Transcript Problem Session-2

ECO102
Principles of
Macroeconomics
Problem Session-4-5-6
by
Research Assistant
Serkan Değirmenci
19.04.2012
03.05.2012
10.05.2012
Today
• Mankiw (2008), Principles of Economics:
- Chapter 28: Unemployment:
 Questions for Review (QfR): 1-7 (page: 636)
 Problem and Applications (P&A): 1-10 (page: 636-637)
Chapter 28: QfR-1 (page: 636)
• What are the three categories into which the Bureau of Labor
Statistics divides everyone? How does it compute the labor
force, the unemployment rate, and the labor force
participation rate?
• ANSWER:
The BLS categorizes each adult (16 years of age and older) as
either employed, unemployed, or not in the labor force.
The labor force consists of the sum of the employed and the
unemployed.
The unemployment rate is the percentage of the labor force
that is unemployed.
The labor-force participation rate is the percentage of the
total adult population that is in the labor force.
Chapter 28: QfR-2 (page: 636)
• Is unemployment typically short-term or long-term? Explain.
• ANSWER:
Unemployment is typically short term. Most people who
become unemployed are able to find new jobs fairly quickly.
But some unemployment is attributable to the relatively few
workers who are jobless for long periods of time.
Chapter 28: QfR-3 (page: 636)
• Why is frictional unemployment inevitable? How might the
government reduce the amount of frictional unemployment?
• ANSWER:
Frictional unemployment is inevitable because the economy is
always changing. Some firms are shrinking while others are
expanding. Some regions are experiencing faster growth than other
regions. Transitions of workers between firms and between regions
are accompanied by temporary unemployment.
The government could help to reduce the amount of frictional
unemployment through public policies that provide information
about job vacancies in order to match workers and jobs more
quickly, and through public training programs that help ease the
transition of workers from declining to expanding industries and
help disadvantaged groups escape poverty.
Chapter 28: QfR-4 (page: 636)
• Are minimum-wage laws a better explanation for structural
unemployment among teenagers or among college
graduates? Why?
• ANSWER:
Minimum-wage laws are a better explanation for
unemployment among teenagers than among college
graduates. Teenagers have fewer job-related skills than
college graduates do, so their wages are low enough to be
affected by the minimum wage. College graduates' wages
generally exceed the minimum wage.
Chapter 28: QfR-5 (page: 636)
• How do unions affect the natural rate of unemployment?
• ANSWER:
Unions may affect the natural rate of unemployment via the
effect on insiders and outsiders. Because unions raise the
wage above the equilibrium level, the quantity of labor
demanded declines while the quantity supplied of labor rises,
so there is unemployment. Insiders are those who keep their
jobs. Outsiders, workers who become unemployed, have two
choices: either get a job in a firm that is not unionized, or
remain unemployed and wait for a job to open up in the
union sector. As a result, the natural rate of unemployment is
higher than it would be without unions.
Chapter 28: QfR-6 (page: 636)
• What claims do advocates of unions make to argue that
unions are good for the economy?
• ANSWER:
Advocates of unions claim that unions are good for the
economy because they are an antidote to the market power
of the firms that hire workers and they are important for
helping firms respond efficiently to workers' concerns.
Chapter 28: QfR-7 (page: 636)
• Explain four ways in which a firm might increase its profits by
raising the wages it pays.
• ANSWER:
Four reasons why a firm's profits might increase when it raises
wages are:
(1) better paid workers are healthier and more productive;
(2) worker turnover is reduced;
(3) the firm can attract higher quality workers; and
(4) worker effort is increased.
Chapter 28: P&A-1 (page: 636)
• As shown in Figure 3, the overall labor-force participation rate of men
declined between 1970 and 2000. At the same time, the labor force
participation rate of women increased sharply. This overall decline reflects
different patterns for different age groups, however, as shown in the
following tables.
All Men
Men
16-24
Men
25-54
Men
55 and older
1970
80%
69%
96%
56%
2000
75
69
92
40
All Women
Women
16-24
Women
25-54
Women
55 and older
1970
43%
51%
50%
25%
2000
60
63
77
26
Chapter 28: P&A-1 (page: 636)-cont.
• Given this information, what factor do you think played the key role in the
decline in male labor-force participation over this period?
What do you think explains the increase in labor-force participation for
women?
• ANSWER:
Men age 55 and over experienced the greatest decline in labor-force
participation. This was because of increased Social Security benefits and
retirement income, encouraging retirement at an earlier age.
The rise in female labor force participation may be the result of changes in
social attitudes, labor-saving devices in the home such as dishwashers and
microwave ovens, and lower fertility rates.
Chapter 28: P&A-2 (page: 636)
•
•
The Bureau of Labor Statistics announced that in February 2008, of all adult
Americans, 145,993,000 were employed, 7,381,000 were unemployed, and
79,436,000 were not in the labor force. Use this information to calculate:
a. the adult population
b. the labor force
c. the labor-force participation rate
d. the unemployment rate
ANSWER:
The labor force consists of the number of employed (145,993,000) plus the
number of unemployed (7,381,000), which equals 153,374,000.
To find the labor-force participation rate, we need to know the size of the adult
population. Adding the labor force (153,374,000) to the number of people not in
the labor force (79,436,000) gives the adult population of 232,810,000. The laborforce participation rate is the labor force (153,374,000) divided by the adult
population (232,810,000) times 100%, which equals 66%.
The unemployment rate is the number of unemployed (7,381,000) divided by the
labor force (153,374,000) times 100%, which equals 4.8%.
Chapter 28: P&A-3 (page: 636)
•
•
Go to the website of the Turkish Statistical Institute (www.turkstat.gov.tr). What is
the national unemployment rate right now? Find the unemployment rate for the
demographic group that best fits a description of you (for example, based on age,
sex, and race). Is it higher or lower than the national average? Why do you think
this is so?
ANSWER:
Many answers are possible.
Chapter 28: P&A-4 (page: 636)
•
Between 2004 and 2007, total U.S. employment increased by 6.8 million workers,
but the number of unemployed workers declined by only 1.1 million.
How are these numbers consistent with each other?
Why might one expect a reduction in the number of people counted as
unemployed to be smaller than the increase in the number of people employed?
ANSWER:
The fact that employment increased 6.8 million while unemployment declined 1.1
million is consistent with growth in the labor force of 5.7 million workers. The
labor force constantly increases as the population grows and as labor-force
participation increases, so the increase in the number of people employed may
always exceed the reduction in the number unemployed.
Chapter 28: P&A-5 (page: 636-637)
•
Economists use labor-market data to evaluate how well an economy is using its
most valuable resource-its people. Two closely watched statistics are the
unemployment rate and the employment-population ratio.
Explain what happens to each of these in the following scenarious.
In your opinion, which statistic is the more meaningful gauge of how well the
economy is doing?
a. An auto company goes bankrupt and lays off its workers, who immediately start
looking for new jobs.
b. After an unsuccessful search, some of the laid-off workers quit looking for new
jobs.
c. Numerous students graduate from college but cannot find work.
d. Numerous students graduate from college and immediately begin new jobs.
e. A stock market boom induces newly enriched 60-year-old workers to take early
retirement.
f. Advances in health care prolong the life of many retirees.
Chapter 28: P&A-5 (page: 636-637)-cont.
•
ANSWER:
a. If an auto company goes bankrupt and its workers immediate begin looking for
work, the unemployment rate will rise and the employment-population ratio will
fall.
b. If some of the unemployed auto workers give up looking for a job, the
unemployment rate will fall and the employment-population ratio will remain the
same.
c. If numerous students graduate from college and cannot find work, the
unemployment rate will rise and the employment-population ratio will remain
unchanged.
d. If numerous students graduate from college and immediately begin new jobs,
the unemployment rate will fall and the employment-population ratio will rise.
e. If a stock market boom induces earlier retirement, the unemployment rate will
rise and the employment-population ratio will fall.
f. Advances in health care that prolong the life of retirees will not affect the
unemployment rate and will lower the employment-population ratio.
Chapter 28: P&A-6 (page: 637)
•
•
Are the following workers more likely to experience short-term or long-term unemployment? Explain.
a. a construction worker laid off because of bad weather
b. a manufacturing worker who loses her job at a plant in an isolated area
c. a stagecoach-industry worker laid off because of competition from railroads
d. a short-order cook who loses his job when a new restaurant opens across the street
e. an expert welder with little formal education who loses her job when the company installs automatic
welding machinery
ANSWER:
a. A construction worker who is laid off because of bad weather is likely to experience short-term
unemployment, because the worker will be back to work as soon as the weather clears up.
b. A manufacturing worker who loses her job at a plant in an isolated area is likely to experience long-term
unemployment, because there are probably few other employment opportunities in the area. She may
need to move somewhere else to find a suitable job, which means she will be out of work for some time.
c. A worker in the stagecoach industry who was laid off because of the growth of railroads is likely to be
unemployed for a long time. The worker will have a lot of trouble finding another job because his entire
industry is shrinking. He will probably need to gain additional training or skills to get a job in a different
industry.
d. A short-order cook who loses his job when a new restaurant opens is likely to find another job fairly
quickly, perhaps even at the new restaurant, and thus will probably have only a short spell of
unemployment.
e. An expert welder with little education who loses her job when the company installs automatic welding
machinery is likely to be without a job for a long time, because she lacks the technological skills to keep up
with the latest equipment. To remain in the welding industry, she may need to go back to school and learn
the newest techniques.
Chapter 28: P&A-7 (page: 637)
•
•
Using a diagram of the labor market, show the effect of an increase in the
minimum wage on the wage paid to workers, the number of workers supplied, the
number of workers demanded, and the amount of unemployment.
ANSWER:
Figure 2 shows a diagram of the labor market with a binding minimum wage. At
the initial minimum wage (m1), the quantity of labor supplied L1S is greater than
the quantity of labor demanded L1D, and unemployment is equal to L1S − L1D. An
increase in the minimum wage to m2 leads to an increase in the quantity of labor
supplied to L2S and a decrease in the quantity of labor demanded to L2D. As a
result, unemployment increases as the minimum wage rises.
Chapter 28: P&A-8 (page: 637)
•
Consider an economy with two labor markets-one for manufacturing workers and
one for service workers. Suppose initially that neither is unionized.
a. If manufacturing workers formed a union, what impact on the wages and
employment in manufacturing would you predict?
b. How would these changes in the manufacturing labor market affect the supply
of labor in the market for service workers?
What would happen to the equilibrium wage and employment in this labor
market?
Chapter 28: P&A-8 (page: 637)-cont.
•
•
ANSWER:
a. Figure 3 illustrates the effect of a union being established in the manufacturing labor
market. In the figure on the left, the wage rises from w1U to w2U and the quantity of labor
demanded declines from U1 to U2D. Because the wage is higher, the quantity supplied of labor
increases to U2S, so there are U2S − U2D unemployed workers in the unionized manufacturing
sector.
b. When those workers who become unemployed in the manufacturing sector seek
employment in the service labor market, shown in the figure on the right, the supply of labor
shifts to the right from S1 to S2. The result is a decline in the wage in the nonunionized service
sector from w1N to w2N and an increase in employment in the nonunionized service sector
from N1 to N2.
Chapter 28: P&A-9 (page: 637)
•
Structural unemployment is sometimes said to result from a mismatch between
the job skills that employers want and the job skills workers have. To explore this
idea, consider an economy with two industries: auto manufacturing and aircraft
manufacturing.
a. If workers in these two industries require similar amounts of training, and if
workers at the beginning of their careers could choose which industry to train for,
what would you expect to happen to the wages in these two industries? How long
would this process take? Explain.
b. Suppose that one day the economy opens itself to international trade and, as a
result, starts importing autos and exporting aircradt. What would happen to
demand for labor in these two industries?
c. Suppose that workers in one industry cannot be quickly retrained for the other.
How would these shifts in demand affect equilibrium wages both in the short run
and in the long run?
d. If for some reason wages fail to adjust to the new equilibrium level, what would
occur?
Chapter 28: P&A-9 (page: 637)-cont.
• ANSWER:
a. Wages between the two industries would be equal. If not, new workers
would choose the industry with the higher wage, pushing the wage in that
industry down.
b. If the country begins importing autos, the demand for domestic auto
workers will fall. If the country begins to export aircraft, there would be
an increase in the demand for workers in the aircraft industry.
c. In the short run, wages in the auto industry will fall, while wages in the
aircraft industry will rise. Over time, new workers will move into the
aircraft industry bringing its wage down until wages are equal across the
two industries.
d. If the wage does not adjust to its equilibrium level, there would be a
shortage of workers in the aircraft industry and a surplus of labor
(unemployment) in the auto industry.
Chapter 28: P&A-10 (page: 637)
•
Suppose that Congress passes a law requiring employers to provide employees
some benefit (such as health care) that raises the cost of an employee by $4 per
hour.
a. What effect does this employer mandate have on the demand for labor? (In
answering this and the following questions, be quantitative when you can.)
b. If employees place a value on this benefit exactly equal to its cost, what effect
does this employer mandate have on the supply of labor?
c. If the wage is free to balance supply and demand, how does this law affect the
wage and the level of employment? Are employers better or worse off? Are
employees better or worse off?
d. Suppose that, before the mandate, the wage in this market was $3 above the
minimum wage. In this case, how does the employer mandate affect the wage, the
level of employment, and the level of unemployment?
e. Now suppose that workers do not value the mandated benefit at all. How does
this alternative assumption change your answers to parts (b) and (c)?
Chapter 28: P&A-10 (page: 637)-cont.
• ANSWER:
a. If a firm was not providing such benefits prior to the legislation, the
curve showing the demand for labor would shift down by exactly $4 at
each quantity of labor, because the firm would not be willing to pay as
high a wage given the increased cost of the benefits.
b. If employees value the benefit by exactly $4 per hour, they would be
willing to work the same amount for a wage that's $4 less per hour, so the
supply curve of labor shifts down by exactly $4.
Chapter 28: P&A-10 (page: 637)-cont.
•
ANSWER:
c. Figure 4 shows the equilibrium in the labor market. Because the demand and supply curves
of labor both shift down by $4, the equilibrium quantity of labor is unchanged and the wage
rate declines by $4. Both employees and employers are just as well off as before.
d. If the minimum wage prevents the wage from falling, the result will be increased
unemployment, as Figure 5 shows. Initially, the equilibrium quantity of labor is L1 and the
equilibrium wage is w1, which is $3 lower than the minimum wage wm. After the law is
passed, demand falls to D2 and supply rises to S2. Because of the minimum wage, the
quantity of labor demanded (L2D) will be smaller than the quantity supplied (L2S). Thus, there
will be unemployment equal to L2S – L2D.
Chapter 28: P&A-10 (page: 637)-cont.
•
ANSWER:
e. If the workers do not value the mandated benefit at all, the supply curve of labor does not
shift down. As a result, the wage rate will decline by less than $4 and the equilibrium
quantity of labor will decline, as shown in Figure 6. Employers are worse off, because they
now pay a greater total wage plus benefits for fewer workers. Employees are worse off,
because they get a lower wage and fewer are employed.
Today
• Mankiw (2008), Principles of Economics
- Chapter 31: Open-Economy
Macroeconomics: Basic Concepts
 Questions for Review (QfR): 1-5 (page: 713)
 Problems and Applications (P&A): 1-12 (page: 713714)
Chapter 31: QfR-1 (page: 713)
• Define net exports and net capital outflow. Explain how
and why they are related.
• ANSWER: (SEE PAGE 692 & 696-697)
• The net exports of a country are the value of its
exports minus the value of its imports.
• Net capital outflow refers to the purchase of foreign
assets by domestic residents minus the purchase of
domestic assets by foreigners.
• Net exports are equal to net capital outflow by an
accounting identity, because exports from one
country to another are matched by payments of
some asset from the second country to the first.
Chapter 31: QfR-2 (page: 713)
• Explain the relationship among saving, investment,
and net capital outflow.
• ANSWER: (SEE PAGE 699)
• Saving equals domestic investment plus net capital
outflow, because any dollar saved can be used to
finance accumulation of domestic capital or it can be
used to finance the purchase of capital abroad.
Y = C + I + G + NX
Y – C – G = I + NX
S = I + NX
NX = NCO
S = I + NCO
Chapter 31: QfR-3 (page: 713)
• If Japanese car costs 500,000 yen, a similar American
car costs $10,000, and a dollar can buy 100 yen,
what are the nominal and real exchange rates?
• ANSWER: (SEE PAGE 703-704-705)
• If a dollar can buy 100 yen, the nominal exchange
rate is 100 yen per dollar.
• The real exchange rate equals the nominal
exchange rate times the domestic price divided by
the foreign price, which equals 100 yen per dollar
times $10,000 per American car divided by 500,000
yen per Japanese car, which equals two Japanese
cars per American car.
Chapter 31: QfR-4 (page: 713)
• Describe the economic logic behind the theory of
purchasing-power parity?
• ANSWER: (SEE PAGE 707)
• The economic logic behind the theory of purchasingpower parity is that a good must sell for the same
price in all locations. Otherwise, people would profit
by engaging in arbitrage.
Chapter 31: QfR-5 (page: 713)
• If the Fed started printing large quantities of U.S.
Dollars, what would happen to the number of
Japanese yen a dollar could buy? Why?
• ANSWER: (SEE PAGE 709)
• If the Fed started printing large quantities of U.S.
dollars, the U.S. price level would increase, and a
dollar would buy fewer Japanese yen.
Chapter 31: P&A-1 (page: 713)
Would each of the following transactions be included in
net exports or net capital outflow?
Be sure to say whether it would represent an increase or
a decrease in that variable.
a. An American buys a Sony TV.
b. An American buys a share of Sony stock.
c. The Sony pension fund buys a bond from the U.S.
treasury.
d. A worker at Sony plant in Japan buys some Georgia
peaches from an American farmer.
Chapter 31: P&A-1-cont. (page: 713)
a. When an American buys a Sony TV, there is a
decrease in net exports.
b. When an American buys a share of Sony stock,
there is an increase in net capital outflow.
c. When the Sony pension fund buys a U.S.
Treasury bond, there is a decrease in net capital
outflow.
d. When a worker at Sony buys some Georgia
peaches from an American farmer, there is an
increase in net exports.
Chapter 31: P&A-2 (page: 713)
International trade in each of the following products has
increased over time. Suggest some reasons this might be
so.
a. wheat
b. banking services
c. computer software
d. automobiles
Chapter 31: P&A-2-cont. (page: 713)
a. Wheat is traded more internationally than in the past
because shipping costs have declined, as have trade
restrictions.
b. Banking services are traded more internationally than in
the past because communications costs have declined, as
have trade restrictions.
c. Computer software is traded more internationally than in
the past because the computer industry has grown and the
software is easier to transport (because it can now be
downloaded electronically).
d. Automobiles are traded more internationally than in the
past because transportation costs have declined, as have
tariffs and quotas.
Chapter 31: P&A-3 (page: 713)
How would the following transactions affect U.S. exports,
imports, and net exports?
a. An American art professor spends the summer touring
museums in Europe.
b. Students in Paris flock to see the latest movie from
Hollywood.
c. Your uncle buys a new Volvo.
d. The student bookstore at Oxford University in England
sells a pair of Levi’s 501 jeans.
e. A Canadian citizen shops at a store in northern
Vermont to avoid Canadian sales taxes.
Chapter 31: P&A-3-cont. (page: 713)
a. When an American art professor spends the summer touring
museums in Europe, he spends money buying foreign goods and services,
so U.S. exports are unchanged, imports increase, and net exports
decrease.
b. When students in Paris flock to see the latest movie from Hollywood,
foreigners are buying a U.S. good, so U.S. exports rise, imports are
unchanged, and net exports increase.
c.
When your uncle buys a new Volvo, an American is buying a foreign
good, so U.S. exports are unchanged, imports rise, and net exports
decline.
d. When the student bookstore at Oxford University sells a pair of Levi's
501 jeans, foreigners are buying U.S. goods, so U.S. exports increase,
imports are unchanged, and net exports increase.
e. When a Canadian citizen shops in northern Vermont to avoid
Canadian sales taxes, a foreigner is buying U.S. goods, so U.S. exports
increase, imports are unchanged, and net exports increase.
Chapter 31: P&A-4 (page: 713)
Describe the difference between foreign direct
investment and foreign portfolio investment.
Who is more likely to engage in foreign direct
investment-a corporation or an individual investor?
Who is more likely to engage in foreign portfolio
investment?
Chapter 31: P&A-4-cont. (page: 713)
Foreign direct investment requires actively managing
an investment, for example, by opening a retail store
in a foreign country.
Foreign portfolio investment is passive, for example,
buying corporate stock in a retail chain in a foreign
country.
As a result, a corporation is more likely to engage in
foreign direct investment, while an individual
investor is more likely to engage in foreign portfolio
investment.
Chapter 31: P&A-5 (page: 713)
How would the following transactions affect U.S. Net
capital outflow? Also, state whether each involves direct
investment or portfolio investment.
a. An American cellular phone company establishes an
office in the Czech Republic.
b. Harrod’s of London sells stock to the General Electric
pension fund.
c. Honda expands its factory in Marysville, Ohio.
d. A Fidelity mutual fund sells its Volkswagen stock to a
French investor.
Chapter 31: P&A-5-cont. (page: 713)
a. When an American cellular phone company establishes an office in
the Czech Republic, U.S. net capital outflow increases, because the U.S.
company makes a direct investment in capital in the foreign country.
b. When Harrod's of London sells stock to the General Electric pension
fund, U.S. net capital outflow increases, because the U.S. company makes
a portfolio investment in the foreign country.
c.
When Honda expands its factory in Marysville, Ohio, U.S. net capital
outflow declines, because the foreign company makes a direct investment
in capital in the United States.
d. When a Fidelity mutual fund sells its Volkswagen stock to a French
investor, U.S. net capital outflow declines (if the French investor pays in
U.S. dollars), because the U.S. company is reducing its portfolio
investment in a foreign country.
Chapter 31: P&A-6 (page: 714)
Holding national saving constant, does an increase in net
capital outflow increase, decrease, or have no effect on a
country’s accumulation of domestic capital?
ANSWER:
If national saving is constant and net capital outflow
increases, domestic investment must decrease,
because national saving equals domestic investment
plus net capital outflow.
If domestic investment declines, the country's
accumulation of domestic capital declines.
Chapter 31: P&A-7 (page: 714)
The business section of most major newspapers contains
a table of showing U.S. exchange rates. Find such a table
in a paper or online and use it to answer the following
questions.
a. Does this table show nominal or real exchange rates?
Explain.
b. What are the exchange rates between the United
States and Canada and the United States and Japan?
Calculate the exchange rate between Canada and Japan.
c. If U.S. inflation exceeds Japanese inflation over the
next year, would you expect the U.S. Dollar to appreciate
or depreciate relative to the Japanese yen?
Chapter 31: P&A-7-cont. (page: 714)
a. The newspaper shows nominal exchange rates,
because it shows the number of units of one
currency that can be exchanged for another
currency.
b. Many answers are possible.
c. If U.S. inflation exceeds Japanese inflation over
the next year, you would expect the dollar to
depreciate relative to the Japanese yen because a
dollar would decline in value (in terms of the goods
and services it can buy) more than the yen would.
Chapter 31: P&A-8 (page: 714)
Would each of the following groups be happy or unhappy
if the U.S. Dollar appreciated? Explain.
a. Dutch pension funds holding U.S. Government bonds
b. U.S. Manufacturing industries
c. Australian tourists planning a trip to the United States.
d. An American firm trying to purchase property
overseas.
Chapter 31: P&A-8-cont. (page: 714)
a. Dutch pension funds holding U.S. government bonds would be
happy if the U.S. dollar appreciated. They would then get more
Dutch guilders for each dollar they earned on their U.S. investment.
In general, if you have an investment in a foreign country, you are
better off if that country's currency appreciates.
b. U.S. manufacturing industries would be unhappy if the U.S.
dollar appreciated because their prices would be higher in terms of
foreign currencies, which will reduce their sales.
c. Australian tourists planning a trip to the United States would
be unhappy if the U.S. dollar appreciated because they would get
fewer U.S. dollars for each Australian dollar, so their vacation will be
more expensive.
d. An American firm trying to purchase property overseas would
be happy if the U.S. dollar appreciated because it would get more
units of the foreign currency and could thus buy more property.
Chapter 31: P&A-9 (page: 714)
What is happening to the U.S. real exchange rate in each
of the following situations? Explain.
a. The U.S. nominal exchange rate is unchanged, but
prices rise faster in the United States than abroad.
b. The U.S. nominal exchange rate is unchanged, but
prices rise faster abroad than in the United States .
c. The U.S. nominal exchange rate declines, and prices
are unchanged in the United States and abroad.
d. The U.S. nominal exchange rate declines, and prices
rise faster abroad than in the United States.
Chapter 31: P&A-9-cont. (page: 714)
All the parts of this question can be answered by keeping in mind the definition of
the real exchange rate. The real exchange rate equals the nominal exchange
rate times the domestic price level divided by the foreign price level.
a.
If the U.S. nominal exchange rate is unchanged, but prices rise faster in the
United States than abroad, the real exchange rate rises.
b.
If the U.S. nominal exchange rate is unchanged, but prices rise faster abroad
than in the United States, the real exchange rate declines.
c.
If the U.S. nominal exchange rate declines and prices are unchanged in the
United States and abroad, the real exchange rate declines.
d.
If the U.S. nominal exchange rate declines and prices rise faster abroad than
in the United States, the real exchange rate declines.
Chapter 31: P&A-10 (page: 714)
A can of soda costs $0.75 in the United States and 12
pesos in Mexico. What would the peso-dollar exchange
rate be if purchasing-power parity holds?
If a monetary expansion caused all prices in Mexico to
double, so that soda rose to 24 pesos, what would
happen to the peso-dollar exchange rate?
ANSWER:
If purchasing-power parity holds, then 12 pesos per
soda divided by $0.75 per soda equals the exchange
rate of 16 pesos per dollar. If prices in Mexico
doubled, the exchange rate will double to 32 pesos
per dollar.
Chapter 31: P&A-11 (page: 714)
Assume that American rice sells for $100 per bushel,
Japanese rice sells for 16,000 yen per bushel, and the
nominal exchange rate is 80 yen per dollar.
a. Explain how could make a profit from this situation.
What could be your profit per bushel of rice? If other
people exploit the same opportunity, what would
happen to the price of rice in Japan and the price of rice
in the United States?
b. Suppose that rice is the only commodity in the world.
What would happen to the real exchange rate between
the United States and Japan?
Chapter 31: P&A-11-cont. (page: 714)
a. To make a profit, you would want to buy rice where it is cheap and
sell it where it is expensive. Because American rice costs 100 dollars per
bushel, and the exchange rate is 80 yen per dollar, American rice costs 100
x 80 equals 8,000 yen per bushel. So American rice at 8,000 yen per bushel
is cheaper than Japanese rice at 16,000 yen per bushel. So you could take
8,000 yen, exchange them for 100 dollars, buy a bushel of American rice,
then sell it in Japan for 16,000 yen, making a profit of 8,000 yen. As people
did this, the demand for American rice would rise, increasing the price in
America, and the supply of Japanese rice would rise, reducing the price in
Japan. The process would continue until the prices in the two countries
were the same.
b. If rice were the only commodity in the world, the real exchange rate
between the United States and Japan would start out too low, then rise as
people bought rice in America and sold it in Japan, until the real exchange
became one in long-run equilibrium.
Chapter 31: P&A-12 (page: 714)
A case study in the chapter analyzed purchasing-power
parity for several countries using the price of Big Macs.
Here are for a few more countries:
Country
Price of a Big
Mac
Predicted
Exchange
Rate
Actual
Exchange
Rate
Indonesia
15,900 rupiah
9,015
rupiah/$
Hungary
600 forints
180 forints/$
Czech
Republic
52.9 korunas
21.1
korunas/$
Brazil
6.90 real
1.91 real/$
Canada
3.88 C$
1.05 C$/$
Chapter 31: P&A-12 (page: 714)
a. For each country, compute the predicted exchange
rate of the local currency per U.S. Dollar. (Recall that the
U.S. price of a Big Mac was $3.41.)
b. According to purchasing-power parity, what is the
predicted exchange rate between the Hungarian forint
and the Canadian dollar? What is the actual exchange
rate?
c. How well does the theory of purchasing-power parity
explain exchange rates?
Chapter 31: P&A-12 (page: 714)
If you take X units of foreign currency per Big Mac divided by 3.41 dollars per Big
Mac, you get X/3.06 units of the foreign currency per dollar; that is the predicted
exchange rate.
a.
Indonesia: 15,900/3.41 = 4,663 rupiah/$
Hungary: 600/3.41 = 176 forint/$
Czech Republic: 52.9/3.41 = 15.5 koruna/$
Brazil: 6.9/3.41 = 2.02 real/$
Canada: 3.88/3.41 = 1.14C$/$
b.
Under purchasing-power parity, the exchange rate of the Hungarian forint to
the Canadian dollar is 600 forints per Big Mac divided by 3.88 Canadian dollars per
Big Mac equals 155 forints per Canadian dollar. The actual exchange rate is 180
forints per dollar divided by 1.05 Canadian dollars per dollar equals 171 forints per
Canadian dollar.
c.
The exchange rate predicted by the Big Mac index (155 forints per Canadian
dollar) is somewhat close to the actual exchange rate of 171 forints per Canadian
dollar.
Today
• Mankiw (2008), Principles of Economics
- Chapter 32: A Macroeconomic Theory of the
Open Economy
 Questions for Review (QfR): 1-4 (page: 734)
 Problems and Applications (P&A): 1-13 (page: 735736)
Chapter 32: QfR-1 (page: 734)
• Describe supply and demand in the market for loanable
funds and the market for foreign-currency exchange.
• How are these markets linked?
• ANSWER: (SEE PAGE 721)
• The supply of loanable funds comes from national saving;
the demand for loanable funds comes from domestic
investment and net capital outflow. (SEE PAGES 716-717)
• The supply of dollars in the market for foreign exchange
comes from net capital outflow; the demand for dollars
in the market for foreign exchange comes from net
exports. (SEE PAGE 718)
• The link between the two markets is net capital outflow.
Chapter 32: QfR-2 (page: 734)
• Why are budget deficits and trade deficits sometimes
called the twin deficits?
• ANSWER: (SEE PAGES 724-728)-see FIGURE 5
• Government budget deficits and trade deficits are
sometimes called the twin deficits because a
government budget deficit often leads to a trade deficit.
The government budget deficit leads to reduced national
saving, causing the interest rate to increase, and
reducing net capital outflow.
• The decline in net capital outflow reduces the supply of
dollars, raising the real exchange rate.
• Thus, the trade balance will move toward deficit.
Chapter 32: QfR-3 (page: 734)
• Suppose that a textile workers’ union encourages
people to buy only American-made clothes.
• What would this policy do to the trade balance and
the real exchange rate?
• What is the impact on the textile industry?
• What is the impact on the auto industry?
Chapter 32: QfR-3 (page: 734)-cont.
ANSWER: (SEE PAGES 728-730)-SIMILAR TO FIGURE 6
If a union of textile workers encourages people to
buy only American-made clothes, imports would be
reduced, so net exports would increase for any
given real exchange rate.
This would cause the demand curve in the market
for foreign exchange to shift to the right, as shown
in Figure 2. The result is a rise in the real exchange
rate, but no effect on the trade balance. The textile
industry would import less, but other industries,
such as the auto industry, would import more
because of the higher real exchange rate.
Chapter 32: QfR-3 (page: 734) -cont.
Figure 2
Chapter 32: QfR-4 (page: 734)
• What is capital flight?
• When a country experiences capital flight, what is
the effect on its interest rate and exchange rate?
• ANSWER: (SEE PAGES 730-732)-SEE FIGURE 7
• Capital flight is a large and sudden movement of
funds out of a country.
• Capital flight causes the interest rate to increase
and the exchange rate to depreciate. SEE FIGURE 7.
Chapter 32: P&A-1 (page: 735)
An article in USA Today (December 16, 2004) began
“President Bush said Wednesday that the White House will
shore up the sliding dollar by working to cut record budget
and trade deficits.”
a. According to the model in this chapter, would a
reduction in the budget deficit reduce the trade deficit?
Would it raise the value of dollar? Explain.
b. Suppose that a reduction in the budget deficit made
international investors more confident in the U.S.
economy. How would this increase in confidence affect
the value of the dollar? How would it affect the trade
deficit?
Chapter 32: P&A-1 (page: 735)-cont.
ANSWER:
a. A reduction in the U.S. government budget deficit
would increase national saving, shifting the supply
curve of loanable funds to the right in Figure 3.
This would reduce the real interest rate in the
United States, thus increasing net capital outflow,
and reducing the real exchange rate.
The real value of the dollar would decline, not
increase as the president suggested.
However, the trade deficit will decline.
Chapter 32: P&A-1 (page: 735) -cont.
Figure 3
Chapter 32: P&A-1 (page: 735)-cont.
ANSWER:
b. The increased confidence would lead to a
reduction in net capital outflow as shown in Figure
4.
The demand for loanable funds will fall, along with
the real interest rate.
The decline in net capital outflow will also reduce
the supply of dollars, increasing the real exchange
rate.
Thus, the trade balance will move toward deficit.
Chapter 32: P&A-1 (page: 735) -cont.
Figure 4
Chapter 32: P&A-2 (page: 735)
Suppose that Congress is considering an investment
tax credit, which subsidizes domestic investment.
a. How does this policy affect national saving, domestic
investment, net capital outflow, the interest rate,
the exchange rate, and the trade balance?
b. Representatives of several large exporters oppose
the policy. Why might that be the case?
Chapter 32: P&A-2 (page: 735)-cont.
ANSWER:
a. If Congress passes an investment tax credit, it subsidizes
domestic investment. The desire to increase domestic
investment leads firms to borrow more, increasing the demand
for loanable funds, as shown in Figure 5. This raises the real
interest rate, thus reducing net capital outflow. The decline in
net capital outflow reduces the supply of dollars in the market
for foreign exchange, raising the real exchange rate. The trade
balance also moves toward deficit, because net capital outflow,
hence net exports, is lower. The higher real interest rate also
increases the quantity of national saving. In summary, saving
increases, domestic investment increases, net capital outflow
declines, the real interest rate increases, the real exchange rate
increases, and the trade balance moves toward deficit.
Chapter 32: P&A-2 (page: 735) -cont.
Figure 5
Chapter 32: P&A-2 (page: 735)-cont.
ANSWER:
b. A rise in the real exchange rate reduces exports.
Chapter 32: P&A-3 (page: 735)
• Japan generally runs a significant trade surplus. Do you think
this is most related to high foreign demand for Japanese goods,
low Japanese demand for foreign goods, a high Japanese
saving rate relative to Japanese investment, or structural
barriers against imports into Japan? Explain your answer.
• ANSWER:
• Japan generally runs a trade surplus because the Japanese
savings rate is high relative to Japanese domestic investment.
The result is high net capital outflow, which is matched by high
net exports, resulting in a trade surplus. The other possibilities
(high foreign demand for Japanese goods, low Japanese demand
for foreign goods, and structural barriers against imports into
Japan) would affect the real exchange rate, but not the trade
surplus.
Chapter 32: P&A-4 (page: 735)
The chapter notes that the rise in the U.S. trade deficit during
the 1980s was due largely to the rise in the U.S. budget deficit.
On the other hand, the popular press sometimes claims that the
increased trade deficit resulted from a decline in the quality of
U.S. products relative to foreign products.
a. Assume that U.S. products did decline in relative quality
during the 1980s. How did this affect net exports at any given
exchange rate?
b. Draw a three-panel diagram to show the effect of this shift in
net exports on the U.S. real exchange rate and trade balance.
c. Is the claim in the popular press consistent with the model in
this chapter? Does a decline in the quality of U.S. products have
any effect on our standard of living? (Hint: When we sell our
goods to foreigners, what do we receive in return?)
Chapter 32: P&A-4 (page: 735)-cont.
ANSWER:
a. A decline in the quality of U.S. goods at a given real
exchange rate would reduce net exports, reducing the demand
for dollars, thus shifting the demand curve for dollars to the
left in the market for foreign exchange, as shown in Figure 6.
b. The shift to the left of the demand curve for dollars leads to
a decline in the real exchange rate. Because net capital outflow
is unchanged, and net exports equals net capital outflow, there
is no change in equilibrium in net exports or the trade balance.
c. The claim in the popular press is incorrect. A change in the
quality of U.S. goods cannot lead to a rise in the trade deficit.
The decline in the real exchange rate means that we get fewer
foreign goods in exchange for our goods, so our standard of
living may decline.
Chapter 32: P&A-4 (page: 735) -cont.
Figure 6
Chapter 32: P&A-5 (page: 735)
• An economist discussing trade policy in The New Republic wrote: “One
of the benefits of the United States removing its trade restrictions [is]
the gain to U.S. industries that produce goods for export. Export
industries would find it easier to sell their goods abroad—even if other
countries didn’t follow our example and reduce their trade barriers.”
Explain in words why U.S. export industries would benefit from a
reduction in restrictions on imports to the United States.
• ANSWER:
• A reduction in restrictions of imports would reduce net exports at any
given real exchange rate, thus shifting the demand curve for dollars
to the left. The shift of the demand curve for dollars leads to a
decline in the real exchange rate, which increases net exports.
Because net capital outflow is unchanged, and net exports equals net
capital outflow, there is no change in equilibrium in net exports or
the trade balance. But both imports and exports rise, so export
industries benefit.
Chapter 32: P&A-6 (page: 735)
Suppose the French suddenly develop a
strong taste for California wines.
Answer the following questions in words and
using a diagram.
a. What happens to the demand for dollars in
the market for foreign-currency exchange?
b. What happens to the value of dollars in the
market for foreign-currency exchange?
c. What happens to the quantity of net
exports?
Chapter 32: P&A-6 (page: 735)-cont.
ANSWER:
a. When the French develop a strong taste
for California wines, the demand for dollars in
the foreign-currency market increases at any
given real exchange rate, as shown in Figure
7.
b. The result of the increased demand for
dollars is a rise in the real exchange rate.
c. The quantity of net exports is unchanged.
Chapter 32: P&A-6 (page: 735) -cont.
Figure 7
Chapter 32: P&A-7 (page: 735)
A senator renounces her past support for
protectionism: “The U.S. trade deficit must be
reduced, but import quotas only annoy our
trading partners. If we subsidize U.S. exports
instead, we can reduce the deficit by
increasing our competitiveness.”
Using a three-panel diagram, show the effect
of an export subsidy on net exports and the
real exchange rate.
Do you agree with the senator?
Chapter 32: P&A-7 (page: 735)-cont.
ANSWER:
An export subsidy increases net exports at any
given real exchange rate. This causes the demand for
dollars to shift to the right in the market for foreign
exchange, as shown in Figure 8. The effect is a higher
real exchange rate, but no change in net exports. So
the senator is wrong; an export subsidy will not
reduce the trade deficit.
Chapter 32: P&A-7 (page: 735) -cont.
Figure 8
Chapter 32: P&A-8 (page: 735)
Suppose the United States decides to subsidize
the export of U.S. agricultural products, but it
does not increase taxes or decrease any other
government spending to offset this expenditure.
Using a three-panel diagram, show what
happens to national saving, domestic
investment, net capital outflow, the interest
rate, the exchange rate, and the trade balance.
Also explain in words how this U.S. policy affects
the amount of imports, exports, and net
exports.
Chapter 32: P&A-8 (page: 735)-cont.
ANSWER:
If the government increases its spending without
increasing taxes, public saving will fall (as will
national saving). As Figure 9 shows, this will raise
the real interest rate, reducing investment. Net
capital outflow will fall. The real exchange rate will
rise, causing exports to fall and imports to rise,
moving the trade balance toward deficit.
Chapter 32: P&A-8 (page: 735) -cont.
Figure 9
Chapter 32: P&A-9 (page: 735-736)
Suppose that real interest rates increase
across Europe.
Explain how this development will affect
U.S. net capital outflow.
Then explain how it will affect U.S. net
exports by using a formula from the
chapter and by drawing a diagram.
What will happen to the U.S. real
interest rate and real exchange rate?
Chapter 32: P&A-9 (page: 735-736)-cont.
ANSWER:
Higher real interest rates in Europe lead to
increased U.S. net capital outflow. Higher net
capital outflow leads to higher net exports,
because in equilibrium net exports equal net
capital outflow (NX = NCO ). Figure 10 shows
that the increase in net capital outflow leads
to a lower real exchange rate, higher real
interest rate, and increased net exports.
Chapter 32: P&A-9 (page: 735-736) -cont.
