Answers to review quizzes marcroeconomics 12e parkin chapter 12

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W H AT I S E C O N O M I C S ? Answers to the Review Quizzes 189 THE BUSINESS CYCLE, INFLATION, AND DEFLATION** Page 338 (page 746 in Economics) Explain the mainstream theory of the business cycle Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth According to the mainstream view, potential GDP grows steadily and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP When aggregate demand grows more slowly than potential GDP, the inflation rate is low and, because money wages are sticky and not adjust to the lower the inflation rate, the economy slides into a recessionary gap so that real GDP is less than potential GDP When aggregate demand grows more rapidly than potential GDP, the inflation rate is high and the economy moves into a strong expansion accompanied by inflation What are the four special forms of the mainstream theory of the business cycle and how they differ? The four special forms of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence The monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand As a result, only unexpected changes in aggregate demand growth lead to business cycles Finally, new Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles 189 190 According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change? Real business cycle (RBC) theory says that economic fluctuations are caused by technological change that makes productivity growth fluctuate Fluctuations in the rate of technological change are the impulse that creates the business cycle According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labor, the supply of labor, employment, and the real wage rate? According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labor The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate Via the intertemporal substitution effect, the lower real interest rate decreases the supply of labor Because both the demand for labor and the supply of labor decrease, employment decreases The real wage rate also falls because the decrease in the demand for labor exceeds the decrease in the supply of labor What are the main criticisms of RBC theory and how its supporters defend it? Critics of the real business cycle theory level three criticisms at it: 1) the money wage rate is sticky; 2) the intertemporal substitution effect is small so that the small changes in the real wage rate cannot account for large changes in employment; and, 3) measured productivity shocks are likely to be caused by changes in aggregate demand so that business cycle fluctuations cause the measured productivity shocks Real business cycle supporters respond that 1) the real business cycle theory is consistent with the facts about economic growth and it explains the facts about business cycles; and 2) real business cycle theory is consistent with a wide range of microeconomic evidence about labor supply, labor demand, investment demand, and the distribution of income between labor and capital Page 344 (page 752 in Economics) How does demand-pull inflation begin? Demand-pull inflation begins with an increase in aggregate demand The increase in aggregate demand increases real GDP and the price level What must happen to create a demand-pull inflation spiral? When the economy is at an above full-employment equilibrium, the money wage rate rises which decreases the short-run aggregate supply The decrease in the short-run aggregate supply decreases real GDP and raises the price level If nothing else changes, the price level eventually stops rising To create a demandpull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases How does cost-push inflation begin? Cost-push inflation begins with an increase in the money wage rate or an increase in the money prices of raw materials, which decreases short-run aggregate supply The decrease in short-run aggregate supply raises the price level and decreases real GDP What must happen to create a cost-push inflation spiral? If the Fed responds to each decrease in short-run aggregate supply by increasing the quantity of money, aggregate demand increases and freewheeling cost-push inflation ensues 190 What is stagflation and why does cost-push inflation cause stagflation? W H AT I S E C O N O M I C S ? 191 Stagflation occurs when real GDP decreases and the price level rises Cost-push inflation causes stagflation when short-run aggregate supply decreases because a decrease in short-run aggregate supply raises the price level and decreases real GDP How does expected inflation occur? Expected increases in aggregate demand or expected decreases in short-run aggregate supply create expected inflation because they change the expected price level For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise With the correct expectation, real GDP remains equal to potential GDP and unemployment remains at its natural rate How real GDP and the price level change if the forecast of inflation is incorrect? If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected and real GDP exceeds potential GDP If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected and real GDP is less than potential GDP 191 Page 347 (page 755 in Economics) What is deflation? Deflation is a persistently falling price level What is the distinction between deflation and a one-time fall in the price level? Deflation is a persistently falling price level; that