymore. Moreover, we assume no indirect taxes (taxes are paid only by the
household sector).
 The “financial sector” is the intermediary that channels savings from the
households, who have surplus funds, to investors in the business sector, who
have shortage of funds.
 Allowing for exports (X) and imports (M) makes the economy an “open
economy”. The difference (X-M) is known as net exports (NX), which is
equivalent to the current account surplus (deficit) in the balance of payments.
From the balance of payment’s identity, it follows that the current account
surplus (deficit) must be equal to the capital account deficit (surplus).
 This simple circular flow enables us to define real GDP using three
different approaches (under some conventional assumptions, all three ways are
identical):
- Production approach: the GDP is the value of all measurable final goods
and services produced in the economy during a given period of time.
- Income approach: the GDP is the sum of all returns to factors of
production received during a given period of time. It is simply the sum of
wages, rents, interests, and profits.
- Expenditure approach: the GDP is equal to actual aggregate expenditure.
It could be calculated as the sum of actual consumption, actual
investment, actual government expenditure, and actual net exports.

3
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Notes on the Multiplier Effect

The basic idea of the multiplier effect is that a change in aggregate expenditure,
ceteris paribus, causes a greater change in aggregate income. More formally, a
change in aggregate expenditure by dE leads to a change in aggregate income
by dY, where dY > dE. This is primarily due to the fact that some proportion of
an increase in income is spent; i.e. MPC > 0.

 If MPC = 0, all “spending” multipliers will be equal to 1, and tax

multiplier will be equal to zero. Intuitively, this means that an increase in
expenditure will lead to exactly the same increase in income, while an
increase in taxes (a leakage) will be completely offset by an equal decrease
in saving (another leakage), which leaves the aggregate income unchanged.

 The higher the MPC, the higher the multiplier effect. On the extreme, if
MPC is equal to 1 (i.e. a given change in disposable income does not affect
savings), the resulting change in income due to a very small change in
expenditure is infinite.

 Let’s see how it works. Consider an initial increase in G by $100 (dG =

100). Suppose that MPC is 0.75 (c = 0.75).

 The initial increase in government purchases leads an immediate (and

direct) increase in aggregate income by $100. This is simply because this
$100 is now an increase in the income of the producers (and sellers) of the
goods and services for which the government paid $100. Let’s call this
group of producers (and sellers) group A.

 What do you think group A will use this money for? Right, 75% of it will
be spent on goods and services sold by another group of sellers, say group B,
and the remaining 25% will be saved. Following the same line of reasoning,
$75 [0.75 (100)] of new incomes are now created in the economy.

 Group B will do exactly the same thing. 75% of this $75 will be spent.
They are now new incomes for group C, and so forth. This process will
continue until the last change in aggregate income is equal to zero.

 We can calculate the “accumulated” change in aggregate income in this

process as follows:

dY = 100 + .75 (100) + (.75) (.75) 100 + (.75) (.75) (.75) 100 + ………..
dY = 100 [ 1 + .75 + (.75)2 + (.75)3 + ………………+ 0]

More generally,

4
 \

  i

dY  dG c  c  c  c  ........  c
0 1 2 3 
  1 
 dG  c   dG 
 i 0  1 c 
This is true for all |c| < 1.
Therefore,

dY 1

dG 1  c
This is the value of the spending multiplier in a closed economy with lump-sum
taxes.

Does the tax multiplier work differently in a closed economy?

I would say Yes and No. It follows the same basic idea under the same
simplifying assumptions (this is the “yes”), but its effect has an opposite
direction and a different magnitude (that’s the “no” !!). Let’s work it out.

 Consider a tax increase by $100 (paid by group A). Initially, this reduces
disposable income (Y-T) by $100. Here is a critical point: A change in Yd does
not affect the aggregate income directly; it affects it indirectly through its effect
on consumption!!

 Given that MPC = .75, a decrease in Yd by $100 will lead to a decrease in

consumption spending by $75. Remember, this means the incomes received by
group A will decrease by $75.

 In response to an increase in its (disposable) income by $75, group A is

expected to reduce its consumption by 75% of $75 (and to reduce its saving by
25% of $75). This means a decrease in the (disposable) income of group C by
.75 ($75) …. and so on.

Mathematically,

dY = – .75 (100) – (.75) (.75) 100 – (.75) (.75) (.75) 100 – ………..
dY = –100 [.75 + (.75)2 + (.75)3 + ………………+ 0]

More generally,

5
 \

  i

dY  dT c  c  c  ........  c
1 2 3 
  c 
 dT   c   dT 


 i1   1 c 
Again, this is true for all |c| < 1.
Therefore,

dY c

dT 1  c
This is the value of the tax multiplier in a closed economy with lump-sum taxes.

6
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The Simple Keynesian Model

(I) Consumption Function:

 Consumption function is a relation between consumption expenditure (C)
as the dependent variable, and disposable income (Yd) as the independent
variable.
 Disposable income (Yd): is the amount of income (Y) that is actually
available for consumers. The part of income that is not available for consumers is
taxes. Therefore,
Yd  Y  T
Yd  C  S
This means, consumption function is represented by:
C  f Yd 
Consumption function takes the following form:

C  c0  c1Yd
c0 is the autonomous consumption, which means the part of
consumption which does not depend on disposable income. The
value of c 0 is constant regardless of the value of disposable income.
c 0 is the value of consumption expenditure when Yd = zero.
Therefore, c 0 is the intercept of the consumption function.
c1 is the marginal propensity to consume (MPC), which is the change
in consumption expenditure due to a one-unit change in disposable
income. Therefore, c1 is the slope of the consumption function. That
is,
dC
MPC  c1  , 0  c1  1
dYd

c1 Yd is induced consumption, which is the part of consumption that

depends on disposable income.
(II) Saving Function:
We can derive the saving function as follows:
 As Yd  C  S , therefore:

7
 \

S  Yd  C ------------------------- (1)
 We know that:
C  c0  c1Yd ------------------------- (2)
 Therefore, we can substitute for C in equation (1) by its value in equation (2):
S  Yd  c0  c1Yd 
S  Yd  c0  c1Yd

S  c0  1 c1 Yd

This is the saving function, which shows that there is a positive relationship
between saving, as the dependent variable, and disposable income, as the
independent variable.
 c0 is the autonomous saving, which means the part of saving that does
not depend on disposable income. (  c 0 ) is the value of saving when
Yd = zero. This value is negative because despite the fact that Yd =
zero, there is some level of consumption expenditure ( c 0 ). (  c 0 ) is
the intercept of the saving function
(1  c1 ) is the “marginal propensity to save” (MPS), which is the change in
saving due to a one-unit change in disposable income. Therefore,
(1  c1 ) is the slope of the saving function. That is,

MPS  1  c1   , 0  1  c1   1
dS
dYd

(1  c1 )Yd is “induced saving”, which is the part of saving which depends on

disposable income.