Figure 10
Chapter 32: P&A-10 (page: 736)
Suppose that Americans decide to increase their
saving.
a. If the elasticity of U.S. net capital outflow with
respect to the real interest rate is very high, will
this increase in private saving have a large or
small effect on U.S. domestic investment?
b. If the elasticity of U.S. exports with respect to
the real exchange rate is very low, will this
increase in private saving have a large or small
effect on the U.S. real exchange rate?
Chapter 32: P&A-10 (page: 736)-cont.
ANSWER:
a. If the elasticity of U.S. net capital outflow with respect
to the real interest rate is very high, the lower real interest
rate that occurs because of the increase in private saving
will increase net capital outflow a great deal, so U.S.
domestic investment will not increase much.
b. Because an increase in private saving reduces the real
interest rate, inducing an increase in net capital outflow,
the real exchange rate will decline. If the elasticity of U.S.
exports with respect to the real exchange rate is very low,
it will take a large decline in the real exchange rate to
increase U.S. net exports by enough to match the increase
in net capital outflow.
Chapter 32: P&A-11 (page: 736)
Over the past decade, some of Chinese saving has
been used to finance American investment.
That is, the Chinese have been buying American capital
assets.
a. If the Chinese decided they no longer wanted to buy
U.S. assets, what would happen in the U.S. market for
loanable funds? In particular, what would happen to
U.S. interest rates, U.S. saving, and U.S. investment?
b. What would happen in the market for foreign
currency exchange? In particular, what would happen
to the value of the dollar and the U.S. trade balance?
Chapter 32: P&A-11 (page: 736)-cont.
ANSWER:
a. If the Chinese decided they no longer wanted to
buy U.S. assets, U.S. net capital outflow would
increase, increasing the demand for loanable funds,
as shown in Figure 11. The result is a rise in U.S.
interest rates, an increase in the quantity of U.S.
saving (because of the higher interest rate), and
lower U.S. domestic investment.
b. In the market for foreign exchange, the real
exchange rate declines and the balance of trade
moves toward surplus.
Chapter 32: P&A-11 (page: 736) -cont.
Figure 11
Chapter 32: P&A-12 (page: 736)
In 1998 the Russian government defaulted on its
debt payments, leading investors worldwide to raise
their preference for U.S. government bonds, which
are considered very safe.
What effect do you think this “flight to safety” had
on the U.S. economy?
Be sure to note the impact on national saving,
domestic investment, net capital outflow, the
interest rate, the exchange rate, and the trade
balance.
Chapter 32: P&A-12 (page: 736)-cont.
ANSWER:
The flight to safety led to a desire by foreigners to buy U.S.
government bonds, resulting in a decline in U.S. net capital
outflow, as shown in Figure 12. The decline in net capital
outflow also means a decline in the demand for loanable
funds. As the figure shows, the shift to the left in the demand
curve results in a decline in the real interest rate in the United
States. In addition, the decrease in net capital outflow
decreases the supply of dollars in the foreign-exchange
market, causing the dollar to appreciate, shown as a rise in
the real exchange rate. The lower real interest rate causes
national saving to decline, but increases domestic investment.
Because net capital outflow is lower, net exports are lower,
thus the trade balance moves toward deficit.
Chapter 32: P&A-12 (page: 736) -cont.
Figure 12
Chapter 32: P&A-13 (page: 736)
Suppose that U.S. mutual funds suddenly decide to invest
more in Canada.
a. What happens to Canadian net capital outflow, Canadian
saving, and Canadian domestic investment?
b. What is the long-run effect on the Canadian capital stock?
c. How will this change in the capital stock affect the Canadian
labor market? Does this U.S. investment in Canada make
Canadian workers better off or worse off?
d. Do you think this will make U.S. workers better off or worse
off? Can you think of any reason why the impact on U.S.
citizens generally may be different from the impact on U.S.
workers?
Chapter 32: P&A-13 (page: 736)-cont.
ANSWER:
a.
When U.S. mutual funds become more interested in investing in Canada,
Canadian net capital outflow declines as the U.S. mutual funds make portfolio
investments in Canadian stocks and bonds. The demand for loanable funds shifts
to the left and the net capital outflow curve shifts to the left, as shown in Figure
13. As the figure shows, the real interest rate declines, thus reducing Canada’s
private saving, but increasing Canada’s domestic investment. In equilibrium,
Canadian net capital outflow declines.
b.
Because Canada's domestic investment increases, in the long run, Canada's
capital stock will increase.
c.
With a higher capital stock, Canadian workers will be more productive (the
value of their marginal product will increase) so wages will rise. Thus, Canadian
workers will be better off.
d.
The shift of investment into Canada means increased U.S. net capital
outflow. As a result, the U.S. real interest rises, leading to less domestic
investment, which in the long run reduces the U.S. capital stock, lowers the value
of marginal product of U.S. workers, and therefore decreases the wages of U.S.
workers. The impact on U.S. citizens would be different from the impact on U.S.
workers because some U.S. citizens own capital that now earns a higher real
interest rate.
Chapter 32: P&A-13 (page: 736) -cont.
Figure 13
Today
• Mankiw (2008), Principles of Economics
- Chapter 33: Aggregate Demand and
Aggregate Supply (PAGES BTW: 739-775)
 Questions for Review (QfR): 1-7 (page: 773)
 Problems and Applications (P&A): 1-14 (page: 773-775)
Chapter 33: QfR-1 (page: 773)
Name two macroeconomic variables that decline
when the economy goes into a recession.
Name one macroeconomic variable that rises during
a recession.
ANSWER: (SEE PAGES 740-741-742)-see FIGURE-1
Two macroeconomic variables that decline when the
economy goes into a recession are real GDP and
investment spending (many other answers are
possible).
A macroeconomic variable that rises during a
recession is the unemployment rate.
Chapter 33: QfR-2 (page: 773)
Draw a diagram with aggregate demand, short-run
aggregate supply, and long-run aggregate supply. Be
careful to label the axes correctly.
ANSWER: (SEE FIGURE-7 ON PAGE 762)
Figure 3 shows aggregate demand, short-run
aggregate supply, and long-run aggregate supply.
Chapter 33: QfR-2 (page: 773)-cont.
Figure 3
Chapter 33: QfR-3 (page: 773)
List and explain the three reasons why the
aggregate demand curve is downward sloping.
ANSWER: (SEE PAGES: 746-749)-see FIGURE-3
The aggregate-demand curve is downward sloping because:
The
Wealth
Effect
The
Interest
-Rate
Effect
The
Exchange
-Rate
Effect
(1) a decrease in the price level makes consumers feel wealthier,
which in turn encourages them to spend more, so there is a larger
quantity of goods and services demanded;
(2) a lower price level reduces the interest rate, encouraging
greater spending on investment, so there is a larger quantity of
goods and services demanded;
(3) a fall in the U.S. price level causes U.S. interest rates to fall, so
the real exchange rate depreciates, stimulating U.S. net exports,
so there is a larger quantity of goods and services demanded.
Chapter 33: QfR-4 (page: 773)
Explain why the long-run aggregate-supply curve is
vertical.
ANSWER: (SEE PAGES: 752-753)-see FIGURE-4
The long-run aggregate supply curve is vertical
because in the long run, an economy's supply of goods and
services (its real GDP) depends on its supplies of capital,
labor, and natural resources and on the available production
technology used to turn these resources into goods and
services.
The price level does not affect these long-run
determinants of real GDP.
Chapter 33: QfR-5 (page: 773)
List and explain the three theories for why the short-run
aggregate-supply curve is upward sloping.
ANSWER: (SEE PAGES: 755-760)-see FIGURE-6
Three theories explain why the short-run aggregate-supply curve is
upward sloping: (1) the sticky-wage theory, in which a lower price level
makes employment and production less profitable because wages do not
adjust immediately to the price level, so firms reduce the quantity of
goods and services supplied; (2) the sticky-price theory, in which an
unexpected fall in the price level leaves some firms with higher-thandesired prices because not all prices adjust instantly to changing
conditions, which depresses sales and induces firms to reduce the
quantity of goods and services they produce; and (3) the misperceptions
theory, in which a lower price level causes misperceptions about relative
prices, and these misperceptions induce suppliers to respond to the lower
price level by decreasing the quantity of goods and services supplied.
Chapter 33: QfR-6 (page: 773)
What might shift the aggregate-demand curve to the left?
Use the model of aggregate demand and aggregate supply to
trace through the short-run and long-run effects of such a
shift on output and the price level.
ANSWER: (SEE PAGES: 749-751)-see TABLE-1; CHP-34
The aggregate-demand curve might shift to the left when
something (other than a rise in the price level) causes a
reduction in consumption spending (such as a desire for
increased saving), a reduction in investment spending (such
as increased taxes on the returns to investment), decreased
government spending (such as a cutback in defense
spending), or reduced net exports (such as when foreign
economies go into recession).
Chapter 33: QfR-6 (page: 773)-cont.
Figure 4 traces through the steps of such a shift in aggregate
demand.
The economy begins in equilibrium, with short-run aggregate
supply, AS1, intersecting aggregate demand, AD1, at point A.
When the aggregate-demand curve shifts to the left to AD2,
the economy moves from point A to point B, reducing the
price level and the quantity of output.
Over time, people adjust their perceptions, wages, and
prices, shifting the short-run aggregate-supply curve down
to AS2, and moving the economy from point B to point C,
which is back on the long-run aggregate-supply curve and
has a lower price level.
Chapter 33: QfR-6 (page: 773)-cont.
Figure 4
Chapter 33: QfR-7 (page: 773)
What might shift the aggregate-supply curve to the left?
Use the model of aggregate demand and aggregate supply to
trace through the short-run and long-run effects of such a
shift on output and the price level.
ANSWER: (SEE PAGES: 753-755+760-761)-see TABLE-2
The aggregate-supply curve might shift to the left because of
a decline in the economy's capital stock, labor supply, or
productivity, or an increase in the natural rate of
unemployment, all of which shift both the long-run and
short-run aggregate-supply curves to the left.
An increase in the expected price level shifts just the shortrun aggregate-supply curve (not the long-run aggregatesupply curve) to the left.
Chapter 33: QfR-7 (page: 773)-cont.
Figure 5 traces through the effects of a shift in shortrun aggregate supply.
The economy starts in equilibrium at point A. The
aggregate-supply curve shifts to the left from AS1 to
AS2.
The new equilibrium is at point B, the intersection of
the aggregate-demand curve and AS2.
As time goes on, perceptions and expectations
adjust and the economy returns to long-run
equilibrium at point A, because the short-run
aggregate-supply curve shifts back to its original
position.
Chapter 33: QfR-7 (page: 773)-cont.
Figure 5
Chapter 33: P&A-1 (page: 773)
Explain whether each of the following events will
increase, decrease, or have no effect on long-run
aggregate supply.
a. The United States experiences a wave of
immigration.
b. Congress raises the minimum wage to $10 per
hour.
c. Intel invents a new and more powerful computer
chip.
d. A severe hurricane damages factories along the
East Coast.
Chapter 33: P&A-1 (page: 773)-cont.
ANSWER: (SEE PAGES: 753-755)
a. When the United States experiences a wave of
immigration, the labor force increases, so long-run aggregate
supply shifts to the right.
b. When Congress raises the minimum wage to $10 per hour,
the natural rate of unemployment rises, so the long-run
aggregate-supply curve shifts to the left.
c. When Intel invents a new and more powerful computer
chip, productivity increases, so long-run aggregate supply
increases because more output can be produced with the same
inputs.
d. When a severe hurricane damages factories along the East
Coast, the capital stock is smaller, so long-run aggregate supply
declines.
Chapter 33: P&A-2 (page: 773-774)
Suppose an economy is in long-run equilibrium.
a. Use the model of aggregate demand and aggregate
supply to illustrate the initial equilibrium (call it point
A). Be sure to include both short-run and long-run
aggregate supply.
b. The central bank raises the money supply by 5
percent. Use your diagram to show what happens to
output and the price level as the economy moves from
the initial to the new short-run equilibrium (call it
point B).
c. Now show the new long-run equilibrium (call it point
C). What causes the economy to move from point B to
point C?
Chapter 33: P&A-2 (page: 773-774)-cont.
d. According to the sticky-wage theory of aggregate
supply, how do nominal wages at point A compare to
nominal wages at point B? How do nominal wages at
point A compare to nominal wages at point C?
e. According to the sticky-wage theory of aggregate
supply, how do real wages at point A compare to real
wages at point B? How do real wages at point A
compare to real wages at point C?
f. Judging by the impact of the money supply on nominal
and real wages, is this analysis consistent with the
proposition that money has real effects in the short
run but is neutral in the long run?
Chapter 33: P&A-2 (page: 773-774)-cont.
ANSWER:
a. The current state of the economy is shown in Figure 7. The
aggregate-demand curve and short-run aggregate-supply
curve intersect at the same point on the long-run aggregatesupply curve. (SEE PAGE: 762-see FIGURE-7)
Figure 7
Chapter 33: P&A-2 (page: 773-774)-cont.
ANSWER:
b. If the central bank increases the money supply, aggregate demand
shifts to the right (to point B). In the short run, there is an increase in
output and the price level.
c.
Over time, nominal wages, prices, and perceptions will adjust to
this new price level. As a result, the short-run aggregate-supply curve
will shift to the left. The economy will return to its natural rate of output
(point C).
d. According to the sticky-wage theory, nominal wages at points A and
B are equal. However, nominal wages at point C are higher.
e. According to the sticky-wage theory, real wages at point B are
lower than real wages at point A. However, real wages at points A and C
are equal.
f.
Yes, this analysis is consistent with long-run monetary neutrality.
In the long run, an increase in the money supply causes an increase in
the nominal wage, but leaves the real wage unchanged.