is, the price level continually falls A one-time fall in the price level occurs when the price level falls but thereafter starts to grow once again What causes deflation? Deflation occurs if aggregate demand increases at a persistently slower rate than aggregate supply This situation typically occurs when the quantity of money grows slowly so that aggregate demand also grows slowly How does the quantity theory of money help us to understand the process of deflation? The equation of exchange shows that the growth rate of the price level equals the money growth rate plus the rate of change of velocity minus the growth rate of real GDP The quantity theory adds two assumptions to the equation of exchange: The trend rate of change of velocity does not depend on the money growth rate and the trend growth rate of real GDP equals the growth rate of potential GDP, which also does not depend on the money growth rate With these assumptions, the quantity theory predicts that a nation’s deflation (or inflation) rate equals the money growth rate plus the trend growth in velocity minus the trend growth in real GDP The situation in Japan illustrates that this prediction is close to what actually occurred What are the consequences of deflation? Unanticipated deflation means that workers who have long-term wage contracts receive a higher real wage rate But firms respond to the higher real wage by hiring fewer workers, so employment and output fall The reduction in output decreases profits Firms respond by decreasing investment, which reduces the growth rate of the capital stock, thereby slowing growth in potential GDP The deflation also lowers the nominal interest rate, which increases the quantity of money people hold, which decreases the velocity of circulation, further adding to deflation How can deflation be ended? Deflation can be ended by increasing the money growth rate In particular, the money growth rate must be changed to equal the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation Page 349(page 757 in Economics) How would you use the Phillips curve to illustrate an unexpected change in inflation? An unexpected change in inflation results in a movement along the short-run Phillips curve In particular, an unexpected increase in the inflation rate lowers the unemployment rate and an unexpected decrease in the inflation rate raises the unemployment rate If the expected inflation rate increases by 10 percentage points, how the short-run Phillips curve and the long-run Phillips curve change? A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips 156 CHAPTER 12 curve directly below it) A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve If the natural unemployment rate increases, what happens to the short-run Phillips curve and the long-run Phillips curve? An increase in the natural unemployment rate shifts both the short-run and longrun Phillips curves rightward by an amount equal to the increase in the natural unemployment rate Does the United States have a stable short-run Phillips curve? Explain why or why not The United States does not have a stable short-run Phillips curve The U.S shortrun Phillips curve shifts with changes in the expected inflation rate and the natural unemployment rate, so it is not stable T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N Answers to the Study Plan Problems and Applications Debate on Causes of Joblessness Grows What is the cause of the high unemployment rate? One side says there is not enough government spending The other says it’s a structural problem— people who can’t move to take new jobs because they are tied down to burdensome mortgages or firms that can’t find workers with the requisite skills to fill job openings Source: The Wall Street Journal, September 4, 2010 Which business cycle theory would say that the rise in unemployment is cyclical? Which would say it is an increase in the natural rate? Why? It is likely that most of the mainstream business cycle theories say that the rise in the unemployment rate is cyclical in nature Definitely the Keynesian cycle theory and new Keynesian cycle theory agree that the rise is cyclical It is also likely that the monetarist cycle theory and new classical cycle theory agree The real business cycle theory, however, disagrees It regards all unemployment as natural and so it would assert that the rise in the unemployment rate reflects a rise in the natural rate High Food and Energy Prices Here to Stay On top of rising energy prices, a severe drought, bad harvests, and a poor monsoon season in Asia have sent grain prices soaring Globally, this is the third major food price shock in five years Source: The Telegraph, August 29, 2012 Explain what type of inflation the news clip is describing and provide a graphical analysis of it The news clip is describing a cost-push inflation The costs of important inputs, such as oil, as well as the cost of other raw materials, such as grain, have all risen Figure 12.1 illustrates a cost-push inflation In it the short-run aggregate supply curve has shifted leftward, from SAS to SAS and the price level has risen from 122 to 124 157 158 Use The AD0 CHAPTER 12 Figure 12.2 to answer Problems to economy starts out on the curves labeled and SAS0 Some events occur and the economy experiences a demand-pull inflation What might those events have been? Describe their initial effects and explain how a demand-pull inflation spiral results Anything