Q1: Price flexibility plays a key role in the classical model by ensuring that the markets reach equilibrium.

a) Explain which price adjusts to bring equilibrium in the labor market. Describe how the price adjusts when the demand exceeds supply in this market. In the labor market the wage is the price that adjusts to bring the labor market into equilibrium. The wages are believed to induce workers to enter sectors where their services are in greatest demand and to leave sectors with labor surpluses. Wage level is a major determinant of the supply of and demand for labor.The labor market will reach equilibrium as the amount of workers willing to work for a certain price equals the amount of workers employers are willing to hire for that wage. On a supply and demand curve the employees represent the supply curve while the employers represent the demand curve. It is possible to find the wage rate that clears the labor market, the equilibrium wage rate, by combining the labor demand curve and the labor supply curve. This is done in Fig a.1. The equilibrium wage rate(W0) is the rate at which the quantity of labor demanded (DL0) is equal to the quantity of labor supplied (SL0). The equilibrium wage rate is equal to the marginal revenue product of the last worker hired. Figure a.1

Fig a.2 illustrates the effect of increase in the demand for labor. Suppose the labor market begins at the intersection of DL0 and SL0 so that the equilibrium wage rate is W0. An increase in the demand for labor will shift the labor demand curve outward from DL0 to DL1 and cause the equilibrium wage to rise to W1, assuming that all other factors are held constant.

Figure a.2

b) Explain which price adjusts to bring equilibrium in the loanable funds market. Describe how the price adjusts when supply exceeds demand in this market. The special price in this model is the cost of credit - the interest rate, represented by the variable r. Loanable Funds Model assumes only one interest rate, which can be thought of as a proxy average for the entire structure of interest rates.

The demand and supply curves in this model have a special meaning. The demand curve represents the demand for credit by borrowers and the supply curve represents the supply of credit by lenders.

An example of this is seen in Figure b.1, which shows the impact of a decline in consumer borrowing. Suppose consumers thought that current consumer debt levels were too high and they react by cutting back on their use of credit. This would be shown as a shift to the left of the demand for credit. This by itself would result in a decline in interest rates and a lower volume of credit, as shown. It should be remembered in this model as in any comparative statics model, the analysis of cause and effect that comes from consideration of a change in a single variable assumes no change in the other variables in the model - the relationship is considered in isolation. Therefore, in this example, we might conclude that a contraction of consumer demand for credit has the tendency of lowering interest rates, or considered in isolation from other factors, would lower interest rates. Figure b.1

Q2:If the demand for money depends positively on real income and depends inversely on the nominal interest rate, what will happen to the price level today, if the central bank announces (and people believe) that it will decrease the money growth rate in the future, but it does not change the money supply today? The quantity theory of money says that todays money supply determines todays price level. The conclusion remains partly true: if the nominal interest rate and the level of output are held constant, the price level moves proportionately with the money supply. Yet the nominal interest rate is not constant; it depends on expected inflation, which in turn depends on growth in the

money supply. The presence of the nominal interest rate in the money demand function yields an additional channel through which money supply affects the price level. This general money demand equation implies that the price level depends not only on todays money supply but also on the money supply expected in the future. To see why, suppose the Fed announces that it will decrease the money supply in the future, but it doesnt change the money supply today. This announcement causes people to expect lower money growth and lower inflation. Through the Fisher effect, this decrease in expected inflation rate decreases the nominal interest rate. The lower nominal interest rate increases the demand for real money balances. Because the quantity of money has not changed, the increased demand for real money balances leads to a lower price level today. The effect of money on prices is complex. The conclusion is that the price level depends on a weighted average of the current money supply and the money supply expected to prevail in the future.

Q3: You are given the information about the following leading indicators. For each indicator explain whether the information suggests that a recession or expansion should be expected in the future. a) Average initial weekly claims for unemployment insurance rises. The average number of initial weekly claims for unemployment insurance is a significant indicator of the labor market condition, and since the employment rate is a leading indicator of economic wellbeing, an increase in the number of people making new claims for unemployment insurance suggests an economic recession.

b) New building permits issued increase. A raise in new building permits indicates an increase in real estate demand, which usually is caused by such determinants as reduction in real interest rate, raise in credit availability, or/and increase in the national income. All of these indicators are associated with economic expansion. c) The interest rate spread between the 10-year Treasury note and the 3-month Treasury bill narrows. This spread also known as the slope of the yield curve reflects the expected future interest rate. The real interest rate requires an adjustment to inflation, thus the expected future interest rate factors in future inflation, which consequently reflects the condition of the economy. Narrowing down this spread means that the interest rates are expected to decrease, which typically occurs when economic activity decreases signaling for a recession. d) The Index of Supplier Deliveries falls.

The Index of Supplier Deliveries also known as vendor performance measures the number of companies receiving slower deliveries from suppliers. This index is a leading indicator of economic activity because typically delivery rate decreases when suppliers experience increased demand for their goods. Hence, a fall in this index indicates an increase in economic activity, which leads to economic expansion.

Q4: During a recession, consumers may want to save money more to provide themselves with a reserve to cushion possible job losses. Use the Keynesian model to describe the impact of an exogenous decrease in consumption (a decrease in C) on the equilibrium level of income in the economy. Will aggregate national saving increase? Q5: If inflation is bad, why isnt deflation good? Use the IS-LM model to explain how deflation could result in a contraction of output. Deflation is a decrease in the general price level over a period of time. Deflation is the opposite of inflation. During deflation the demand for liquidity goes up, in preference to goods or interest. During deflation the purchasing power of moneyincreases. In economic theory deflation is a general reduction in the level of prices, or of the prices of an entire kind of asset or commodity. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices. In the IS-LM model this is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy and the going price for goods. Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The solution to falling aggregate demand is stimulus either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand, and borrow at interest rates which are below those available to private entities. The "bad" deflationoccurs when aggregate demand falls in the economy, leading to a decrease in output (meaning more unemployment) and a falling average price level (deflation). See the graph below: