Answers to Exercises

1.

Let us begin at U_n and Y_n: If aggregate demand increases to AD₂, prices are higher than expected, output expands (from Y_n to Y₂), and prices increase (from P₁ to P₂). The increase in the price level starts an increase in the inflation rate. Also, as output increases, the unemployment rate falls from U_n to U₂. When expected prices equal the actual price level, wage rates increase and employers reduce their production. The AS curve shifts to AS₂ and the Phillips curve shifts to p₂ as expected inflation increases. When actual prices equal expected prices, the economy is on its long-run aggregate supply and its long-run Phillips curves. When expected prices and actual prices differ, the economy is on its short-run aggregate supply curve and its short-run Phillips curve.

2. If workers receive higher than expected wage offers because of unexpected inflation, they may

accept those offers and shorten their job searches. Thus, the unemployment rate will fall. If prices are higher than businesses expect, they may view those higher prices as increases in relative prices. Thus, businesses will increase production and employment, and the unemployment rate will be reduced.

3.

Let us start with point A: An unexpected increase in the money supply leads to unexpected inflation. This moves the economy from point A to point B on the Phillips curve. When prices are correctly anticipated, the Phillips curve shifts to the right, p₂, and the economy moves to point C on the long-run Phillips curve. An unexpected decrease in the money supply leads to unexpectedly lower prices. This means that the unemployment rate rises and the economy moves from point A to point D. When price expectations are adjusted so that they are equal to actual prices, the short-run Phillips curve shifts to p₃. The unemployment rate rises and the economy moves to point E. In both cases, there is a clockwise movement in the diagram.

4a. Macroeconomic expectations comprise adaptive expectations and rational expectations. Adaptive expectations are formed as individuals use past movements in the variable to predict the future movements of the variable. Rational expectations are formed as individuals use all relevant information about a variable and within the context of a model predict future changes in the variable.

b. Announced changes in policy can affect output if expectations are adaptive; announced policy will not affect output if expectations are rational.

5. G = T + B + DM. Government spending can be financed with any combination of taxes, government borrowing, and increased monetary base. If an increase in spending exceeds an increase in taxes, the deficit can be financed by increasing government borrowing and the monetary base. If the government borrows, the demand for loanable funds will increase and interest rates will rise. If the Fed does not wish for interest rates to rise, it may buy the bonds that were issued and thus increase the monetary base. Hence, fiscal and monetary policies are linked.

6. a. If a country has a limited ability to increase taxes and is unable to borrow in financial markets, its only option is to finance government expenditures through inflationary money creation.

b. To engage in a noninflationary monetary policy, either the government budget must be in balance or the government must borrow to finance any deficit.

7. All of these "policies" could be time inconsistent if the parent is unwilling to follow through later.

8. a. The public will probably believe the policy because the central bank has generated and maintained its credibility.
b. The public will not believe the policy because the bank lacks credibility.

9. a. Recessions will occur immediately after elections, with expansions occurring before and during election years.
b. Business cycles will be largely random events.

10. Without an independent monetary authority, monetary policy would be blatantly political. Politicians would manipulate the money supply and interest rates to win votes so that their reelection would be the main goal of monetary policy rather than the long-run economic health of the economy.

11. $5 billion

12. $120 billion

13. a. Output would fall, and we would expect a recession.
b. Output would tend to rise and the price level would tend to fall.
c. Output would tend to rise.

14.

AD is increased by fiscal and/or monetary policy prior to the election. The economy moves along the short-run AS curve so that real GDP increases prior to the election. Later, following the election, the short-run AS curve shifts to the left and the price level rises as real GDP falls.

15.

Fiscal and/or monetary policy stimulates the economy prior to the election and the surprising increase in spending and inflation rates leads to a movement along Phillips curve I. After the election, as the public comes to realize that the inflation rate has increased, the short-run Phillips curve shifts out to curve II and the economy moves to a point along the long-run Phillips curve at a higher inflation rate.

Answers to Study Guide Homework

1. The relationship between the inflation rate and the unemployment rate.

2. a. In the short run, there is a possible trade-off between inflation and unemployment.

b. In the long run, no tradeoff is possible.

3. a. M; b. R; c. R; d. F; e. F; f. M

4. a. Adaptive expectations (based only on past experience)

b. Rational expectations (based on all available information, not just the past)

5. Rain causes AS to shift to the left. Equilibrium price level will increase, and real GDP will fall, as shown below.

Answers to Internet Exercise

This exercise allows students to explore the relationship between inflation and unemployment by developing an understanding of an alternative measure of the natural rate of unemployment. By reading a portion of the Economic Report of the President, students will answer questions regarding the NAIRU. The purpose of the exercise is to expose students to measures of unemployment rather than those commonly reported to the public via the media. The instructor should review student answers for a basic understanding of the tradeoffs between unemployment and inflation.

NAIRU is the unemployment rate at which - absent special factors - the odds of falling and rising inflation are roughly balanced.

NAIRU is not a constant over time. It is affected by factors such as the demographic composition of the labor force and changes in the structure of labor and product markets.

The influence of special, transitory factors has prevented prices and labor costs from accelerating. Those mentioned in the ERP include the costs of providing workers with non-wage compensation rising at a very low rate and computer prices (driven by technology) declining at a faster than average rate.

The NAIRU was originally determined to be at a midpoint of 5.5%, but was revised downward to 5.4%.