that increases aggregate demand can be the factor that starts a demand-pull inflation For instance, an increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of a demand-pull inflation To sustain the inflation, the quantity of money must keep increasing Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion Aggregate demand increases and the AD curve shifts rightward to AD1 The new equilibrium is at the intersection of AD1 and SAS 0, so the price level rises and real GDP increases There is an inflationary gap Starting at the intersection of AD1 and SAS 0, there is an inflationary gap so the money wage rate rises and short-run aggregate supply decreases The SAS curve starts to shift leftward toward SAS1 The price level keeps rising, but real GDP now decreases If the central bank responds with persistent increases in the quantity of money, the process repeats: AD shifts to AD2, an inflationary gap opens again, the money wage rate rises again, and the SAS curve shifts toward SAS2 Some events occur and the economy experiences a cost-push inflation What might those events have been? Describe their initial effects and explain how a cost-push inflation spiral results Anything that decreases short-run aggregate supply can set off a cost-push inflation For instance, an increase in the money wage rate or an increase in the money price of raw materials could be the start of a cost-push inflation But to sustain such an inflation, the quantity of money must keep increasing Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion Short-run aggregate supply decreases and the SAS curve shifts leftward to SAS1 The price level rises and real GDP decreases There is now a recessionary gap Starting out at the intersection of AD0 and SAS 1, there is a recessionary gap so real GDP is below potential GDP and unemployment is above the natural rate In an attempt to restore full employment, the central bank increases the quantity of money The aggregate demand curve shifts rightward to AD1 Real GDP returns to $16 trillion and the price level rises to 160 A further cost increase occurs, which shifts the short-run aggregate supply curve to SAS2 and a recessionary gap opens up again The economy is again below potential GDP In an attempt to restore full employment, the central bank increases the quantity of money The aggregate demand curve shifts rightward to AD2 Real GDP returns to $16 trillion and the price level rises to 200 T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N Some events occur and the economy is expected to experience inflation What might those events have been? Describe their initial effects and what happens as an expected inflation proceeds Anything that increases aggregate demand can set off an expected inflation as long as the event is expected For instance, an expected increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of an expected inflation But to sustain such an expected inflation, the quantity of money must keep increasing along its expected path Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion Aggregate demand increases, and the AD curve shifts rightward to AD1 The increase in aggregate demand is expected so the money wage rate rises and the SAS curve shifts to SAS The price level rises, and real GDP remains equal to potential GDP Starting at the intersection of AD1 and SAS 1, a further expected increase in aggregate demand occurs The AD curve shifts to AD2, and because the increase in aggregate demand is expected, the money wage rate rises again and the SAS curve shifts to SAS2 Again, the price level rises and real GDP remains equal to potential GDP Suppose that the velocity of circulation of money is constant and real GDP is growing at percent a year a To achieve an inflation target of percent a year, at what rate would the central bank grow the quantity of money? To achieve a target inflation rate, the growth rate of the quantity of money must equal the inflation target plus real GDP growth minus growth in velocity In the situation at hand, the growth in the quantity of money should equal percent a year plus percent a year minus percent, or percent a year b At what growth rate of the quantity of money would deflation be created? Deflation occurs if the inflation rate is less than zero Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate The rate of velocity change is zero and the real GDP growth rate is percent a year So the inflation rate is negative when the money growth rate is less than the real GDP growth rate, which is percent a year Eurozone Unemployment Hits Record High As Inflation Rises Unexpectedly Eurozone unemployment rose to 10.7 percent At the same time, eurozone inflation unexpectedly rose to 2.7 percent a year, up from the previous month’s 2.6 percent a year Source: Huffington Post, March 1, 2012 a How does the Phillips curve model account for a very high unemployment rate? The Phillips curve can account for very high unemployment either by a very low inflation rate, which creates a movement along a stationary short-run Phillips curve, or by a very high natural unemployment rate, which shifts both the shortrun and long-run Phillips curves rightward b Explain the change in unemployment and inflation in the eurozone in terms of what is happening to the short-run and long-run Phillips curves The small burst of unexpected inflation mentioned in the news clip brought a movement up along the short-run Phillips curve But a large increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves 159 160 CHAPTER 12 rightward So in the Eurozone, the trade-off between inflation and unemployment worsened as the short-run Phillips curve shifted rightward From the Fed’s Minutes Members expected real GDP growth to be moderate over coming quarters and then to pick up very gradually, with the unemployment rate declining only slowly With longer-term inflation expectations stable, members anticipated that inflation over the medium run would be at or below percent a year Source: FOMC Minutes, June 2012 Are FOMC members predicting that the U.S economy will move along a shortrun Phillips curve or that the short-run Phillips curve will shift through 2012 and 2013? Explain The Fed is predicting that the U.S economy will move leftward along a generally flat short-run Phillips curve The Fed expects that the unemployment rate will fall Because the Fed thinks longer-term inflation expectations are stable, it does not expect the short-run Phillips curve to shift T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N Answers to Additional Problems and Applications Use the following information to work Problems to 11 Suppose that the business cycle in the United States is best described by RBC theory and that a new technology increases productivity Draw a graph to show the effect of the new technology in the market for loanable funds The advance in technology makes investment in industries that can utilize the new technology more profitable Investment demand increases, which increases the demand for loanable funds As Figure 12.3 shows, the increase in the demand for loanable funds shifts the demand for loanable funds curve rightward from DLF0 to DLF1 The increase in the demand for loanable funds raises the equilibrium real interest rate and increases the equilibrium quantity of loanable funds In Figure 12.3 the real interest rate rises from percent a year to percent a year and the quantity of loanable funds increases from $2.5 trillion to $2.7 trillion 10 Draw a graph to show the effect of the new technology in the labor market The advance in technology directly increases the demand for labor as firms look to hire more workers to exploit the technology In addition, the supply of labor increases as workers respond to the higher real interest rate The increase in the supply of labor, however, is less than the increase in the demand for labor As Figure 12.4 shows, the demand for labor curve shifts rightward from LD0 to LD1 and the supply of labor curve shifts rightward from LS0 to LS1 Both changes increase the equilibrium quantity of employment In Figure 12.4 employment increases from 300 billion hours to 330 billion hours The effect on the real wage rate is ambiguous, but if, as illustrated in the figure, the increase in demand exceeds the increase in supply, then the net effect raises the real wage rate In Figure 12.4 the real wage rate rises from $20 per hour to $30 per hour 11 Explain the when-to-work decision when technology advances The when-to-work decision is an important part of the real business cycle theory The increase in technology raises the real interest rate Changes in the real interest rate create an “intertemporal substitution effect,” which is the “when-towork” decision If the real interest rate rises, the return to current work increases 161 162 CHAPTER 12 because any funds saved reap a higher real interest rate (The effect is called “intertemporal” because in the future the increased saving influences people to work less.) As a result, a higher real interest rate increases the current supply of labor, which shifts the supply of labor curve rightward and increases equilibrium employment T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N 12 U.K Treasury Chief Zeros In on Productivity In 2013, U.K productivity, measured in terms of output per hour worked, was 17 percent lower than the average of the G7 In response, U.K Treasury Chief said the government will invest in new infrastructure, including roads and airports, boost worker skills through education reforms, and publish a more detailed productivity plan Source: The Wall Street Journal, May 20, 2015 Explain the relationship between real wages and productivity in this news clip in terms of real business cycle theory The article suggests that “the government will invest in new infrastructure, including roads and airports, and boost worker skills through education reforms.” On the one hand, increase in investment will increase the demand for loanable funds, resulting in a lower real interest rate On the other hand, increases in productivity will increase the demand for labor Due to intertemporal substitution effect, the higher real interest rate increases the supply of labor RBC theorists believe that the effect of intertemporal substitution is large If the effect is so large that the increase in the supply of labor is greater than the demand for labor, then the real wage rate will be lower If the demand for labor is greater than the supply of labor, then the real wage rate will increase Use the following news clip to work Problems 13 and 14 Food Costs Are Stoking Asia Inflation Prices for foodstuffs, including essential items such as rice and milk, have risen in recent months, causing higher inflation rates in Asian countries, such as India, China, Thailand, and Indonesia Food-price increases have significantly pushed inflation rates across the region