Consumption and saving functions could be illustrated by the following figure:

8
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C, S
45o line (Yd =
C)
C

C = Yd
S=0
E

c0

Yd

- c0

On this graph:
 At any point on the 45o line, the value on the horizontal axis equals the value
on the vertical axis. Therefore, the 45o line enables us to measure disposable
income (Yd) on the vertical axis, as well as consumption and saving.
 Point E is known as the break-even point. At this point, all disposable income
is spent on consumption (C = Yd), which means that there is no saving (S = 0).
Point E is not an equilibrium point, it is just a break-even point.
 To the left of point E, C > Yd, which implies S < 0. Similarly, to the right of
point E, consumption expenditure is less than disposable income (C < Yd) ,
which means that saving is positive (S > 0).

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Multipliers in the IS-LM model

General Rules in deriving various multipliers:
1) Consumption function:
Use C = c (Y – T) if taxes are lump-sum. Otherwise,
Use C = c (Y – T(Y)) to derive the G-multiplier.
Use C = c (Y – tY) to derive the T-multiplier, where t is the tax rate (t = T').
 Note that you should not assume that taxes are lump-sum if the question
does not say that explicitly.
2) Investment function:
Use I = I (r) if the question says that investment is a function of interest rate.
Use I = I (r,Y) if the question says investment is a function of both income and
interest rate.
 Careful: never assume that I is exogenous in the IS-LM model. I may be
exogenous only in the simple Keynesian model.
3) Money demand function:
Always use: Md = k (Y) – l (r), where Md is real money demand.
 Always remember the “ceteris paribus” assumption.
- When you derive the G-multiplier, assume that dm = dT (or dt) = 0.
- When you derive the T-multiplier, assume that dm = dG = 0.
- When you derive the MP-multiplier, assume that dG = dT (or dt) = 0.
Deriving multipliers in the IS-LM model:
For the following, I’ll assume that taxes are proportional and investment in a
function of both income and interest rate. I’ll leave the easier cases of lump-sum
taxes and I = I (r) to you.

Government expenditure multiplier (Fiscal Policy multiplier)   :

dY
I.
 dG 

 IS equation: Y  cY  T Y   I r , Y   G
Totally Differentiating: dY  cdY  T dY   I r dr  I Y dY  dG
I I
where I r   0 and I Y   0.
r Y

10
 \

Rearranging: 1  c1  T   I Y dY  I r dr  dG -------------------- (1)

 m  k Y   l r 
M
 LM equation:
P
Totally differentiating: dm  k dY  l dr -------------------- (2)
Here, dm = 0. Therefore, 0  k dY  l dr
k
Rearranging: k dY  l dr  dr   dY -------------------- (3)
l
 Substituting for dr from (3) in (1):
 
1  c1  T   I Y dY  I r   k dY   dG
 l 
 Irk
1  c 1  T    I  dY  dG
l  
Y


dY 1
G - multiplier (or FP - multiplier)  
Irk
1  c1  T   I Y 
dG
l
Tax multiplier 
dY 
II. :
 Ydt 

 IS equation: Y  cY  tY   I r , Y   G
Totally Differentiating: dY  cdY  tdY  Ydt   I r dr  I Y dY  dG
Setting dG = 0 and rearranging:
1  c1  t   IY dY  cYdt  I r dr -------------------- (4)
 Substituting for dr from (3) in (4):

1  c1  t   IY dY  cYdt  I r   k  dY 

 l 
 Ir k
1  c 1  t   I   dY  cYdt

Y
l  

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dY  c
T - multiplier  
Irk
1  c1  T   I Y 
Ydt
l
Monetary Policy multiplier   :
dY
III.
 dm 

 Setting dG = 0 in (1): 1  c1  T   I Y dY  I r dr ------------- (5)

1 k
 Solving for dr in (2): l dr  dm  k dY  dr  dm  dY ------------- (6)
l l
 Substituting for dr from (6) in (5):
 
1  c1  T   I Y dY  I r  1 dm  k dY 
 l l 
 Ir k
1  c 1  T    I  dY 
Ir
dm
l   l
Y


Ir
M P - multiplier 
dY
 l
Irk
1  c1  T   I Y 
dm
l
Notes:
 G-multiplier is always greater than T-multiplier (always = no matter what
assumptions we are using). This is simply because MPC is always less than one.
 FP-multiplier > MP multiplier iff |Ir| < |l'|. Intuitively, this is the case if
investment is less sensitive to changes in the real interest rate than the demand
for money. (Keep it between you and me: this is almost always the case, it has
some theoretical justification and empirical evidence).
 If taxes are lump-sum, keeping every thing else as it is, you just need to set
T' or t equal to zero in the multiplier formulas shown above, and you will get the
right multipliers.
 If I = I (r), keeping every thing else as it is, you just need to set IY equal to
zero in the multiplier formulas shown above, and you will get the right
multipliers.
 The only difference between the IS-LM model and the simple Keynesian
model is that money (and hence the real interest rate) is neutral in the simple
Keynesian model. Accordingly, you just need to set Ir = 0 to get the simple

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model’s multipliers we had before. Try it!! You will be surprised that in this
case MP-multiplier is a big ZERO!! This is what I mean by “money is neutral in
the simple Keynesian model”.