Chapter 33: P&A-3 (page: 774)
Suppose the economy is in a long-run equilibrium.
a. Draw a diagram to illustrate the state of the economy. Be
sure to show aggregate demand, short-run aggregate supply,
and long-run aggregate supply.
b. Now suppose that a stock-market crash causes aggregate
demand to fall. Use your diagram to show what happens to
output and the price level in the short run. What happens
to the unemployment rate?
c. Use the sticky-wage theory of aggregate supply to explain
what will happen to output and the price level in the long
run (assuming there is no change in policy). What role does
the expected price level play in this adjustment? Be sure to
illustrate your analysis in a graph.
Chapter 33: P&A-3 (page: 774)-cont.
ANSWER:
a. The current state of the economy is shown in Figure 6. The
aggregate-demand curve and short-run aggregate-supply
curve intersect at the same point on the long-run aggregatesupply curve.
Figure 6
Chapter 33: P&A-3 (page: 774)-cont.
ANSWER: (SEE PAGES: 762-765)-see FIGURE-8
b. A stock market crash leads to a leftward shift of
aggregate demand. The equilibrium level of output and the
price level will fall. Because the quantity of output is less
than the natural rate of output, the unemployment rate will
rise above the natural rate of unemployment.
c. If nominal wages are unchanged as the price level falls,
firms will be forced to cut back on employment and
production.
Over time as expectations adjust, the short-run aggregatesupply curve will shift to the right, moving the economy back
to the natural rate of output.
Chapter 33: P&A-4 (page: 774)
In 1939, with the U.S. economy not yet fully recovered from
the Great Depression, President Roosevelt proclaimed that
Thanksgiving would fall a week earlier than usual so that the
shopping period before Christmas would be longer.
Explain what President Roosevelt might have been trying to
achieve, using the model of aggregate demand and aggregate
supply.
ANSWER:
The idea of lengthening the shopping period between
Thanksgiving and Christmas was to increase aggregate
demand.
As Figure 8 shows, this could increase output back to its longrun equilibrium level.
Chapter 33: P&A-4 (page: 774)-cont.
Figure 8
Chapter 33: P&A-5 (page: 774)
Explain why the following statements are false.
a. “The aggregate-demand curve slopes downward
because it is the horizontal sum of the demand curves for
individual goods.”
b. “The long-run aggregate-supply curve is vertical
because economic forces do not affect long-run
aggregate supply.”
c. “If firms adjusted their prices every day, then the
short-run aggregate-supply curve would be horizontal.”
d. “Whenever the economy enters a recession, its longrun aggregate-supply curve shifts to the left.”
Chapter 33: P&A-5 (page: 774)-cont.
ANSWER:
a. The statement that "the aggregate-demand curve slopes downward because it is the
horizontal sum of the demand curves for individual goods" is false. The aggregatedemand curve slopes downward because a fall in the price level raises the overall
quantity of goods and services demanded through the wealth effect, the interestrate effect, and the exchange-rate effect.
b. The statement that "the long-run aggregate-supply curve is vertical because
economic forces do not affect long-run aggregate supply" is false. Economic forces of
various kinds (such as population and productivity) do affect long-run aggregate
supply. The long-run aggregate-supply curve is vertical because the price level does
not affect long-run aggregate supply.
c. The statement that "if firms adjusted their prices every day, then the short-run
aggregate-supply curve would be horizontal" is false. If firms adjusted prices quickly
and if sticky prices were the only possible cause for the upward slope of the shortrun aggregate-supply curve, then the short-run aggregate-supply curve would be
vertical, not horizontal. The short-run aggregate supply curve would be horizontal
only if prices were completely fixed.
d. The statement that "whenever the economy enters a recession, its long-run
aggregate-supply curve shifts to the left" is false. An economy could enter a
recession if either the aggregate-demand curve or the short-run aggregate-supply
curve shifts to the left.
Chapter 33: P&A-6 (page: 774)
For each of the three theories for the upward slope
of the short-run aggregate-supply curve, carefully
explain the following:
a. How the economy recovers from a recession and
returns to its long-run equilibrium without any
policy intervention.
b. What determines the speed of that recovery.
Chapter 33: P&A-6 (page: 774)-cont.
ANSWER:
a. According to the sticky-wage theory, the economy is in a
recession because the price level has declined so that real wages
are too high, thus labor demand is too low. Over time, as nominal
wages are adjusted so that real wages decline, the economy returns
to full employment.
According to the sticky-price theory, the economy is in a recession
because not all prices adjust quickly. Over time, firms are able to
adjust their prices more fully, and the economy returns to the longrun aggregate-supply curve.
According to the misperceptions theory, the economy is in a
recession when the price level is below what was expected. Over
time, as people observe the lower price level, their expectations
adjust, and the economy returns to the long-run aggregate-supply
curve.
Chapter 33: P&A-6 (page: 774)-cont.
ANSWER:
b. The speed of the recovery in each theory depends on how
quickly price expectations, wages, and prices adjust.
Chapter 33: P&A-7 (page: 774)
Suppose the Fed expands the money supply, but
because the public expects this Fed action, it
simultaneously raises its expectation of the price
level.
What will happen to output and the price level in the
short run?
Compare this result to the outcome if the Fed
expanded the money supply but the public didn’t
change its expectation of the price level.
Chapter 33: P&A-7 (page: 774)-cont.
If the Fed increases the money supply and people
expect a higher price level, the aggregate-demand
curve shifts to the right and the short-run
aggregate-supply curve shifts to the left, as shown
in Figure 9.
The economy moves from point A to point B, with
no change in output and a rise in the price level (to
P2).
If the public does not change its expectation of the
price level, the short-run aggregate-supply curve
does not shift, the economy ends up at point C, and
output increases along with the price level (to P3).
Chapter 33: P&A-7 (page: 774)-cont.
Figure 9
Chapter 33: P&A-8 (page: 774)
Suppose that the economy is currently in a
recession.
If policymakers take no action, how will the
economy evolve over time?
Explain in words and using an aggregatedemand/aggregate-supply diagram.
ANSWER:
Figure 10 depicts an economy in a recession. The short-run
aggregate-supply curve is AS1 and the economy is at
equilibrium at point A, which is to the left of the long-run
aggregate-supply curve. If policymakers take no action, the
economy will return to the long-run aggregate-supply curve
over time as the short-run aggregate-supply curve shifts to the
right to AS2. The economy's new equilibrium is at point B.
Chapter 33: P&A-8 (page: 774)-cont.
Figure 10
Chapter 33: P&A-9 (page: 774)
The economy begins in long-run equilibrium. Then one day, the president
appoints a new chairman of the Federal Reserve. This new chairman is
well-known for his view that inflation is not a major problem for an
economy.
a. How would this news affect the price level that people would expect to
prevail?
b. How would this change in the expected price level affect the nominal
wage that workers and firms agree to in their new labor contracts?
c. How would this change in the nominal wage affect the profitability of
producing goods and services at any given price level?
d. How does this change in profitability affect the short-run aggregatesupply curve?
e. If aggregate demand is held constant, how does this shift in the
aggregate-supply curve affect the price level and the quantity of output
produced?
f. Do you think this Fed chairman was a good appointment?
Chapter 33: P&A-9 (page: 774)-cont.
a.
People will likely expect that the new chairman will not actively
fight inflation so they will expect the price level to rise.
b. If people believe that the price level will be higher over the next
year, workers will want higher nominal wages.
c.
Higher labor costs lead to reduced profitability.
d. The short-run aggregate-supply curve will shift to the left as shown
in Figure 11.
Figure 11
Chapter 33: P&A-9 (page: 774)-cont.
e. A decline in short-run aggregate supply
leads to reduced output and a higher price
level.
f. No, this choice was probably not wise.
The end result is stagflation, which provides
limited choices in terms of policies to remedy
the situation.
Chapter 33: P&A-10 (page: 774)
Explain whether each of the following events shifts
the short-run aggregate-supply curve, the aggregate
demand curve, both, or neither.
For each event that does shift a curve, draw a
diagram to illustrate the effect on the economy.
a. Households decide to save a larger share of their
income.
b. Florida orange groves suffer a prolonged period of
below-freezing temperatures.
c. Increased job opportunities overseas cause many
people to leave the country.
Chapter 33: P&A-10 (page: 774)-cont.
ANSWER:
a. If households decide to save a larger share of their income, they
must spend less on consumer goods, so the aggregate-demand
curve shifts to the left, as shown in Figure 12. The equilibrium
changes from point A to point B, so the price level declines and
output declines.
Figure 12
Chapter 33: P&A-10 (page: 774)-cont.
ANSWER:
b. If Florida orange groves suffer a prolonged period of below-freezing
temperatures, the orange harvest will be reduced. This decline in the
natural rate of output is represented in Figure 13 by a shift to the left in
both the short-run and long-run aggregate-supply curves.
The equilibrium changes from point A to point B, so the price level rises
and output declines.
Figure 13
Chapter 33: P&A-10 (page: 774)-cont.
ANSWER:
c. If increased job opportunities cause people to leave the country, the long-run
and short-run aggregate-supply curves will shift to the left because there are
fewer people producing output. The aggregate-demand curve will shift to the left
because there are fewer people consuming goods and services. The result is a
decline in the quantity of output, as Figure 14 shows. Whether the price level rises
or declines depends on the relative sizes of the shifts in the aggregate-demand
curve and the aggregate-supply curves.
Figure 14
Chapter 33: P&A-11 (page: 774-775)
For each of the following events, explain the shortrun and long-run effects on output and the price
level, assuming policymakers take no action.
a. The stock market declines sharply, reducing
consumers’ wealth.
b. The federal government increases spending on
national defense.
c. A technological improvement raises productivity.
d. A recession overseas causes foreigners to buy
fewer U.S. goods.
Chapter 33: P&A-11 (page: 774-775)-cont.
ANSWER:
a. When the stock market declines sharply, wealth declines, so the
aggregate-demand curve shifts to the left, as shown in Figure 15. In the
short run, the economy moves from point A to point B, as output declines
and the price level declines. In the long run, the short-run aggregatesupply curve shifts to the right to restore equilibrium at point C, with
unchanged output and a lower price level compared to point A.
Figure 15
Chapter 33: P&A-11 (page: 774-775)-cont.
ANSWER:
b. When the federal government increases spending on national defense, the
rise in government purchases shifts the aggregate-demand curve to the
right, as shown in Figure 16. In the short run, the economy moves from point
A to point B, as output and the price level rise. In the long run, the short-run
aggregate-supply curve shifts to the left to restore equilibrium at point C, with
unchanged output and a higher price level compared to point A.
Figure 16
Chapter 33: P&A-11 (page: 774-775)-cont.
ANSWER:
c. When a technological improvement raises productivity, the long-run and
short-run aggregate-supply curves shift to the right, as shown in Figure
17. The economy moves from point A to point B, as output rises and the
price level declines.
Figure 17
Chapter 33: P&A-11 (page: 774-775)-cont.
ANSWER:
d. When a recession overseas causes foreigners to buy fewer U.S. goods,
net exports decline, so the aggregate-demand curve shifts to the left, as
shown in Figure 18. In the short run, the economy moves from point A to
point B, as output declines and the price level declines. In the long run,
the short-run aggregate-supply curve shifts to the right to restore
equilibrium at point C, with unchanged output and a lower price level
compared to point A.
Figure 18
Chapter 33: P&A-12 (page: 775)
Suppose the U.S. economy begins in long-run
equilibrium.
Concerns about global climate change cause the
government to significantly restrict the production
of electricity from fossil fuels.
Because of this change in policy, foreign investors
lose confidence in the economy, and the dollar falls
in foreign-exchange markets.
Draw a diagram to show the short-run effect of
these events, and explain why these changes occur.
Chapter 33: P&A-12 (page: 775)-cont.
ANSWER:
If the value of the dollar falls in foreign exchange markets, U.S.
exports will rise and imports will fall.
This will cause the aggregate-demand curve to shift to the right (as
shown in Figure 19). The price level and output will both rise in the
short run.
Figure 19
Chapter 33: P&A-13 (page: 775)
Suppose that firms become very optimistic about future
business conditions and invest heavily in new capital
equipment.
a. Draw an aggregate-demand/aggregate-supply diagram to
show the short-run effect of this optimism on the economy.
Label the new levels of prices and real output. Explain in words
why the aggregate quantity of output supplied changes?
b. Now use the diagram from part (a) to show the new long-run
equilibrium of the economy. (For now, assume there is no
change in the long-run aggregate-supply curve.) Explain in
words why the aggregate quantity of output demanded changes
between the short run and the long run.
c. How might the investment boom affect the long-run
aggregate-supply curve? Explain.
Chapter 33: P&A-13 (page: 775)-cont.
ANSWER:
a. If firms become optimistic about future business conditions
and increase investment, the result is shown in Figure 20.
The economy begins at point A with aggregate-demand
curve AD1 and short-run aggregate-supply curve AS1. The
equilibrium has price level P1 and output level Y1.
Increased optimism leads to greater investment, so the
aggregate-demand curve shifts to AD2. Now the economy is
at point B, with price level P2 and output level Y2.
The aggregate quantity of output supplied rises because the
price level has risen and people have misperceptions about
the price level, wages are sticky, or prices are sticky, all of
which cause output supplied to increase.
Chapter 33: P&A-13 (page: 775)-cont.
Figure 20
Chapter 33: P&A-13 (page: 775)-cont.
ANSWER:
b. Over time, as the misperceptions of the price level
disappear, wages adjust, or prices adjust, the short-run
aggregate-supply curve shifts up to AS2 and the economy
gets to equilibrium at point C, with price level P3 and output
level Y1.