A 20 percent increase in rice prices regionally is estimated to add 1.5 percentage points to inflation Shortage in supply is seen as the major reason for the price hike In Indonesia, the central bank has called the inflation “temporary” and expects the next harvest season to increase the supply Therefore, the central bank has kept its benchmark interest rate constant In fact, akin to Indonesia, policy makers across Asia are banking on a good harvest to fight inflation over the short term A bad harvest, on the other hand, will spur governments to react seriously Source: The Wall Street Journal, Feb 11, 2010 13 What type of inflation process is referred to in this news clip? Explain how the central bank’s decision to keep the benchmark interest-rate constant could be effective in curbing the inflation The inflation process referred to in the news clip is a cost-push inflation There is a shortage in supply of foodstuffs causing the prices to rise Therefore, aggregate supply decreases, the short-run aggregate supply curve shifts leftward, the price level rises and real GDP decreases If Indonesia’s central bank keeps the benchmark interest rate unchanged, there will be no shift in the aggregate demand curve Also, a temporary inflation implies that there are no strong inflationary expectations, and the aggregate supply curve will return to its original position shortly Finally, the price will return to its initial level and the economy will go back to its initial equilibrium Thus, the central bank’s decision to keep the benchmark interest rate constant can be effective in curbing temporary cost-push inflation 163 164 14 CHAPTER 12 Explain what would happen to the economy if inflationary expectations are formed on the basis of a prolonged shortage in supply and increasing foodprices? Once higher inflationary expectations are formed, workers will demand for higher wages, and the short-run aggregate supply curve will shift leftward Therefore, the price level will rise, real GDP will fall and the unemployment rate will rise, ushering in stagflation T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N 15 Europe’s Deflation Risk The United States is planning to push Europe toward new and more aggressive efforts to boost aggregate demand given a renewed risk of deflation in the euro zone Source: Reuters, September 12, 2014 a Explain the process by which deflation occurs Deflation occurs when aggregate demand persistently grows more slowly than aggregate supply This situation occurs when the money growth rate grows too slowly, which leads to slower growth in aggregate demand b How might Europe boost its aggregate demand? Might the boost to aggregate demand create demand-pull inflation? Europe can persistently boost aggregate demand by persistently increasing the growth rate of the quantity of money If this growth rate is raised too high, then the boost to aggregate demand runs the risk of creating a demand-pull inflation Use the following data to work Problems 16 and 17 An economy has an unemployment rate of percent and an inflation rate of percent a year at point A in Figure 12.5 Then some events occur that move the economy from A to B to D to C and back to A 16 Describe the events that could create this sequence Has the economy experienced demand-pull inflation, costpush inflation, expected inflation, or none of these? First the inflation rate increases from percent a year to 15 percent a year and the unemployment rate does not change Then the unemployment rate increases from percent to percent and the inflation rate does not change Next the inflation rate falls from 15 percent a year to percent a year and the unemployment rate does not change Finally the unemployment rate falls from percent to percent and the inflation rate does not change This set of changes could be the result of an expected increase in the inflation rate from percent to 15 percent, followed by an increase in the natural unemployment rate from percent to percent, followed by an expected fall in the inflation rate from 15 percent to percent, finally followed by a decrease in the natural unemployment rate from percent to percent 165 166 17 CHAPTER 12 Draw in the figure the sequence of the economy’s short-run and long-run Phillips curves Figure 12.6 shows these short-run and long-run Phillips curves The initial increase in the expected inflation rate moves the economy up its (stationary) long-run Phillips curve LRPC0 from point A to point B The short-run Phillips curve shifts upward from SRPC0 to SRPC1 and intersects the long-run Phillips curve at point B Then the increase in the natural unemployment rate shifts both the longrun and short-run Phillips curves rightward to LRPC1 and SRPC2 so that they intersect at point D Next the fall in the expected inflation rate moves the economy along its (stationary) new longrun Phillips curve LRPC1 from point D to point C The short-run Phillips curve shifts downward from SRPC2 to SRPC3 and intersects the long-run Phillips curve at point C Finally, the fall in the natural unemployment rate shifts both the long-run and short-run Phillips curves leftward back to LRPC0 and SRPC0 so that they intersect at point A Use the following information to work Problems 18 and 19 The Reserve Bank of New Zealand signed an agreement with the New Zealand government in which the Bank agreed to maintain inflation inside a low target range Failure to achieve the target would result in the