Answers to Exercises

1. Keynesians focus on fluctuations in aggregate demand as the source of macroeconomic instability. New Keynesians look to microeconomic sources of instability, such as wage and price rigidities.

2. Monetary policy works with a long and variable lag because the time that is required for the recognition, reaction, and effect lags varies from one circumstance to another. For example, if the economy is going into a recession because of a widely known supply shock, the recognition lag may be short. If the Fed also reacts quickly by increasing the money supply, the reaction lag is also short. But if either the recession comes as a surprise or policymakers are indecisive, the lags will be longer.

3. Old classical economics assumed that people were aware of all alternative wages and prices in the economy. New classical economics assumes that people develop rational expectations about prices and wages. Thus, although in the short run they may be fooled into thinking a general price or wage change is a relative change, in the long run (often not very long according to the theory) people correct their expectations.

4.

Keynesians claim that if the economy is in a recession with output below potential output, as in the above diagram at Y₁, monetary and fiscal policies can be used to increase aggregate demand to AD₂ and thus generate an equilibrium at potential output.

From a monetarist perspective, if the economy is in a recession with output Y1 less than potential output Y_p, the economy should be left alone to correct itself. This would occur as

prices and wages fall and the aggregate supply curve shifts from AS₁ to AS₂. The economy would follow the path A to B. Monetarists believe that although policy can shift the aggregate demand curve, the economy will correct itself before policy can have its effect. In fact, in the monetarist view policy can create instability. This occurs when aggregate supply shifts before aggregate demand. This moves the economy along the path ABCD.

For new classical economists the economy tends to operate at potential output Y_p. If policy is unexpected, an increase in aggregate demand will increase output and prices. The increase in output will last only until expectations are adjusted. The economy will follow the path ABC. If the policy is expected, the economy will follow the path AC.

5. All of the theories recognize the effect of changes in aggregate demand on prices and output in the short run.

6. Soon people in the economy would recognize that the Fed was attempting to fool them and would anticipate the policy. In the end the only policy that could work would be one that was unpredictable. Unfortunately, such a policy would also be unpredictable to the Fed and would have unpredictable effects on the economy. Furthermore, repeated attempts to increase the money supply would cause higher and higher inflation. Finally the Fed would loose its credibility.

7. Keynesian macroeconomics evolved largely as a result of the fact that classical macro theory could not explain the high unemployment and negative growth during the Great Depression. Monetarism and new classical macroeconomics evolved in response to the stagflation of the 1970s and the apparent impotence of Keynesian macro policies.

8. Keynesian

9. Monetarist

10. New classical

11. Monetarist

12. Keynesian

13. Keynesian

14. Keynesian

15. New classical

Answers to Study Guide Homework

1. D; A; A

2. A; D; D

3. A; A; A

4. A; D; D

5. a. Monetarists
b. New classical economists
c. Keynesians and New Keynesians
d. Monetarists
e. Monetarists and new classical economists

Answers to Internet Exercise

The purpose of this exercise is to expose students to economic data for a developing country. By calculating growth rates in real GDP and money supply, students will be able to determine if a relationship exists similar to the relationship that exists in the United States. The exercise will also serve as a review of graphical interpretation of data.

1.

2.

3. The diagram shows that changes in real GDP appear to occur slightly ahead of changes in the money supply for the Philippines.