Notes on the IS and LM curves

LM Curve
IS Curve (Equilibrium in the
(Equilibrium in the goods market: I + G = S + T) money market: (Md =
Ms)
I. Equation M
(w/ Y  C  I G  m  KY  Lr
P
derivation): Y  c0  c1 Y  tY   b0  b1r  b2Y   G Where M is nominal
money supply, P is the
Where b0 is autonomous investment, -b1 and b2 are coefficients
price level, m is real
of sensitivity of investment to changes in interest rate and
money supply, K and -L
income, respectively. (b2 is also known as MPI).
are coefficients of
Y 1  c1 1  t   b2   c0  b0  G   b1r sensitivity of money
demand to changes in
Y 1  c1 1  t   b2   A  b1r income and interest rate,
Where A= a  e  G0  . Dividing by 1  c1 1  t   b2 : respectively.

YIS 
A

b1
r KY  m  Lr
1  c1 1  t   b2  1  c1 1  t   b2  Dividing by K:

A m L
Where
1  c1 1  t   b2  is the horizontal intercept of the YLM   r
K K
 b1
IS curve, and
1  c1 1  t   b2  is the inverse of its slope. Where
m

M
P is the
K K
intercept of the LM
L
curve, and is the
K
inverse of its slope.

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I. Slope: dr 1  c 1  T   I Y 1  c1 1  t   b2 dr k K
   
dY IS Ir b1 dY LM l L

II. Shifters: A change in any factor that appears in the A change in any factor
intercept of the IS curve will shift the IS curve. that appears in the
intercept of the LM
 An increase in c0, b0, or G will shift IS to
curve will shift the
the right (parallelly). (e.g. an expansionary
LM curve.
fiscal policy).
 An increase in M
 An increase in the tax rate, i.e. a
(an expansionary
contractionary fiscal policy, or an increase in
monetary policy) will
the saving rate, i.e. MPS, will shift IS to the
shift LM to the right
left (unparallelly).
(parallelly).
 An increase in MPC or MPI will shift IS to
 An increase in P
the right (unparallelly).
will shift LM to the
left (parallelly).
 An increase in K
(=k') (when Md
becomes more
sensitive to changes in
income, or when
individuals prefer to
keep a higher
proportion of their
income in liquidity)
will shift LM to the
left (unparallelly).
III. Rotators: A change in any factor that appears in the A change in any factor
slope of the IS curve will rotate the IS curve. that appears in the
slope of the LM curve
 An increase in the tax rate or in the MPS,
will rotate the LM
will rotate IS anti-clockwise. Therefore, IS
curve.
becomes flatter.
 An increase in K
 An increase in the MPC or in the MPI, will
(=k') will rotate LM
rotate IS clockwise. Therefore, IS becomes
anti-clockwise.
steeper.
Therefore, LM
 An increase in Ir (= b1) (when investment becomes steeper.
becomes more sensitive to changes in r) rotates

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IS clockwise. Therefore, IS becomes steeper.  An increase in L

(=l') (when Md
becomes more
sensitive to changes in
interest rate) will
rotate LM clockwise.
Therefore, LM
becomes flatter.
IV. Points off  At any point to the right of (or above) the  At any point to the
the curve IS curve: right of (or below) the
Y>E OR S+T>I+G LM curve: Md > Ms.

 At any point to the left of (or below) the IS  At any point to the
curve: left of (or above) the
Y<E OR S+T<I+G LM curve: Md < Ms

15
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Effects of Various Combinations of Fiscal and Monetary Policies Using the

IS-LM Model
4) An expansionary fiscal policy (an increase in G or a decrease in “lump-sum” taxes) leads
IS to shift to the right. With the absence of any monetary policy, this raises both the
equilibrium income and the equilibrium interest rate.

 Similarly, a contractionary fiscal policy (a decrease in G or an increase in “lump-sum”

taxes) leads IS to shift to the left. With the absence of any monetary policy, this lowers both
the equilibrium income and the equilibrium interest rate.
5) An expansionary (loose) monetary policy (an increase in money supply) leads LM to shift
to the right. With the absence of any fiscal policy, this raises the equilibrium income but
reduces the equilibrium interest rate.

 Similarly, a contractionary (tight) monetary policy (a reduction in money supply) leads

LM to shift to the left. With the absence of any fiscal policy, this lowers the equilibrium
income but raises the equilibrium interest rate.

Some combinations are really interesting (and important for the exam purposes as
well). The following table summarizes the effects of these combinations.

Effects on Y
Effect on I Effect on Md Effects on T and BD
and R
Expansionary FP Y increases, Ambiguous Definitely increases T definitely increase, but the
& expansionary but the effect effect on BD is ambiguous
 I definitely (dMs = dMd).
MP on r is increases if r  Transactions Md  BD increases if the increase
(both G and Ms ambiguous decreases or increases in G > the increase in T.
increase)  r increases remains  BD decreases if the increase
if the shift in constant.  Speculative Md
may increase, in G < the increase in T.
IS > the shift  I may decrease, or remain  BD remains unchanged if
in LM. increase, constant, depending the increase in G = the
 r decreases decrease, or on the change in r. increase in T.
if the shift in remain
IS < the shift unchanged if
in LM. r increases.
 r remains
unchanged if
the two shifts
are equal.

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Effects on Y and
Effect on I Effect on Md Effects on T and BD
R
Expansionary r increases, but the Ambiguous Definitely Ambiguous
FP & effect on Y is decreases
I definitely  T increase, decrease, or
contractionary ambiguous decreases if Y (dMs = dMd). remain constant depending
MP  Y increases if decreases or remains  Transactions Md on the change in Y.
(G increases the shift in IS > constant. may increase,  BD definitely increases if
and Ms the shift in LM.
 I may increase, decrease, or Y decreases or remains
decreases)
 Y decreases if decrease, or remain remain constant, constant.
the shift in IS < unchanged if Y depending on the  BD may decrease,
the shift in LM. increases. change in Y.
increase, or remain constant
Y remains  Speculative Md if Y increases.
unchanged if the decreases.
two shifts are
equal.
Contractionary r decreases, but Ambiguous Definitely Ambiguous
FP & the effect on Y is I definitely increases  T increase, decrease, or
expansionary ambiguous increases if Y (dMs = dMd). remain constant depending
MP  Y increases if increases or remains  Transactions Md on the change in Y.
(G decreases the shift in IS < constant. may increase,  BD definitely decreases if
and Ms the shift in LM.
 I may increase, decrease, or Y increases or remains
increases)
 Y decreases if decrease, or remain remain constant, constant.
the shift in IS > unchanged if Y depending on the  BD may decrease,
the shift in LM. decreases. change in Y.
increase, or remain constant
Y remains  Speculative Md if Y decreases.
unchanged if the increases.
two shifts are
equal.
Contractionary Y decreases, but Ambiguous Definitely T definitely decrease, but
FP & the effect on r is I definitely decreases the effect on BD is
contractionary ambiguous decreases if r (dMs = dMd). ambiguous
MP  r increases if the increases or remains  Transactions Md  BD increases if the
(both G and shift in IS < the constant. decreases decrease in G < the decrease
Ms decrease) shift in LM. in T.
 I may increase,  Speculative Md
 r decreases if the decrease, or remain may increase,  BD decreases if the
shift in IS > the unchanged if r decrease, or decrease in G > the decrease
shift in LM. decreases. remain constant, in T.
r remains depending on the  BD doesn’t change if the
unchanged if the change in r. decrease in G = the decrease
two shifts are in T.
equal.