The quantity of output demanded declines as the price level
rises.
c. The investment boom might increase the long-run
aggregate-supply curve because higher investment today
means a larger capital stock in the future, thus higher
productivity and output.
Chapter 33: P&A-14 (page: 775)
In economy A, all workers agree in advance on the nominal
wages that their employers will pay them.
In economy B, half of all workers have these nominal wage
contracts, while the other half have indexed employment
contracts, so their wages rise and fall automatically with the
price level.
According to the sticky-wage theory of aggregate supply,
which economy has a more steeply sloped short-run
aggregate-supply curve?
In which economy would a 5 percent increase in the money
supply have a larger impact on output?
In which economy would it have a larger impact on the price
level? Explain.
Chapter 33: P&A-14 (page: 775)-cont.
ANSWER:
Economy B would have a more steeply sloped
short-run aggregate-supply curve than would
Economy A, because only half of the wages in
Economy B are “sticky.”
A 5% increase in the money supply would
have a larger effect on output in Economy A
and a larger effect on the price level in
Economy B.
Today
• Mankiw (2008), Principles of Economics
- Chapter 34: The Influence of Monetary and
Fiscal Policy on Aggregate Demand (PAGES
777-800)
 Questions for Review (QfR): 1-5 (page: 799)
 Problems and Applications (P&A): 1-13 (pages:
799-800)
Chapter 34: QfR-1 (page: 799)
What is the theory of liquidity preference? How does it help
explain the downward slope of the aggregate demand curve?
ANSWER: (SEE PAGE 779-783+SEE FIGURE 2 (P. 783))
The theory of liquidity preference is Keynes's theory of how
the interest rate is determined.
According to the theory, the aggregate-demand curve slopes
downward because: (1) a higher price level raises money
demand; (2) higher money demand leads to a higher interest
rate; and (3) a higher interest rate reduces the quantity of
goods and services demanded.
Thus, the price level has a negative relationship with the
quantity of goods and services demanded.
2
The money market and the slope of the aggregate-demand
curve
(a) The Money Market
Interest
rate
Money
supply
(b) The Aggregate-Demand Curve
2. . . . increases the
demand for money . . .
3. . . . which increases
equilibrium interest rate . . .
r2
Money demand at
price level P2, MD2
r1
Price
level
1. An increase
in the price level . . .
4. . . . which in turn
reduces the quantity of
goods and services
demanded.
P2
P1
Aggregate
demand
Money demand at
price level P1, MD1
0
Quantity fixed
by the Fed
Quantity
of money
0
Y2
Y1
Quantity
of output
An increase in the price level from P1 to P2 shifts the money-demand curve to the right, as in panel (a). This increase in
money demand causes the interest rate to rise from r1 to r2. Because the interest rate is the cost of borrowing, the
increase in the interest rate reduces the quantity of goods and services demanded from Y1 to Y2. This negative
relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-demand
156
curve, as in panel (b).
Chapter 34: QfR-2 (page: 799)
Use the theory of liquidity preference to explain
how a decrease in the money supply affects the
aggregate demand curve.
ANSWER: (SEE PAGES: 783-785)-(REVERSE OF FIG. 3)
A decrease in the money supply shifts the moneysupply curve to the left.
The equilibrium interest rate will rise.
The higher interest rate reduces consumption and
investment, so aggregate demand falls.
Thus, the aggregate-demand curve shifts to the left.
3
A monetary injection
(a) The Money Market
Interest
rate
Money supply,
MS1
(b) The Aggregate-Demand Curve
Price
level
MS2
1. When the Fed
increases the
money supply . . .
r1
P
r2
AD2
Money demand
at price level P
0
2. . . . the equilibrium
interest rate falls . . .
Quantity
of money
Aggregate
demand, AD1
0
Y1
Y2
Quantity of output
3. . . . which increases the quantity of goods and
services demanded at a given price level.
In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest rate from
r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity
of goods and services demanded at a given price level from Y1 to Y2. Thus, in panel (b), the aggregate158
demand curve shifts to the right from AD1 to AD2.
Chapter 34: QfR-3 (page: 799)
The government spends $3 billion to buy police cars.
Explain why aggregate demand might increase by
more than $3 billion. Explain why aggregate
demand might increase by less than $3 billion.
ANSWER:
If the government spends $3 billion to buy police cars,
aggregate demand might increase by more than $3 billion
because of the multiplier effect on aggregate demand.
Aggregate demand might increase by less than $3 billion
because of the crowding-out effect on aggregate demand.
4
The multiplier effect
Price
level
$20 billion
2. . . . but the multiplier
effect can amplify the
shift in aggregate
demand.
AD2
AD3
Aggregate demand, AD1
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
Quantity of
Output
An increase in government purchases of $20 billion can shift the aggregate-demand curve to the right
by more than $20 billion. This multiplier effect arises because increases in aggregate income stimulate
additional spending by consumers.
160
5
The crowding-out effect
(a) The Money Market
Interest
rate
Money
supply
(b) The Aggregate-Demand Curve
2. . . . the increase in
spending increases
money demand . . .
Price
level
1. When an increase in government purchases
increases aggregate demand . . .
3. . . . which increases
the equilibrium interest
rate . . .
r2
r1
$20 billion
4. . . which in turn
partly offsets the
initial increase in
aggregate demand.
MD2
AD2
Aggregate demand, AD1
Money demand, MD1
0
Quantity fixed
by the Fed
Quantity
of money
0
AD3
Quantity
of output
Panel (a) shows the money market. When the government increases its purchases of goods and services, the resulting
increase in income raises the demand for money from MD1 to MD2, and this causes the equilibrium interest rate to rise
from r1 to r2. Panel (b) shows the effects on aggregate demand. The initial impact of the increase in government purchases
shifts the aggregate-demand curve from AD1 to AD2. Yet because the interest rate is the cost of borrowing, the increase in
the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods. This
crowding out of investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the
161
aggregate-demand curve shifts only to AD3.
Chapter 34: QfR-4 (page: 799)
Suppose that survey measures of consumer confidence indicate a wave of
pessimism is sweeping the country. If policymakers do nothing, what will
happen to aggregate demand? What should the Fed do if it wants to
stabilize aggregate demand? If the Fed does nothing, what might
Congress do to stabilize aggregate demand?
ANSWER:
If pessimism sweeps the country, households reduce consumption
spending and firms reduce investment, so aggregate demand falls.
If the Fed wants to stabilize aggregate demand, it must increase
the money supply, reducing the interest rate, which will induce
households to save less and spend more and will encourage firms
to invest more, both of which will increase aggregate demand.
If the Fed does not increase the money supply, Congress could
increase government purchases or reduce taxes to increase
aggregate demand.
Chapter 34: QfR-5 (page: 799)
Give an example of a government policy that acts as
an automatic stabilizer. Explain why this policy has
this effect.
ANSWER:
Government policies that act as automatic stabilizers include the tax
system and government spending through the unemployment-benefit
system. The tax system acts as an automatic stabilizer because when
incomes are high, people pay more in taxes, so they cannot spend as
much. When incomes are low, so are taxes; thus, people can spend
more. The result is that spending is partly stabilized. Government
spending through the unemployment-benefit system acts as an
automatic stabilizer because in recessions the government transfers
money to the unemployed so their incomes do not fall as much and thus
their spending will not fall as much.
Chapter 34: P&A-1 (page: 799)
Suppose banks install automatic teller machines on
every block and, by making cash readily available,
reduce the amount of money people want to hold.
a. Assume the Fed does not change the money
supply. According to the theory of liquidity
preference, what happens to the interest rate?
What happens to aggregate demand?
b. If the Fed wants to stabilize aggregate demand,
how should it respond?
Chapter 34: P&A-1 (page: 799)-cont.
ANSWER:
a. When more ATMs are available, money demand is
reduced and the money-demand curve shifts to the left
from MD 1 to MD 2, as shown in Figure 6. If the Fed does
not change the money supply, which is at MS1, the
interest rate will decline from r1 to r2. The decline in the
interest rate shifts the aggregate-demand curve to the
right, as consumption and investment increase.
b. If the Fed wants to stabilize aggregate demand, it
should reduce the money supply to MS 2, so the interest
rate will remain at r1 and aggregate demand will not
change.
Chapter 34: P&A-1 (page: 799)-cont.
Chapter 34: P&A-2 (page: 799)
Explain how each of the following developments would affect the
supply of money, the demand for money, and the interest rate.
Illustrate your answers with diagrams.
a. The Fed’s bond traders buy bonds in open-market operations.
b. An increase in credit card availability reduces the cash people
hold.
c. The Federal Reserve reduces banks’ reserve requirements.
d. Households decide to hold more money to use for holiday
shopping.
e. A wave of optimism boosts business investment and expands
aggregate demand.
Chapter 34: P&A-2 (page: 799)-cont.
ANSWER:
a. When the Fed’s bond traders buy bonds in open-market
operations, the money-supply curve shifts to the right from
MS 1 to MS 2, as shown in Figure 1. The result is a decline in
the interest rate.
Figure 1
Chapter 34: P&A-2 (page: 799)-cont.
ANSWER:
b. When an increase in credit card availability reduces the cash
people hold, the money-demand curve shifts to the left from
MD 1 to MD 2, as shown in Figure 2. The result is a decline in
the interest rate.
Figure 2
Chapter 34: P&A-2 (page: 799)-cont.
ANSWER:
c.
When the Federal Reserve reduces reserve requirements, the money
supply increases, so the money-supply curve shifts to the right from MS 1
to MS 2, as shown in Figure 1. The result is a decline in the interest rate.
d. When households decide to hold more money to use for holiday
shopping, the money-demand curve shifts to the right from MD 1 to MD 2,
as shown in Figure 3. The result is a rise in the interest rate.
Figure 3
Chapter 34: P&A-2 (page: 799)-cont.
ANSWER:
e. When a wave of optimism boosts business investment and
expands aggregate demand, money demand increases from
MD 1 to MD 2 in Figure 3. The increase in money demand
increases the interest rate.
Figure 3
Chapter 34: P&A-3 (page: 799)
The Federal Reserve expands the money supply by 5 percent.
a. Use the theory of liquidity preference to illustrate in a graph
the impact of this policy on the interest rate.
b. Use the model of aggregate demand and aggregate supply
to illustrate the impact of this change in the interest rate on
output and the price level in the short-run.
c. When the economy makes the transition from its short-run
equilibrium to its long-run equilibrium, what will happen to
the price level?
d. How will this change in the price level affect the demand for
money and the equilibrium interest rate?
e. Is this analysis consistent with the proposition that money
has real effects in the short-run but is neutral in the longrun?
Chapter 34: P&A-3 (page: 799)-cont.
ANSWER:
a. The increase in the money supply will cause the equilibrium interest rate
to decline, as shown in Figure 4. Households will increase spending and
will invest in more new housing. Firms too will increase investment
spending. This will cause the aggregate demand curve to shift to the right
as shown in Figure 5.
Figure 4
Figure 5
Chapter 34: P&A-3 (page: 799)-cont.
ANSWER:
b. As shown in Figure 5, the increase in aggregate demand will
cause an increase in both output and the price level in the
short run.
c. When the economy makes the transition from its short-run
equilibrium to its long-run equilibrium, short-run aggregate
supply will decline, causing the price level to rise even
further.
d. The increase in the price level will cause an increase in the
demand for money, raising the equilibrium interest rate.
e. Yes. While output initially rises because of the increase in
aggregate demand, it will fall once short-run aggregate
supply declines. Thus, there is no long-run effect of the
increase in the money supply on real output.
Chapter 34: P&A-4 (page: 799)
Consider two policies—a tax cut that will last for only one
year, and a tax cut that is expected to be permanent.
Which policy will stimulate greater spending by consumers?
Which policy will have the greater impact on aggregate
demand? Explain.
ANSWER:
A tax cut that is permanent will have a bigger impact on
consumer spending and aggregate demand. If the tax cut
is permanent, consumers will view it as adding
substantially to their financial resources, and they will
increase their spending substantially.
If the tax cut is temporary, consumers will view it as
adding just a little to their financial resources, so they
will not increase spending as much.
Chapter 34: P&A-5 (page: 799-800)
a.
b.
c.
d.
The economy is in a recession with high unemployment and low
output.
Draw a graph of aggregate demand and aggregate supply to
illustrate the current situation. Be sure to include the aggregatedemand curve, the short-run aggregate-supply curve, and the
long-run aggregate-supply curve.
Identify an open-market operation that would restore the
economy to its natural level.
Draw a graph of the money market to illustrate the effect of this
open-market operation. Show the resulting change in the
interest rate.
Draw a graph similar to the one in part (a) to show the effect of
the open-market operation on output and the price level.
Explain in words why the policy has the effect that you have
shown in the graph.
Chapter 34: P&A-5 (page: 799-800)-cont.
ANSWER:
a. The current situation is shown in Figure 7.
Figure 7
Chapter 34: P&A-5 (page: 799-800)-cont.
ANSWER:
b. The Fed will want to stimulate aggregate demand. Thus, it will need to
lower the interest rate by increasing the money supply. This could be
achieved if the Fed purchases government bonds from the public.
c. As shown in Figure 8, the Fed's purchase of government bonds shifts the
supply of money to the right, lowering the interest rate.
Figure 8
Chapter 34: P&A-5 (page: 799-800)-cont.
ANSWER:
d. The Fed's purchase of government bonds will increase aggregate demand
as consumers and firms respond to lower interest rates. Output and the
price level will rise as shown in Figure 9.
