Macroeconomics Problem Set 3 - Assignment Example

d. What will the capital-output ratio be at the Golden Rule steady-state? (Hint: recall from Chapter 3 that for the Cobb-Douglas production function, the capital-output ratio is related to the marginal product of capital). 1. In this question, we examine how the goals of the Federal Reserve influence its response to shocks. Suppose that in scenario A, the Fed cares only about keeping the price level stable whereas in scenario B, the Fed cares only about keeping output and employment at their natural levels.

Explain how in each scenario the Fed would respond to the following: A decrease in velocity causes a downward shift on the aggregate demand. Prices are fixed in the short run meaning only output decreases. To ensure output and unemployment are at their natural rates Fed B should increase the money supply to attain the initial equilibrium where prices and output will be constant. Fed, A should also increase the money supply to shift the aggregate demand curve upwards since this is the only way to ensure stable prices at their original equilibrium.

This results to an upward shift of the supply curve. To ensure stable prices, Fed B should hold aggregate demand constant since prices will rise in the short run and then fall in the long run achieving the natural rate of unemployment. This might however result to a recession. To keep output and unemployment at their natural rate Fed B should increase the money supply hence shift the aggregate demand curve upwards. This results to a new equilibrium at higher prices, but there is no loss in output.

Based on the quantity equation MV=PY, if Fed reduces the money supply by 5% the aggregate demand curve will shift downwards. A decrease in M will hence result in a decrease in PY provided V is constant. In the short run, the assumption is that the price levels are fixed meaning that that the aggregate