17
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Notes on Phillips Curve, Okun’s Law, and the Quantity Theory of Money
In the classical macroeconomics, three major relations are of special importance:
I. Phillips Curve:
A. Static Phillips Curve:
This is the original version of Phillips curve, as presented by the British economist
Arthur Phillips in 1958. Using data about unemployment rate and wage inflation in the U.K.
over about a whole century, Phillips finds that there is a stable negative relationship between
unemployment rate and inflation rate. An increase in the inflation rate is associated with a
decrease in unemployment rate, and vice versa. This relationship is called the “Static Phillips
Curve”, and could be represented mathematically as:
 t  a  bU t
This oversimplified version of Phillips curve has several shortcomings, among which:
1. It ignores the effect of expectations on unemployment. That is, it assumes that expected
inflation is constant.
2. It ignores the fact that there is positive natural rate of unemployment (Un). That is, it
assumes that this rate is equal to zero. (Note: there is another name for Un, which is Non-
Accelerating-Inflation Rate of Unemployment, or NAIRU).
3. It assumes that raising inflation to a sufficiently high level (= a in the above equation)
could reduce unemployment rate to zero. This is certainly not true, as unemployment rate has
a floor of Un. It also assumes that inflating only once can reduce unemployment permanently.
4. It failed to explain the phenomenon of stagflation, which implies a simultaneous rise in
both inflation and unemployment.
5. Most importantly, it assumes that nominal variables (such as inflation) have a permanent
effect on real variables (such as unemployment) .
B. Expectations-Augmented Phillips Curve:
Due to the failure of the static Phillips curve, many attempts have been made to
modify it in a way that overcomes the above-listed shortcomings. The most successful one
was made by Milton Friedman and Edmund Phelps in the 1960s. By introducing the natural
rate hypothesis, and by accounting for inflationary expectations, Friedman and Phelps came
up with the so-called Expectations Augmented Phillips Curve.
According to the expectations augmented Phillips curve, unexpected inflation is
negatively related with the difference between the unemployment rate and its natural level.
This could be represented by the following equation:

 t   te   U t  U n 
(Hint: assuming that  te  constant and Un = 0 will result in the static Phillips curve).
According to this Phillips Curve:
 An increase in actual inflation (t) leads to a decrease in current unemployment (Ut).
 An increase in expected inflation (te) leads to an increase in current unemployment (Ut).
This is simply because when they expect higher price level, workers will ask for higher

18
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wages, which raises the cost of labor and thus reduces the demand for labor. As a result, Ut
rises.
 An increase in current inflation usually leads to an increase in expected inflation. This
implies that an increase in inflation due to an expansionary (fiscal or monetary) policy will
initially reduce unemployment. This reduction in unemployment will be cancelled out (fully
or partly) by an increase in Ut because of the increase in expected inflation.
 Therefore, the positive effect of any anticipated expansionary policy on unemployment
will be temporary. In the long run, any anticipated policy will not have any real effects .
This is known as policy ineffectiveness proposition (in its simplest form). To have real
effects, the policy must be unanticipated, unannounced, or surprise policy. In other words,
the government (or the Fed) must deceive the public.
II. Okun’s Law:
Okun’s law is expressed by the following equation:
dU  U t  U t 1   0.43.0  g yt 

OR : g yt  3.0  2.5U t  U t 1 
Note that all numbers in the second equation are in percent. That is, 3 means 3% (or
0.03) and 2.5 means 2.5% (or 0.025). Thus, the resulting gyt should be in percent.
This means:
 With no change in unemployment, the normal growth rate is 3%. Note that when we say
growth rate we mean growth rate of real GDP (or real output).
 An increase in unemployment rate by 1% leads to a reduction in the growth rate by 2.5%.
Hint: unless otherwise specified, and before adopting any economic policy, Ut-1 = Un. Thus,
the normal growth rate is the growth rate when Ut = Ut-1 = Un. According to Okun’s law, the
normal growth rate is always 3%.
III. The Quantity Theory of Money:
The quantity theory of money states that:
P. Y = M. V
where P is the price level, Y is the real output (real GDP), PY is nominal output (nominal
GDP), M is the money supply, and V is the velocity of money.
 Velocity of money is the number of times money circulates in the economy during a given
period, usually one year. Put differently, it is the number of times the money supply is spent
on purchasing goods and services during a given period, usually a year. V is assumed to be
fixed in the short run.
 Given this definition of velocity, it is obvious that the above equation is simply an
identity. It is a definitional, not a functional equation. Nominal GDP, by definition, must
equal to the money supply times the velocity. THIS IS NOT INTERESTING AT ALL,
RIGHT?
 This equation could be interesting if we write it in terms of growth rates, not absolute
values. To do that, we need to take logs across this equation and then differentiate it with
respect to time.

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 \

 Taking logs:
ln P  ln Y  ln M  ln V .
 Differentiate with respect to time:
 ln P P  ln Y Y  ln M M  ln V V
      
P t Y t M t V t
V  ln X 1
We know that is zero because V is constant. We also know that  , and that
t X X
X
 X . Applying these rules to P, Y, and M, we get:
t
P Y M
   t  g yt  g mt  t  g mt  g yt
P Y M
This implies that:
- If g mt  g yt , inflation rate will be zero.

