Econ 132 - Summer 2006

Midterm 1 Answers

Answers.

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Getting Ready for Midterm 1

We are spending Tuesday and Wednesday getting ready for Midterm 1 on Thursday.

The Phillips Curve

Keynesians and classical economists differ sharply in their explanation for business cycles.

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Keynesians attribute business cycles to shifts in aggregate demand. This would cause a positive relationship between income and prices. See the top diagram.

Classical economists attribute business cycles to shifts in aggregate supply. This would cause a negative relationship between income and prices. See the bottom diagram.

We discussed how these views are supported (or contradicted) by the Phillips curve data (handout).

Aggregate Demand and Supply - The Keynesian Perspective

Keynesians focus on aggregate demand.

]]> We derived the aggregate demand curve by holding M fixed and changing P.

Fiscal policy can shift the aggregage demand curve.

Monetary policy can also shift the aggregate demand curve. (This is from the next day's lecture.)

The Keynesians and classical economists differ in how they see the slope of the aggregate supply curve.

The IS/LM Model

Assume that prices are fixed.

]]> Derive the IS curve:

Derive the LM curve:

Put them together:

Fiscal policy shifts the IS curve:

Monetary policy shifts the LM curve:

And,

A Simple IS/MP Model

We developed the Keynesian IS/LM Model assuming a fixed price level.

]]> The amount of investment depends on the interest rate.

In the Simple Keynesian Model, letting investment be a function of the interest rate produces an IS curve. Changes in goverment spending can shift that IS curve. The MP curve reflects the central bank's policy of setting the interest rate.

The Keynesian Cross

The Simple Keynesian Model illustrates some basic points with the leanest possible structure.

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The Classical Model

We added the elements to complete the Classical Model.

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The Supply of Labor

We derived a supply of labor curve from utility maximizing behavior by workers. Our variation on the two goods - two prices diagram had consumption and leisure as the two arguments to the worker's utility function. Finding the utility maximizing level of leisure reveals the utility maximizing supply of labor.

We concluded with a backward-bending labor supply curve and a brief discussion of the welfare problem.

A Simple Classical Model

Adding a vertical labor supply curve to our demand for labor produces a Simple Classical Model.

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Shocks to the production function then produce business cycles.

Two Goods - Two Prices

The two goods - two prices model is the basis for the demand curve for a good. We reviewed this element of microeconomics as ground work for deriving the supply of labor.

Profit Maximizing Quantity of Labor Hired

By viewing the firm's optimizing behavior in terms of the profit maximizing quantity of labor, we derived a demand for labor as a function of the real wage rate.

Adding a vertical supply of labor allowed us to construct a Simple Classical Model.

Profit Maximizing Quantity of Output

To establish a connection with microeconomics, we began our discussion of the demand for labor by studying the profit maximizing level of output for a price taker and for a monopolist. The former case provides a nice explanation of the origins of the supply curve for the good the firm produces.

Supply and Demand for Labor

We started the semester with a discussion of the supply and demand for labor.