governor of the Bank (the equivalent of the chairman of the Fed) losing his job 18 Explain how this arrangement might have influenced New Zealand’s short-run Phillips curve The Reserve Bank of New Zealand’s arrangement with New Zealand’s government affected the short-run Phillips curve because it affected people’s expectations of the inflation rate In particular, since the agreement was credible and had significant sanctions for the governor of the Reserve Bank of New Zealand, the public likely kept their expected inflation rates lower than might otherwise have been the case As a result, the short-run Phillips curve was lower than it otherwise would have been and, in addition, was probably less likely to shift higher if the inflation rate temporarily rose 19 Explain how this arrangement might have influenced New Zealand’s long-run Phillips curve The long-run Phillips curve is independent of the inflation rate and of people’s inflationary expectations, so the arrangement probably had little direct effect on the long-run Phillips curve The only way in which the long-run Phillips curve could have been affected was if the arrangement affected the natural unemployment rate If the agreement lowered the natural unemployment rate, the long-run Phillips curve shifted leftward T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N 20 Fed Pause Promises Financial Disaster The indication is that inflationary expectations have become entrenched and strongly rooted in world markets As a result, the risk of global stagflation has become significant A drawn-out inflationary process always precedes stagflation Following the attritional effect of inflation, the economy starts to grow below its potential It experiences a persistent output gap, rising unemployment, and increasingly entrenched inflationary expectations Source: Asia Times Online, May 20, 2008 Evaluate the claim made in the news clip that if “inflationary expectations” become strongly “entrenched” an economy will experience “a persistent output gap.” The comment that inflationary expectations become strongly entrenched likely means that the expected inflation rate becomes high The Phillips curve model, however, shows that even with high expected inflation the economy will eventually return to the long-run Phillips curve and the natural rate of unemployment Hence the assertion that high expected inflation means that the economy will experience a “persistent output gap” is incorrect Use the following information to work Problems 21 and 22 Because the Fed doubled the monetary base in 2008 and the government spent billions of dollars bailing out troubled banks, insurance companies, and auto producers, some people are concerned that a serious upturn in the inflation rate will occur, not immediately but in a few years time At the same time, massive changes in the global economy might bring the need for structural change in the United States 21 Explain how the Fed’s doubling of the monetary base and government bailouts might influence the short-run and long-run Phillips curves Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? The doubling of the monetary base might lead to significant inflation at some point in the future If the inflation is unexpected, it will not change either the short-run Phillips curve or the long-run Phillips curve But if at some point the inflation becomes expected, the short-run Phillips curve will shift upward In either case, however, the long-run Phillips curve is not affected The government bailouts probably decreased the amount of cyclical unemployment that otherwise would have occurred In this case they forestalled a movement downward along the short-run Phillips curve As long as the bailed out companies operate efficiently, the bailouts by themselves did not affect the natural unemployment rate and thereby did not change the long-run Phillips curve 22 Explain how large scale structural change might influence the short-run and long-run Phillips curves Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? Large-scale structural changes increase structural unemployment, thereby increasing the natural unemployment rate The long-run and short-run Phillips curves shift rightward, worsening the tradeoff between unemployment and inflation 167 168 CHAPTER 12 Economics in the News 23 After you have studied Economics in the news on pp 350–351 (758–759 in Economics), answer the following questions a What are the macroeconomic problems in the Eurozone economy that the ECB is seeking to address? The Eurozone economy has slow growth a high unemployment rate It also runs the risk of deflation b Is the European unemployment problem structural, cyclical, or both and how can we determine its type? The European unemployment problem has both structural and cyclical components The Eurozone unemployment rate has been persistently higher than the U.S unemployment rate This difference represents structural unemployment, the result of high European minimum wages, generous unemployment and welfare payments, and massive regulation of the labor market But the faltering economic growth rate in Europe has also lead to cyclical unemployment c Explain which type of unemployment the ECB can help with The ECB can use its monetary policy to increase aggregate demand and lower cyclical unemployment d Use the AS-AD model to show the changes in aggregate demand and/or aggregate supply that created the Eurozone’s macroeconomic problems