- If g mt  g yt , inflation rate will be positive.

- If g mt  g yt , inflation rate will be negative.

I THINK THIS IS MUCH MORE INTERESTING THAN THE ORIGINAL IDENTITY!!!

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Notes on Expectations
We have three major theories of expectations:
I. Naïve Expectations (Random Walk):
This is the simplest type of expectations, and the least realistic one as well. It simply
says that the price level is equal to the last period’s price level, plus a random shock. That is,
Et 1 Pt  Pt 1   t
That is, we care only about last period’s price level when we forecast this period’s
price level. This is an oversimplified way of thinking about how expectations are formed.
II. Adaptive Expectations (Error Correction):
 According to adaptive expectations theory, the expected value of the future price level is
composed of two parts: the actual price level when expectations are formed, and an
adjustment for the error in the previous expectations. Therefore,
(1) Et Pt 1  Pt   Et 1 Pt  Pt  for expectations formed at time t

(2) Et 1 Pt  Pt 1   Et 2 Pt 1  Pt 1  for expectations formed at time t-1

- The term Et Pt 1 is read as “the expectation, formed at time t, of the price level at time
t+1”. Understanding this, you can easily read the terms Et 1 Pt , Et 2 Pt 1 , and so on.
(Note that you can use the notation t 1 Pt instead of Et 1 Pt . Both are the same.)
On the right hand side:
- The first term is the current actual price level. The second term is the adjustment
factor, , times the error made in forecasting the price level in the previous period.
Rearranging the above equations:
Et Pt 1  Pt   Et 1 Pt  Pt  for expectations formed at time t

Et 1 Pt  Pt 1   Et 2 Pt 1  Pt 1  for expectations formed at time t-1

- The LHS represents the error in the expectations formed in the current period, while
the RHS is the error in the last period’s expectations multiplied by the adjustment
factor.
- Note that 0    1 . If = 0, previous errors are completely ignored. Therefore,
Et Pt 1  Pt and Et 1 Pt  Pt 1 , meaning that you only care about last period’s price
level. If = 1, you never change your expectations (you are doing the same error
every period). That is, Et Pt 1  Et 1 Pt  Et 2 Pt 1 . Both cases are extreme, and
usually lies between these two extremes.
 We can manipulate the above equations by substituting for Et 1 Pt in equation (1) using
its value from equation (2). This gives:
Et Pt 1  Pt  Pt 1   Et 2 Pt 1  Pt 1   Pt 

21
 \

Et Pt 1  Pt  Pt 1  Et 2 Pt 1  Pt 1  Pt   Pt  1   Pt 1  Et 2 Pt 1  Pt 

Et Pt 1  1   Pt   1   Pt 1  2 Et 2 Pt 1
But Et 2 Pt 1  Pt 2   Et 3 Pt 2  Pt 2  . Therefore,

Et Pt 1  1   Pt   1   Pt 1  2 Pt 2   Et 3 Pt 2  Pt 2 

Et Pt 1  1   Pt   1   Pt 1  2 1   Pt 2  Et 3 Pt 2 

Et Pt 1  1   Pt   1   Pt 1  2 1   Pt 2  3 Et 3 Pt 2

But Et 3 Pt 2  Pt 3   Et 4 Pt 3  Pt 3  , and so forth. Repeating the same process lead to

the following result:
Et Pt 1  1   Pt   1   Pt 1  2 1   Pt 2  3 1   Pt 3  ...... 
n
Et Pt 1   i 1   Pt i
i 0

Similarly, we can derive that:

Et 1 Pt  1   Pt 1   1   Pt 2  2 1   Pt 3  ...... 
n
Et 1Pt   i 1   Pt  i 1
i 0

Two basic features of the adaptive expectations hypothesis :

o Expectations are formed by looking into the past. The process of expectation formation
doesn’t involve the use of any current available information that is relevant to the price level.
o It assumes that price expectations (or the expected price level) are exogenous. This is a
direct result of the first feature. Not using any available information simply means that no
model is used to expect prices. (Past) prices are used to expect (current) prices, and (past and
current) prices are used to expect (future) prices. In short, we use only prices to expect prices.
o This is equivalent to saying that the expected price level is a function of the current price
level. The current price level is, in turn, a function of past price level, and so forth. This
function could be represented as;
P e  p P  ; 0  p  1

dP e
Where Pe = Et-1Pt, P = Pt, and p   .
dP
- If p   0 , dPe = 0 (no adjustment of the expected price level when P changes). This is
exactly the case of complete money illusion. It implies that workers are interested only
in the money wage, W. This case is relevant only in the short run.

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- If p   1 , dPe = dP (full adjustment of the expected price level when P changes).

There is NO money illusion at all, and workers base their decisions on real wage, w =
W/P. This case is appropriate for the medium and long run.
III. Rational Expectations:
 The rational expectations hypothesis provides an alternative way of forming expectations.
According to this hypothesis, expectations are formed by using the model rather than by
looking into the past. That is, you are using all currently available relevant information in
forming your expectations about the price level. More formally,

P e  f P | all available relevant informatio n

Note that we don’t need to use the time subscripts when talking about rational expectations,
because we are not interested in past price levels any more.
 The main feature of rational expectations hypothesis is its assumption that price
expectations are endogenous. The expected price level is a function of all available relevant
information.