Figure 9
Chapter 34: P&A-6 (page: 800)
In the early 1980s, new legislation allowed banks to pay
interest on checking deposits, which they could not do
previously.
a. If we define money to include checking deposits, what
effect did this legislation have on money demand? Explain.
b. If the Federal Reserve had maintained a constant money
supply in the face of this change, what would have happened
to the interest rate? What would have happened to aggregate
demand and aggregate output?
c. If the Federal Reserve had maintained a constant market
interest rate (the interest rate on nonmonetary assets) in the
face of this change, what change in the money supply would
have been necessary? What would have happened to
aggregate demand and aggregate output?
Chapter 34: P&A-6 (page: 800)-cont.
ANSWER:
a. Legislation allowing banks to pay interest on checking
deposits increases the return to money relative to other
financial assets, thus increasing money demand.
b. If the money supply remained constant (at MS1), the
increase in the demand for money would have raised the
interest rate, as shown in Figure 10. The rise in the interest
rate would have reduced consumption and investment, thus
reducing aggregate demand and output.
c. To maintain a constant interest rate, the Fed would
need to increase the money supply from MS 1 to MS 2. Then
aggregate demand and output would be unaffected.
Chapter 34: P&A-6 (page: 800)-cont.
Figure 10
Chapter 34: P&A-7 (page: 800)
Suppose economists observe that an increase in government
spending of $10 billion raises the total demand for goods
and services by $30 billion.
a. If these economists ignore the possibility of crowding out,
what would they estimate the marginal propensity to
consume (MPC) to be?
b. Now suppose the economists allow for crowding out.
Would their new estimate of the MPC be larger or smaller
than their initial one?
Chapter 34: P&A-7 (page: 800)-cont.
ANSWER:
a. If there is no crowding out, then the multiplier equals 1/(1 –
MPC ). Because the multiplier is 3, then MPC = 2/3.
b. If there is crowding out, then the MPC would be larger than
2/3. An MPC that is larger than 2/3 would lead to a larger
multiplier than 3, which is then reduced down to 3 by the
crowding-out effect.
Chapter 34: P&A-8 (page: 800)
Suppose the government reduces taxes by $20 billion, that
there is no crowding out, and that the marginal propensity to
consume is 3/4.
a. What is the initial effect of the tax reduction on aggregate
demand?
b. What additional effects follow this initial effect? What is the
total effect of the tax cut on aggregate demand?
c. How does the total effect of this $20 billion tax cut compare
to the total effect of a $20 billion increase in government
purchases? Why?
d. Based on your answer to part (c), can you think of a way in
which the government can increase aggregate demand
without changing the government’s budget deficit?
Chapter 34: P&A-8 (page: 800)-cont.
ANSWER:
a. The initial effect of the tax reduction of $20 billion is to increase aggregate
demand by $20 billion x 3/4 (the MPC ) = $15 billion.
b. Additional effects follow this initial effect as the added incomes are spent. The
second round leads to increased consumption spending of $15 billion x 3/4 =
$11.25 billion. The third round gives an increase in consumption of $11.25
billion x 3/4 = $8.44 billion. The effects continue indefinitely. Adding them all
up gives a total effect that depends on the multiplier. With an MPC of 3/4,
the multiplier is 1/(1 – 3/4) = 4. So the total effect is $15 billion x 4 = $60
billion.
c. Government purchases have an initial effect of the full $20 billion, because
they increase aggregate demand directly by that amount. The total effect of an
increase in government purchases is thus $20 billion x 4 = $80 billion. So
government purchases lead to a bigger effect on output than a tax cut does.
The difference arises because government purchases affect aggregate
demand by the full amount, but a tax cut is partly saved by consumers, and
therefore does not lead to as much of an increase in aggregate demand.
d. The government could increase taxes by the same amount it increases its
purchases.
Chapter 34: P&A-9 (page: 800)
a.
b.
c.
d.
An economy is operating with output $400 billion below its natural rate,
and fiscal policy-makers want to close this recessionary gap. The central
bank agrees to adjust the money supply to hold the interest rate constant,
so there is no crowding out. The marginal propensity to consume is 4/5
and the price level is completely fixed in the short-run.
In what direction and by how much would government spending need to
change to close the recessionary gap? Explain your thinking.
In what direction and by how much would taxes need to change to close
the gap? Explain.
If the central bank were to hold the money supply, rather than the
interest rate, constant in response to change in fiscal policy, would your
answers to the previous questions be larger, smaller, or the same?
Explain.
If the policymakers in this economy wanted to close the recessionary gap
without increasing the government’s budget deficit, what are two ways
they accomplish this goal?
Chapter 34: P&A-9 (page: 800)-cont.
ANSWER:
a. If the marginal propensity to consume is 0.8, the spending multiplier will
be 1/(1-0.8) = 5. Therefore, the government would have to increase
spending by $400/5 = $80 billion to close the recessionary gap.
b. With an MPC of 0.8, the tax multiplier is (0.8)(1/(1-0.8)) = (0.8)(5) = 4.
Therefore, the government would need to cut taxes by $400 billion/4 =
$100 billion to close the recessionary gap.
c. If the central bank was to hold the money supply constant, my answer
would be larger because crowding out would occur.
d. They would have to raise both government spending and taxes by $400
billion. The increase in government purchases would result in a boost of
$2,000 billion, while the higher taxes would reduce spending by $1,600
billion. This leaves a $400 billion rise in aggregate spending.
Chapter 34: P&A-10 (page: 800)
Suppose government spending increases. Would the
effect on aggregate demand be larger if the Federal
Reserve took no action in response, or if the Fed
were committed to maintaining a fixed interest rate?
Explain.
ANSWER:
If government spending increases, aggregate demand rises, so
money demand rises. The increase in money demand leads to
a rise in the interest rate and thus a decline in aggregate
demand if the Fed does not respond. But if the Fed maintains
a fixed interest rate, it will increase money supply, so
aggregate demand will not decline. Thus, the effect on
aggregate demand from an increase in government spending
will be larger if the Fed maintains a fixed interest rate.
Chapter 34: P&A-11 (page: 800)
In which of the following circumstances is expansionary fiscal policy more
likely to lead to a short-run increase in investment? Explain.
a. When the investment accelerator is large, or when it is small?
b. When the interest sensitivity of investment is large, or when it is small?
ANSWER:
a. Expansionary fiscal policy is more likely to lead to a short-run increase in
investment if the investment accelerator is large. A large investment
accelerator means that the increase in output caused by expansionary
fiscal policy will induce a large increase in investment. Without a large
accelerator, investment might decline because the increase in aggregate
demand will raise the interest rate.
b. Expansionary fiscal policy is more likely to lead to a short-run increase in
investment if the interest sensitivity of investment is small. Because fiscal
policy increases aggregate demand, thus increasing money demand and
the interest rate, the greater the sensitivity of investment to the interest
rate the greater the decline in investment will be, which will offset the
positive accelerator effect.
Chapter 34: P&A-12 (page: 800)
a.
b.
c.
a.
b.
c.
For various reasons, fiscal policy changes automatically when output and
employment fluctuate.
Explain why tax revenue changes when the economy goes into a recession.
Explain why government spending changes when the economy goes into a
recession.
If the government were to operate under a strict balanced-budget rule, what
would it have to do in a recession? Would that make the recession more or less
severe?
ANSWER:
Tax revenue declines when the economy goes into a recession because taxes are
closely related to economic activity. In a recession, people's incomes and wages
fall, as do firms' profits, so taxes on these things decline.
Government spending rises when the economy goes into a recession because
more people get unemployment-insurance benefits, welfare benefits, and other
forms of income support.
If the government were to operate under a strict balanced-budget rule, it would
have to raise tax rates or cut government spending in a recession. Both would
reduce aggregate demand, making the recession more severe.
Chapter 34: P&A-13 (page: 800)
Some members of Congress have proposed a law
that would make price stability the sole goal of
monetary policy. Suppose such a law were passed.
a. How would the Fed respond to an event that
contracted aggregate demand?
b. How would the Fed respond to an event that caused
an adverse shift in short-run aggregate supply?
In each case, is there another monetary policy that
would lead to greater stability in output?
Chapter 34: P&A-13 (page: 800)-cont.
ANSWER:
a. If there were a contraction in aggregate demand, the Fed would need to
increase the money supply to increase aggregate demand and stabilize the
price level, as shown in Figure 11. By increasing the money supply, the Fed
is able to shift the aggregate-demand curve back to AD 1 from AD 2. This
policy stabilizes output and the price level.
Figure 11
Chapter 34: P&A-13 (page: 800)-cont.
ANSWER:
b. If there were an adverse shift in short-run aggregate supply, the Fed would
need to decrease the money supply to stabilize the price level, shifting the
aggregate-demand curve to the left from AD 1 to AD 2, as shown in Figure
12. This worsens the recession caused by the shift in aggregate supply. To
stabilize output, the Fed would need to increase the money supply,
shifting the aggregate-demand curve from AD 1 to AD 3. However, this
action would raise the price level.
Figure 12
Today
• Mankiw (2008), Principles of Economics
- Chapter 35: The Short-Run Trade-off
between Inflation and Unemployment
(PAGES 801-826)
 Questions for Review (QfR): 1-5 (page: 824)
 Problems and Applications (P&A): 1-11 (pages:
825-826)
Chapter 35: QfR-1 (page: 824)
Draw the short-run tradeoff between inflation and
unemployment. (SEE PAGE 803-FIGURE-1)
How might the Fed move the economy from one point on this
curve to another? (SEE PAGE 804-FIGURE-2)
ANSWER: (see Figure-1 and Figure-2 on pages 803-4)
Figure 5 shows the short-run trade-off between inflation and
unemployment. The Fed can move from one point on this
curve to another by changing the money supply. An increase
in the money supply reduces the unemployment rate and
increases the inflation rate, while a decrease in the money
supply increases the unemployment rate and decreases the
inflation rate.
Chapter 35: QfR-1 (page: 824)-cont.
Figure 5
Chapter 35: QfR-2 (page: 824)
Draw the long-run tradeoff between inflation and
unemployment. (SEE PAGE 806-FIGURE-3)
Explain how the short-run and long-run tradeoffs are
related. (SEE PAGE 810-FIGURE-5)
ANSWER: (see Figure-3 (806)+see Figure-5 (810)
Figure 6 shows the long-run trade-off between inflation and
unemployment. In the long run, there is no trade-off, as the
economy must return to the natural rate of unemployment on the
long-run Phillips curve. In the short run, the economy can move
along a short-run Phillips curve, like SRPC1 shown in the figure. But
over time (as inflation expectations adjust) the short-run Phillips
curve will shift to return the economy to the long-run Phillips
curve, for example shifting from SRPC1 to SRPC2.
Chapter 35: QfR-2 (page: 824)-cont.
Figure 6
Chapter 35: QfR-3 (page: 824)
What’s so natural about the natural rate of unemployment?
(SEE PAGE 807-THE MEANING OF “NATURAL)
Why might the natural rate of unemployment differ across
countries?
ANSWER:
The natural rate of unemployment is natural because it is beyond the
influence of monetary policy. The rate of unemployment will move to
its natural rate in the long run, regardless of the inflation rate.
The natural rate of unemployment might differ across countries
because countries have varying degrees of union power, minimumwage laws, collective-bargaining laws, unemployment insurance,
job-training programs, and other factors that influence labor-market
conditions.
Chapter 35: QfR-4 (page: 824)
Suppose a drought destroys farm crops and drives up
the price of food. What is the effect on the short-run
trade-off between inflation and unemployment?
ANSWER: (SEE PAGE 813-FIGURE-8)
If a drought destroys farm crops and drives up the
price of food, the short-run aggregate-supply curve
shifts up, as does the short-run Phillips curve,
because the costs of production have increased. The
higher short-run Phillips curve means the inflation
rate will be higher for any given unemployment
rate.
Chapter 35: QfR-5 (page: 824)
The Fed decides to reduce inflation. Use the Phillips curve to
show the short-run and long-run effects of this policy.
How might the short-run costs be reduced?
ANSWER: (SEE PAGE 816-FIGURE-10)
When the Fed decides to reduce inflation, the economy moves
down along the short-run Phillips curve, as shown in Figure 7.
Beginning at point A on short-run Phillips curve SRPC1, the
economy moves down to point B as inflation declines. Once
people's expectations adjust to the lower rate of inflation, the
short-run Phillips curve shifts to SRPC2, and the economy moves
to point C. The short-run costs of disinflation, which arise
because the unemployment rate is temporarily above its
natural rate, could be reduced if the Fed's action was credible,
so that expectations would adjust more rapidly.
Chapter 35: QfR-5 (page: 824)-cont.
Figure 7
Chapter 35: P&A-1 (page: 825)
Illustrate the effects of the following developments
on both the short-run and long-run Phillips curves.
Give the economic reasoning underlying your
answers.
a. a rise in the natural rate of unemployment
b. a decline in the price of imported oil
c. a rise in government spending
d. a decline in expected inflation
Chapter 35: P&A-1 (page: 825)-cont.
ANSWER:
a. A rise in the natural rate of unemployment shifts the long-run Phillips
curve to the right and the short-run Phillips curve up, as shown in Figure 9.
The economy is initially on LRPC1 and SRPC1 at an inflation rate of 3%, which
is also the expected rate of inflation. The increase in the natural rate of
unemployment shifts the long-run Phillips curve to LRPC2 and the short-run
Phillips curve to SRPC2, with the expected rate of inflation remaining equal
to 3%.
Figure 9
Chapter 35: P&A-1 (page: 825)-cont.
ANSWER:
b. A decline in the price of imported oil shifts the short-run Phillips curve
down, as shown in Figure 10, from SRPC1 to SRPC2. For any given
unemployment rate, the inflation rate is lower, because oil is such a
significant aspect of production costs in the economy.
Figure 10
Chapter 35: P&A-1 (page: 825)-cont.