Figure 12.7 shows the situation in the Eurozone Starting at point A, equilibrium real GDP is €14.5 trillion and potential GDP is €15 trillion Real GDP is less than potential GDP by €0.5 trillion Over time potential GDP increased by €3 trillion, from €15 trillion to €18 trillion But the aggregate demand increased by less The aggregate demand curve shifted from AD0 to AD1, an increase of only €2.5 at every price level The equilibrium moved to point B At point B equilibrium real GDP is €17 trillion and potential GDP is €18 trillion Equilibrium real GDP is now less than potential GDP by €1 trillion The recession has worsened and Eurozone unemployment has risen e Use the AS-AD model to show the changes in aggregate demand and/or aggregate supply that the ECB must bring about to achieve its goal The ECB’s goal is to increase the quantity of money sufficiently so that aggregate demand increases enough to restore the economy to full employment at potential GDP Figure 12.8 shows the ECB’s goal Starting from point B, with a T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N recessionary gap of €1 trillion, potential GDP will increase by €3 trillion from €18 trillion to €21 trillion The ECB’s goal is to increase aggregate demand by even more If the ECB can increase aggregate demand from AD1 to AD2, an increase of €4.5 at every price level, the new equilibrium point will be at point C At this equilibrium the Eurozone will have returned to potential GDP and employment will equal full employment 24 Germany Leads Slowdown in Eurozone The pace of German economic growth has weakened “markedly,” but the reason is the weaker global prospects Although German policymakers worry about the country’s exposure to a fall in demand for its export goods, evidence is growing that the recovery is broadening with real wage rates rising and unemployment falling, which will lead into stronger consumer spending Source: The Financial Times, September 23, 2010 a How does “exposure to a fall in demand for its export goods” influence Germany’s aggregate demand, aggregate supply, unemployment and inflation? If there is a severe decrease in demand for Germany’s exports, Germany’s aggregate demand decreases There is no impact on aggregate supply The decrease in aggregate demand lowers the price level and decreases real GDP The fall in the price level means that the inflation rate falls; the decrease in real GDP means that unemployment rises b Use the AS-AD model to illustrate your answer to part (a) Figure 12.9 illustrates this situation Aggregate demand decreases and the aggregate demand curve shifts leftward, from AD0 to AD1 The economy moves from point A to point B Real GDP decreases and the price level falls c Use the Phillips curve model to illustrate your answer to part (a) In part (a) the inflation rate fell and the unemployment rate increased People’s inflation expectations likely did not change so the German economy moved along its short-run Phillips curve In 2010, the German inflation rate was percent and the unemployment rate was percent Figure 12.10 shows the effect of the decrease in demand for exports as the movement from point A on the short-run Phillips curve SRPC to point B 169 170 d CHAPTER 12 on the same short-run Phillips curve The inflation rate falls and the unemployment rate rises What you think the news clip means by “the recovery is broadening with real wage rates rising and unemployment falling, which will lead into stronger consumer spending”? The clip is implicitly talking about the multiplier effect It is predicting that aggregate demand will increase as a result of the increase in consumption expenditure Aggregate supply might also change but the emphasis in the news clip is on aggregate demand The increase in aggregate demand increases real GDP and raises the price level The increase in real GDP lowers the unemployment rate and the increase in the price level raises the inflation rate e Use the AS-AD model to illustrate your answer to part (d) f Figure 12.11 illustrates this situation Aggregate demand increases because of the higher consumption expenditure and the aggregate demand curve shifts rightward, from AD0 to AD1 The economy moves from point A to point B Real GDP increases and the price level rises Use the Phillips curve model to illustrate your answer to part (d) In part e the inflation rate rose and the unemployment rate decreased People’s inflation expectations likely did not change so the German economy moved along its short-run Phillips curve In 2010, the German inflation rate was percent and the unemployment rate was percent Figure 12.12 shows the effect of the increase in consumption expenditure as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve The inflation rate rises and the unemployment rate decreases ... Figure 12. 1 illustrates a cost-push inflation In it the short-run aggregate supply curve has shifted leftward, from SAS to SAS and the price level has risen from 122 to 124 157 158 Use The AD0 CHAPTER. .. attempt to restore full employment, the central bank increases the quantity of money The aggregate demand curve shifts rightward to AD1 Real GDP returns to $16 trillion and the price level rises to. .. curve to shift T H E B U S I N E S S C Y C L E , I N F L AT I O N , A N D D E F L A T I O N Answers to Additional Problems and Applications Use the following information to work Problems to 11
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