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Notes on the Aggregate Demand

 The AD curve is derived from the IS-LM model. Each point on the AD curve is an
equilibrium point in the IS-LM model, i.e. a point of intersection between IS and LM curves.
Put differently, each point on the AD curve is a combination of output, Y, and price level, P,
that keeps both goods market and money market in equilibrium.
 To derive the slope, the equation, and the multipliers of the AD, we need to use both IS
and LM equations. This is shown as follows.
Mathematical Derivation of the AD:
IS equation: Y  cY  tY   I r   G

 l r   k Y 
M
LM equation:
P
 Totally differentiating IS equation:
dY  cdY  tdY  Ydt   I dr  dG
1  c1  t dY  cYdt  I dr  dG ………………… (1)
 Totally differentiating LM equation:
PdM  MdP PdM  MdP dM MdP
2
 l dr  k dY  l dr  2
 k dY  l dr   2  k dY
P P P P

1 M k
dr  dM  2 dP  dY ………………… (2)
l P l P l
 Substituting for dr from (2) in (1):
k 
1  c1  t dY  cYdt  I  1 dM 
M
dP  dY  dG
 l P l P 2 l  
 I M I k  
1  c1  t dY  cYdt   I dM  2 dP  dY   dG
 l P l P l 
 I k   I I M
1  c 1  t   dY  c Ydt  dM  dP  dG ………………… (3)
 l   l P l P 2
 We can simplify (3) by setting the initial price level equal to unity (i.e. P = 1). Therefore,

 I k   I I M
1  c 1  t   dY  dG  c Ydt  dM  dP ………………… (4)
 l   l l
 Equation (4) is the general form that can be used to derive the AD equation, the slope of
the AD curve, as well as all multipliers of the AD model.
The slope of the AD curve:
 Along the AD curve, dG = dt = dM = 0. Therefore, we can rewrite (4) as:

24
 \

 I k   I M
1  c1  t   l   dY   l  dP
 

I k 
1  c 1  t  

dP
 l
I M ………………… (5)
dY AD 
l
 This is the slope of AD. Given that 0  c1  t   1 , I' < 0, k' > 0, l' < 0, and M > 0; this
slope must be negative.
The Multipliers of the AD Model:
 The various multipliers of the AD curve measure the effect of fiscal or monetary policies
on equilibrium output. In the AD-AS model, the direct effect of any fiscal or monetary policy
is a shift in only the AD curve, but the equilibrium output is determined by both the AD and
AS curves.
 When the AD curve shifts as a result of a policy, the economy reaches a new intersection
point between the AD and AS. This simply means that the shift in the AD curve is associated
with a movement along the AS curve. This movement along the AS leads to a change in the
equilibrium price level.
 As a result, the effect of any economic policy on the equilibrium output will depend,
among other factors, on this AS-related change in price level. This effect should be included
in the expression of all multipliers.
 To do that, we need to rewrite equation (4) by multiplying the last term of the RHS by
dY
:
dY
 I k   I  I M dP 
1  c1  t   l   dY  dG  cYdt  l  dM   l  dY dY
   
dP dP dP
where is the slope of the AS curve. That is,  . Therefore,
dY dY dY AS

 I k   I  I M dP 
1  c1  t   l   dY  dG  cYdt  l  dM   l  dY dY ………………… (6)
 AS 

We will use equation (6) instead of (4) in deriving all the multipliers.
I. The spending multiplier (G multiplier):
dY
 The spending multiplier is given by . Following ceteris paribus assumption, we
dG
assume that dt = dM = 0. Rewrite (6) as:

25
 \

 I k    I M dP 
1  c 1  t   dY  dG   dY
l    l  dY AS 

 I k  I M dP 
1  c1  t       dY  dG
 l l dY AS 

dY 1 1
 
dG  I k  I M dP  D ………………… (7)
1  c 1  t    
 l l  dY AS 

 This is the government expenditure multiplier, or spending multiplier, or FP multiplier, in

 I k  I M dP 
the AD model, where D  1  c1  t    .
 l l  dY AS 
II. The tax multiplier:
dY
 The spending multiplier is given by . Following ceteris paribus assumption, we
dt
assume that dG = dM = 0. Rewrite (4) as:

 I k    I M dP 
1  c 1  t   dY   c Ydt   dY
l    l  dY AS 

 I k  I M dP 
1  c1  t       dY  cYdt
 l l dY AS 

dY  c Y  c Y
 
dt  I k  I M dP  D ………………… (8)
1  c 1  t      
 l l dY AS 

 This is the tax multiplier in the AD model.

III. The monetary policy multiplier (dM multiplier):
dY
 The spending multiplier is given by . Following ceteris paribus assumption, we
dM
assume that dG = dt = 0. Rewrite (4) as:

 I k   I  I M dP 
1  c 1  t   dY  dM   dY
l   l  l  dY AS 

 I k  I M dP  I
1  c1  t       dY   dM
 l l dY AS  l

26
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dY I  l I  l
 
dM  I k  I M dP  D ………………… (9)
1  c 1  t      
 l l dY AS 

 This is the monetary policy multiplier (multiplier of the change in money) in the AD
model.
The AD equation:
The AD Equation:
 I k   I I M
1  c1  t   l   dY  dG  cYdt  l  dM  l  dP
 
 To derive the AD equation, we may need to simplify equation (4) above. Let
I k 
  1  c1  t   . Also assume that the initial money stock is equal to unity (M = P = 1).
l
Equation (4) becomes:
1 I I 
dY  dG  c Ydt  dM  dP
  l l  
 Setting dG = dt = 0, we get:
I
dY  dM  dP   dY   dM  dP  ………………… (10)
l 
l 
where   .
I
 Also, changes in Y, M, and P could be interpreted as:
dY  Yt  Yt 1 dM  M t  M t 1 dP  Pt  Pt 1
Therefore, equation (10) could be rewritten as:
Yt  Yt 1   M t  M t 1  Pt  Pt 1 
But M t 1  Pt 1  1 . Therefore,

Yt  Yt 1   M t  Pt    Yt  Yt 1   M t  Pt

Pt   Yt  Yt 1   M t  t ………………… (11)

Equation (11) is the AD function (the AD curve equation), where  t is a random

error that represents unanticipated aggregate demand shocks.

