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 i
Trang 1A n s w e r s t o t h e
R e v i e w Q u i z z e s
Page 338 (page 746 in Economics)
1 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 do 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
2 What are the four special forms of the mainstream theory of the business cycle and how do 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
1 2
THE BUSINESS CYCLE,
INFLATION, AND
189
Trang 21 9 0
3 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
4 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
5 What are the main criticisms of RBC theory and how do 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)
1 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
2 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 demand-pull 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
3 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
4 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
5 What is stagflation and why does cost-push inflation cause stagflation?
190
Trang 3Stagflation 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
6 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
7 How do 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
Trang 4Page 347 (page 755 in Economics)
1 What is deflation?
Deflation is a persistently falling price level
2 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
3 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
4 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
5 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
6 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)
1 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
2 If the expected inflation rate increases by 10 percentage points, how do 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
Trang 5curve directly below it) A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve
3 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 long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate
4 Does the United States have a stable short-run Phillips curve? Explain why or why not
The United States does not have a stable run Phillips curve The U.S short-run Phillips curve shifts with changes in the expected inflation rate and the natural unemployment rate, so it is not stable
Trang 6A n s w e r s t o t h e S t u d y P l a n P r o b l e m s a n d
A p p l i c a t i o n s
1 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
2 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 SAS0 to SAS1 and
the price level has risen from 122 to 124
T H E B U S I N E S S C YC L E , I N F L AT I O N , A N D D E F L AT I O N 1 5 7
Trang 7Use Figure 12.2 to answer Problems 3 to 5.
The economy starts out on the curves labeled
AD0 and SAS0
3 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 SAS0,
so the price level rises and real GDP increases There is an inflationary gap
Starting at the intersection of AD1 and SAS0, 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
4 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 SAS1, 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
Trang 85 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 SAS1 The price level rises, and real GDP remains equal to potential GDP
Starting at the intersection of AD1 and SAS1, 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
6 Suppose that the velocity of circulation of money is constant and real GDP is growing at 3 percent a year
a To achieve an inflation target of 2 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 2 percent a
year plus 3 percent a year minus 0 percent, or 5 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 3 percent a year So the inflation rate is
negative when the money growth rate is less than the real GDP growth rate, which
is 3 percent a year
7 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
short-run and long-short-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
T H E B U S I N E S S C YC L E , I N F L AT I O N , A N D D E F L AT I O N 1 5 9
Trang 9rightward So in the Eurozone, the trade-off between inflation and unemployment worsened as the short-run Phillips curve shifted rightward
8 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 2 percent
a year
Source: FOMC Minutes, June 2012 Are FOMC members predicting that the U.S economy will move along a short-run Phillips curve or that the short-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
Trang 10Answers to Additional Problems and Applications
Use the following information to work
Problems 9 to 11
Suppose that the business cycle in the United
States is best described by RBC theory and
that a new technology increases productivity
9 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 4 percent a year to 5 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-to-work” decision If the real interest rate rises, the return to current work increases
T H E B U S I N E S S C YC L E , I N F L AT I O N , A N D D E F L AT I O N 1 6 1