ANSWER:
c. A rise in government spending represents an increase in aggregate
demand, so it moves the economy along the short-run Phillips curve, as
shown in Figure 11. The economy moves from point A to point B, with a
decline in the unemployment rate and an increase in the inflation rate.
Figure 11
Chapter 35: P&A-1 (page: 825)-cont.
ANSWER:
d. A decline in expected inflation causes the short-run Phillips curve to shift
down, as shown in Figure 12. The lower rate of expected inflation shifts the
short-run Phillips curve from SRPC1 to SRPC2.
Figure 12
Chapter 35: P&A-2 (page: 825)
Suppose that a fall in consumer spending causes a
recession.
a. Illustrate the immediate change in the economy using both
an aggregate-supply/aggregate-demand diagram and a
Phillips-curve diagram. On both graphs, label the initial
long-run equilibrium as point A and the resulting short-run
equilibrium as point B. What happens to inflation and
unemployment in the short run?
b. Now suppose that over time expected inflation changes in
the same direction that actual inflation changes. What
happens to the position of the short-run Phillips curve?
After the recession is over, does the economy face a better
or worse set of inflation– unemployment combinations?
Chapter 35: P&A-2 (page: 825)-cont.
ANSWERS:
a. Figure 13 shows how a reduction in consumer spending causes a
recession in both an aggregate-supply/aggregate-demand diagram
and a Phillips-curve diagram. In both diagrams, the economy begins
at full employment at point A. The decline in consumer spending
reduces aggregate demand, shifting the aggregate-demand curve
to the left from AD1 to AD2. The economy initially remains on the
short-run aggregate-supply curve SRAS1, so the new equilibrium
occurs at point B. The movement of the aggregate-demand curve
along the short-run aggregate-supply curve leads to a movement
along short-run Phillips curve SRPC1, from point A to point B. The
lower price level in the aggregate-supply/aggregate-demand
diagram corresponds to the lower inflation rate in the Phillips-curve
diagram. The lower level of output in the aggregatesupply/aggregate-demand diagram corresponds to the higher
unemployment rate in the Phillips-curve diagram.
Chapter 35: P&A-2 (page: 825)-cont.
Figure 13
Chapter 35: P&A-2 (page: 825)-cont.
ANSWERS:
b. As expected inflation falls over time, the short-run
aggregate-supply curve shifts down from AS1 to AS2, and the
short-run Phillips curve shifts down from SRPC1 to SRPC2.
In both diagrams, the economy eventually gets to point C,
which is back on the long-run aggregate-supply curve and
long-run Phillips curve.
After the recession is over, the economy faces a better set of
inflation-unemployment combinations.
Chapter 35: P&A-3 (page: 825)
Suppose the natural rate of unemployment is 6 percent.
On one graph, draw two Phillips curves that can be used to
describe the four situations listed below. Label the point
that shows the position of the economy in each case:
a. Actual inflation is 5 percent and expected inflation is 3
percent.
b. Actual inflation is 3 percent and expected inflation is 5
percent.
c. Actual inflation is 5 percent and expected inflation is 5
percent.
d. Actual inflation is 3 percent and expected inflation is 3
percent.
Chapter 35: P&A-3 (page: 825)-cont.
ANSWER:
Figure 8 shows two different short-run Phillips curves depicting these four
points. Points A and D are on SRPC1 because both have expected inflation
of 3%. Points B and C are on SRPC2 because both have expected inflation
of 5%.
Figure 8
Chapter 35: P&A-4 (page: 825)
Suppose the economy is in a long-run equilibrium.
a. Draw the economy’s short-run and long-run
Phillips curves.
b. Suppose a wave of business pessimism reduces
aggregate demand. Show the effect of this shock on
your diagram from part (a). If the Fed undertakes
expansionary monetary policy, can it return the
economy to its original inflation rate and original
unemployment rate?
Chapter 35: P&A-4 (page: 825)-cont.
c. Now suppose the economy is back in long-run
equilibrium, and then the price of imported oil rises.
Show the effect of this shock with a new diagram like
that in part (a). If the Fed undertakes expansionary
monetary policy, can it return the economy to its
original inflation rate and original unemployment
rate?
If the Fed undertakes contractionary monetary
policy, can it return the economy to its original
inflation rate and original unemployment rate?
Explain why this situation differs from that in part
(b).
Chapter 35: P&A-4 (page: 825)-cont.
ANSWERS:
a. Figure 14 shows the economy in long-run equilibrium
at point A, which is on both the long-run and shortrun Phillips curves.
Figure 14
Chapter 35: P&A-4 (page: 825)-cont.
ANSWERS:
b. A wave of business pessimism reduces
aggregate demand, moving the economy to
point B in the figure. The unemployment rate
rises and the inflation rate declines. If the Fed
undertakes expansionary monetary policy, it
can increase aggregate demand, offsetting
the pessimism and returning the economy to
point A, with the initial inflation rate and
unemployment rate.
Chapter 35: P&A-4 (page: 825)-cont.
ANSWERS:
c. Figure 15 shows the effects on the economy if the price of
imported oil rises. The higher price of imported oil shifts the shortrun Phillips curve up from SRPC 1 to SRPC 2. The economy moves
from point A to point C, with a higher inflation rate and higher
unemployment rate. If the Fed engages in expansionary monetary
policy, it can return the economy to its original unemployment
rate at point D, but the inflation rate will be higher. If the Fed
engages in contractionary monetary policy, it can return the
economy to its original inflation rate at point E, but the
unemployment rate will be higher. This situation differs from that
in part (b) because in part (b) the economy stayed on the same
short-run Phillips curve, but in part (c) the economy moved to a
higher short-run Phillips curve, which gives policymakers a less
favorable trade-off between inflation and unemployment.
Chapter 35: P&A-4 (page: 825)-cont.
Figure 15
Chapter 35: P&A-5 (page: 825)
The inflation rate is 10 percent, and the central bank
is considering slowing the rate of money growth to
reduce inflation to 5 percent. Economist Milton
believes that expectations of inflation change quickly
in response to new policies, whereas economist
James believes that expectations are very sluggish.
Which economist is more likely to favor the proposed
change in monetary policy? Why?
Chapter 35: P&A-5 (page: 825)-cont.
ANSWER:
Economists who believe that expectations adjust
quickly in response to changes in policy would be
more likely to favor using contractionary policy to
reduce inflation than economists with the opposite
views. If expectations adjust quickly, the costs of
reducing inflation (in terms of lost output) will be
relatively small. Thus, Milton would be more in favor
of following a policy to reduce inflation than would
James.
Chapter 35: P&A-6 (page: 825)
Suppose the Federal Reserve’s policy is to maintain
low and stable inflation by keeping unemployment at
its natural level. However, the Fed believes that the
natural rate of unemployment is 4 percent when the
actual natural rate is 5 percent. If the Fed based its
policy decisions on its belief, what would happen to
the economy? How might the Fed come to realize
that its belief about the natural rate was mistaken?
Chapter 35: P&A-6 (page: 825)-cont.
ANSWER:
If the Fed acts on its belief that the natural rate of unemployment is
4%, when the natural rate is in fact 5%, the result will be a spiraling up
of the inflation rate, as shown in Figure 16. Starting from a point on the
long-run Phillips curve, with an unemployment rate of 5%, the Fed will
believe that the economy is in a recession, because the unemployment
rate is greater than its estimate of the natural rate. Therefore, the Fed
will increase the money supply, moving the economy along the shortrun Phillips curve SRPC1. The inflation rate will rise and the
unemployment rate will fall to 4%. As the inflation rate rises over time,
expectations of inflation will rise, and the short-run Phillips curve will
shift up to SRPC2. This process will continue, and the inflation rate will
spiral upwards.
The Fed may eventually realize that its estimate of the natural rate of
unemployment is wrong by examining the rising trend in the inflation
rate.
Chapter 35: P&A-7 (page: 825)
Suppose the price of oil fell sharply (as it did in 1986
and again in 1998).
a. Show the impact of such a change in both the
aggregate-demand/aggregate-supply diagram and in
the Phillips-curve diagram. What happens to inflation
and unemployment in the short run?
b. Do the effects of this event mean there is no shortrun trade-off between inflation and unemployment?
Why or why not?
Chapter 35: P&A-7 (page: 825)-cont.
ANSWERS:
a. Figure 17 shows the effects of a fall in the price of oil.
The short-run aggregate-supply curve shifts to the
right, reducing the price level and increasing the
quantity of output. The short-run Phillips curve shifts
to the left. In both diagrams, the economy moves
from point A to point B. In equilibrium, both the
inflation rate and the unemployment rate decline.
Chapter 35: P&A-7 (page: 825)-cont.
Figure 17
Chapter 35: P&A-7 (page: 825)-cont.
ANSWERS:
b. The effects of this event do not mean there is no
short-run trade-off between inflation and
unemployment, as shifts in aggregate demand still
move the economy along the short-run Phillips
curve.
Chapter 35: P&A-8 (page: 825)
Suppose the Federal Reserve announced that it
would pursue contractionary monetary policy in
order to reduce the inflation rate. Would the
following conditions make the ensuing recession
more or less severe? Explain.
a. Wage contracts have short durations.
b. There is little confidence in the Fed’s determination
to reduce inflation.
c. Expectations of inflation adjust quickly to actual
inflation.
Chapter 35: P&A-8 (page: 825)-cont.
ANSWERS:
a. If wage contracts have short durations, a recession induced by
contractionary monetary policy will be less severe, because wage
contracts can be adjusted more rapidly to reflect the lower inflation
rate. This will allow a more rapid movement of the short-run
aggregate-supply curve and short-run Phillips curve to restore the
economy to long-run equilibrium.
b. If there is little confidence in the Fed's determination to reduce
inflation, a recession induced by contractionary monetary policy will
be more severe. It will take longer for people's inflation expectations
to adjust downwards.
c. If expectations of inflation adjust quickly to actual inflation, a recession
induced by contractionary monetary policy will be less severe. In this
case, people's expectations adjust quickly, so the short-run Phillips
curve shifts quickly to restore the economy to long-run equilibrium at
the natural rate of unemployment.
Chapter 35: P&A-9 (page: 826)
Given the unpopularity of inflation, why don’t
elected leaders always support efforts to reduce
inflation? Many economists believe that countries
can reduce the cost of disinflation by letting their
central banks make decisions about monetary policy
without interference from politicians. Why might this
be so?
Chapter 35: P&A-9 (page: 826)-cont.
ANSWER:
Even though inflation is unpopular, elected leaders do not always support
efforts to reduce inflation because of the short-run costs associated with
disinflation. In particular, as disinflation occurs, the unemployment rate
rises, and when unemployment is high people tend not to vote for
incumbent politicians, blaming them for the bad state of the economy.
Thus, politicians tend not to support disinflation.
Economists believe that countries with independent central banks can
reduce the cost of disinflation because in those countries politicians
cannot interfere with central banks' disinflation efforts. People will believe
the central bank when it announces a disinflation because they know
politicians cannot stop the disinflation. In countries with central banks
that are not independent, people know that politicians who are worried
they will not be reelected could stop a disinflation. As a result, the
credibility of the central bank is lower and the costs of disinflation are
higher.
Chapter 35: P&A-10 (page: 826)
As described in the chapter, the Federal Reserve in 2008 faced
a decrease in aggregate demand caused by the housing and
financial crises and a decrease in short-run aggregate supply
caused by rising commodity prices.
a. Starting from a long-run equilibrium, illustrate the effects of
these two changes using both an aggregate-supply/aggregatedemand diagram and a Phillips-curve diagram. On both
diagrams, label the initial long-run equilibrium as point A and
the resulting short-run equilibrium as point B. For each of the
following variables, state whether it rises or falls, or whether
the impact is ambiguous: output, unemployment, the price
level, the inflation rate.
Chapter 35: P&A-10 (page: 826)-cont.
b. Suppose the Fed responds quickly to these shocks and adjusts
monetary policy to keep unemployment and output at their
natural rates. What action would it take? On the same set of
graphs from part (a), show the results. Label the new
equilibrium as point C.
c. Why might the Fed choose not to pursue the course of action
described in part (b)?
Chapter 35: P&A-10 (page: 826)-cont.
ANSWERS:
a. As shown in the left diagram of Figure 18, equilibrium output
and employment will fall. However, the effects on the price
level and inflation rate will be ambiguous. The fall in
aggregate demand puts downward pressure on prices, while
the decline in short-run aggregate supply pushes prices up.
The diagram on the right side of Figure 18 assumes that the
inflation rate rises.
b. The Fed would have to use expansionary monetary policy to
keep output and employment at their natural rates. Aggregate
demand would shift back to AD1.
c. The Fed may not want to pursue this action because it will
lead to a rise in the inflation rate as shown by point C.
Chapter 35: P&A-11 (page: 826)
Suppose Federal Reserve policymakers accept the theory of the short-run Phillips
curve and the natural-rate hypothesis and want to keep unemployment close to its
natural rate. Unfortunately, because the natural rate of unemployment can change
over time, they aren’t certain about the value of the natural rate. What
macroeconomic variables do you think they should look at when conducting
monetary policy?
ANSWER:
If policymakers are uncertain about the value of the natural rate of
unemployment (as was clearly the case in the 1990s, when economists were
continually revising their estimates of the natural rate downward), they need to
look at other variables. Because there is a correspondence through the Phillips
curve between inflation and unemployment, when unemployment is close to its
natural rate, inflation should not change. Thus, policymakers can look at data on
the inflation rate to judge how close unemployment is to its natural rate. In
addition, they can look at other macroeconomic variables, including the
components of GDP and interest rates, to try to disentangle shifts in aggregate
supply from shifts in aggregate demand, which (when combined with information
about inflation) can help them determine the appropriate stance for monetary
policy.
~ THE END ~