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Notes on Aggregate Supply

 The aggregate supply curve represents the equilibrium in the labor market. Each point on
the AS curve is a combination of output, Y, and price level, P, that keeps the labor market in
equilibrium.
 The supply side of the economy is characterized by 4 equations:
1) Production function: Y  F N , K  , where N is labor and K is capital.
o In the short run, we assume K to be constant. That is, Y  F N , K  , or simply
Y  F N  .
o This production function is concave, which has two implications:
F N 
- The first derivative is positive: f N    0 , where f N  is the marginal
N
physical product of labor (MPPN). Intuitively, this means a positive relationship
between labor and output. Adding more workers leads to more output.
f N 
- The second derivative is negative: f    0 . This simply implies that the law
N
of diminishing returns holds. When we add more labor to a fixed amount of capital,
MPPN decreases. That is, output increases at a decreasing rate.
2) Labor Demand (Nd): labor demand is given by:

 f N   W  P. f N 
W
w , where f   0
P
This implies that when the wage rate increases, producers demand less labor services.
3) Labor Supply (Ns): labor supply is given by:

 g  N   W  P e .g  N 
W
we  e
, where g   0
P
This implies that when the wage rate increases, workers supply more labor services.
4) Price Expectations function: price expectations may be exogenous (as in adaptive
expectation), or endogenous (as in rational expectations).
o With exogenous (adaptive) expectations: we may use P e  pP  , where
dP e
0  p   1 . p   0 in the extreme Keynesian case of perfect money illusion, but
dP
p   1 for the extreme classical case of full adjustment.
o With endogenous (rational) expectations: we use Pt  Et 1 Pt   t , where
Et 1 t  0 .

I. Deriving the Slope of the AS curve with Exogenous (Adaptive) Expectations

 Labor market equilibrium is given by:
P. f N   P e .g N   W -------------- (12)
 Totally differentiating equation (12):

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P. f dN  fdP  P e .g dN  gdP e -------------- (13)

 Assume that the initially, P = Pe = 1. from (12), this implies that f = g = W = w (as
W W
w   W under this assumption). Equation (13) simplifies to:
P 1
f dN  wdP  g dN  wdP e
wdP  dP e   g   f dN

dN 
w
g  f 
dP  dP e  -------------- (14)

 With adaptive expectations, P e  pP  . Totally differentiating yields: dP e  pdP .

Substituting for dPe in (14):
w1  p g  f 
dN  dP  dP  dN
w1  p
-------------- (15)
g  f 
 The short run production function is Y  F N  . Totally differentiating yields:
dY
dY  fdN  dN  -------------- (16)
f
 Substituting for dN from (16) in (15):
g  f 
dP  dY
w1  p  f
 The slope of AS with adaptive expectations is given by:

dP g  f 

dY AS w1  p  f -------------- (17)

 As g   0 , f   0 , w  f  0 , and p  lies between 0 and 1; this slope is positive.

 In the extreme Keynesian case, p   0 , and thus the slope of the AS simplifies to
g  f 
. This shows that the Keynesian supply curve is positively sloped.
w f
g  f 
 In the extreme classical case, p   1 , and thus the slope of the AS is   . This
0
shows that the extreme classical supply curve is vertical.

II. Deriving the Slope of the AS curve with Endogenous (Rational) Expectations
 In this case, the only difference is that we cannot use the relationship P e  pP  .
Therefore, we can start with equation (14), as every thing before that is the same as in the
previous case. We can rewrite (14) as:

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dN 
f
g  f 
dP  dP e  -------------------- (14')

 Substituting for dN from (16) in (14'):

dY
f

f
g  f 
dP  dP e 

dY 
f2
g  f 
  
dP  dP e  dY   dP  dP e -------------- (18) 
f2
where  
g  f 
 Along the AS curve, dPe = 0. Therefore, along the AS:

dP 1 g  f 
dY  dP   
dY AS  f2 -------------------- (19)

 This is the slope of the AS curve with rational expectations. It is clear that it is positive.
 Very important note: this is exactly the same as the slope of the AS curve with
endogenous expectations in the Keynesian case of p   0 (notice that w = f under the
assumption that P = Pe = 1). In this case, past price levels do not affect expected price level,
which is a common feature with rational expectations. This means that under the rational
expectations assumption, we assume no relationship between the expected prices and the past
prices. (Keep it between you and me: this is another way of saying that we assume p   0 ).
III. Deriving the AS function with Endogenous (Rational) Expectations
 We know that dP  Pt  Pt 1 and dP e t 1 Pt t 1 Pt 1  dP e t 1 Pt  Pt 1 . We also
know that dY  Yt  Yt 1 Substituting in (18):

Yt  Yt 1   Pt  Pt 1 t 1 Pt  Pt 1 

Yt  Yt 1   Pt t 1 Pt    t ----------------- (20)

 This is one form of the Lucas supply function.
IV. Deriving the AS function with Exogenous (Adaptive) Expectations
 We can use the supply function in equation (20) with both endogenous and exogenous
expectations. This is essentially because this function is derived from equation (18), which in
turn is obtained from equation (14'), which is nothing but another way of writing equation
(14) that is used with exogenous expectations.
 The only difference is that with endogenous expectations, we assume that the term  t 1 Pt 
in equation (20) is determined endogenously, i.e. from the model. With exogenous
expectations, however, we assume this term to be given exogenously.

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Equilibrium in the AD-AS Model

I. Equilibrium output with exogenous (Adaptive) expectations:
AD equation: Pt   Yt  Yt 1   M t  t --------------------- (11)

AS equation: Yt  Yt 1   Pt t 1 Pt    t --------------------- (20)

 We can combine these two equations to obtain a solution for Yt with exogenous price
expectations and given Yt-1. We assume that  t 1 Pt  is given exogenously.
 Substituting for Pt from AD equation in AS equation:
Yt  Yt 1     Yt  Yt 1   M t   t 1 Pt    t
Yt  Yt 1  Yt  Yt 1  M t    t 1Pt   t
1   Yt  1   Yt 1   M t t 1 Pt      t
Dividing both sides by 1    :


 Yt  Yt 1  M t t 1 Pt   1    t 
1    1    --------------- (21)


Let   .
1   

 1  
 Yt  Yt 1   M t t 1 Pt     t    t  --------------- (21')
   
This is the solution for Yt in its linearized Sargent and Wallace form with exogenous
expectations.
II. Equilibrium output with endogenous (Rational) expectations:
AD equation: Pt   Yt  Yt 1   M t  t --------------------- (11)

AS equation: Yt  Yt 1   Pt t 1 Pt    t --------------------- (20)

Here,  t 1 Pt  is not given exogenously, it is determined by the model. We need to use the
model itself to get an expression for  t 1 Pt  , then use it to solve for Yt.
We need to follow the following four steps:
 Step 1: use the AD equation to solve for t 1 Pt :
Taking expectations on both sides of the AD equations:

t 1 Pt    t 1Yt  Yt 1  t 1 M t ------------------- (22)

where t 1  t  0 under rational expectations assumption, and Y
t 1 t 1  Yt 1 .

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 Step 2: use the AS equation to get Y:

t 1 t

t 1 Yt  Yt 1   t 1 Pt t 1 Pt  t 1  t
By rational expectations hypothesis, we know that t 1 Pt t 1 Pt  t 1  t  0.
Therefore,

t 1 Yt  Yt 1 ------------------- (23)
 Step 3: substitute for t 1 Yt from (10) in (9):

t 1 Pt t 1 M t ------------------- (24)

 Step 4: substitute for Pt (from 11) and t 1 Pt (from 24) in the AS equation (eq. 20):
Yt  Yt 1     Yt  Yt 1   M t  t t 1 M t    t
Yt  Yt 1   Yt  Yt 1    M t t 1 M t   t   t
1   Yt  1   Yt 1   M t t 1 M t   t   t


Yt  Yt 1  M t t 1 M t   1 t   t  ----------------- (25)
1   1  

Let  
1   

 1 
 Yt  Yt 1   M t t 1 M t     t    t  ------------------- (25')
   
This is the solution for Yt with endogenous (rational) expectations.
 Comparing (25) to (21), or (25') to (21'), we can see that the single difference is the
substitution in (25) and (25') of t 1 M t for t 1 Pt in (21) and (21').
 Equations (25) and (25') say that, with endogenous or rational expectations, the difference
between actual money supply M t  and expected money supply  t 1 M t  moves output.
 In equations (21) and (21'), with exogenous or adaptive expectations, it is the difference
between actual money supply M t  and expected prices level  t 1 Pt  that moves output.
 This difference is due to the fact that with endogenous expectations, expectations are
taken from the model. That is, expected price movements are determined by the expected
money movements.
 Equations (25) and (25') are the basis of the famous policy ineffectiveness proposition:
Under rational expectations, it is the deviations of actual policy from the public’s
expectations of it that have an effect on real output. Under rational expectations, any
expected (or anticipated) policy has only nominal effects, i.e. effects on the price level. Only

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unanticipated policies have real effects. This is another way of stating that money is neutral,
even in the short run, if the policy is expected.
 In equations (25) and (25'), Yt deviates from its classical equilibrium level, Yt 1 , only
because of random shocks to demand and supply,  t and  t , and unanticipated policy.
 The original classical model, based on complete wage and price flexibility, had a vertical
AS curve in the long run. The new classical model, based on both flexibility of wages and
prices and policy ineffectiveness, has a vertical AS curve in both short run and long run.

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Macroeconomics Qualifying Examination-302 Module

Claremont Graduate University

Spring, 2008

Dr. Muhammed Safarzadeh

There are 100 points on this part of the qualifying Examination. All parts are equally
weighted. Show all your work.

1. One of the central pillars of the post-Keynesian macroeconomic analysis is the

aggregate consumption function was criticized from its inception based on
inconsistencies between the theory and evidence. Three major theories which try to
reconcile the theory and the evidence have received acceptance and have empirically
explained well the households spending and saving behavior. Discuss the conflict in
empirical evidence on consumption between cyclical or cross-section (short-run and
aggregate secular (long-run) aspect. Describe how each theory explains the observed
inconsistencies. What are the important implications for macroeconomic theory and
policy of the modern consumption theories? Using the premise of the modern
consumption theories, analyze the effect of consumption both in the short-run and
long-run of the following:
a. A sudden rise in the birth rate
b. A progressive tax on the amount of capital owned.
c. A one-time tax cut versus a permanent tax cut
2. One of the main concerns about the rapid growth of the computer technologies
and robotics during the 1980s was that the technologies advances will result in
chronic unemployment in the U.S economy.
a. Using a short-run version of the production function Y=f(k, AN), show
the effect of the technological advancement on employment or
unemployment. Analyze the effect of the technological change on
unemployment under the two assumptions:
i. New technology results in increase in productivity
ii. New technology results in introduction of new goods
b. Using an aggregate price equation, show the effect of the technological
advancement on prices, inflation, nominal wages and real wages
c. Using AD/AS model show the short-run and long-run effects of the
technological change on income, unemployment and price level.
3. By standards of economic efficiency which you will elaborate, what is wrong with
inflation? What is wrong with unemployment? What is the inter-relationship between
inflation and unemployment? Is there any important short-run versus long-run
distinction here? What can national economic policy do to solve these problems? Is
the effect of such policy sustainable? At each state of the argument, show what costs
are associated with what benefits.

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4. To stop the economy from sliding to recession, the Fed has resorted to
expansionary monetary policy, lowering the Federal Funds rate to 2% and
increasing liquidity. The government, on the other hand, has followed by
expecting the tax cut and mailing the rebates early. Take the text book by
Keynesian IS-LM model and analyze the effectiveness of these policies separately
and together under the following assumptions:
a. Assume that individuals have a myopic view of the economy and do not
consider the effects of the policy change on future macro variables.
b. Assume that individuals consider the long-run effects of changes in future
macro variables when forming expectations of future output and future
interest rates (foresighted economic agents).
5. A simple macro-model of the economy is expressed by the following equilibrium
conditions in three markets:
Goods Market: Y=c(Y-tY)+I(r)+G
Money Market: M/P=I(r)+ k(Y)
Labor Market: Pf(N)=Pe(g(N))
The Production technology of the economy is given by the aggregate production
function, Y=F(N, K). it is assumed that economic agents form their expectations of the future
prices by using the current and the past prices as expressed by expectation model Pe =P(P).
Answer the following questions given the information above.

a. Analyze the effectiveness of the monetary policy given the system of

equations above and assumed expectations model: Make a clear distinction
between extreme Keynesian and extreme classical. What is the effect of
monetary policy if economic agents’ expectations are based on adaptive
expectation?
b. Now, assume that economic agent form their expectations of the future prices
based on the rational expectations model, Pt=t-1Pt-et, with t-1et=0. Derive an
expression for AD and AS using the equilibrium model given above. Analyze
and discuss the effectiveness of the monetary policy using the rational
expectations hypothesis. How does your conclusions here differ from the
conclusions derived in part a?

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