Download Answers to Questions in Chapter 16

Answers to Questions in Chapter 16
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383  Why are real wages likely to be more flexible downwards than money wages?
Money wages are unlikely to fall. The reason is that price inflation is virtually always
positive. Thus if money wages were to fall, there would have to be a bigger fall in real
wages. For example if inflation were 10% and firms wanted to cut money wages by
5%, this would mean cutting real wages by 15%: something they would find it hard to
get away with.
Real wages, on the other hand frequently do fall. Because wage agreements are usually
made in money terms, it only needs inflation to go ahead of money wage increases, and
real wages will fall.
Another reason why money wages are less flexible downwards has to do with money
illusion. People will resist a cut in money wages, seeing this as a clear cut in their living
standard. If, however, a money wage increase is given a bit below the rate of inflation
(i.e. a real wage cut), many workers will perceive this as an increase and will be more
inclined to accept it. And indeed, because pay increases normally occur annually, any
money rise (even if below the annual rate of inflation) will be a temporary real rise for
a few months, until inflation overtakes it.
384  Would it be possible for a short-run AS curve to be horizontal (as in diagram (b)) at all
levels of output?
No. Given that some factors are fixed in supply in the short run, there will inevitably be
a limit to output. As that limit is approached, the AS curve will slope upwards until it
becomes vertical at that limit.
384  If firms believe the aggregate supply curve to be relatively elastic, what effect will this
belief have on the outcome of an increase in aggregate demand?
Firms will respond to the increase in aggregate demand by increasing their output and
investment. There are two main reasons. The first is that they will expect output
elsewhere to increase and that they will therefore be able to obtain supplies. The second
is that, if they believe that the rise in aggregate demand is not going to cause inflation
to increase significantly, they will not expect the government to start deflating the
economy and thus dampening demand again. They will therefore expect their increased
sales to continue.
386  Assuming that rates of interest are initially above the equilibrium and that one
particular financial institution chooses not to reduce its rate of interest, what will
happen? What will be the elasticity of supply of loanable funds to an individual
institution?
As other institutions reduce theirs, so savers will switch their deposits to this institution
and new borrowers will go elsewhere. The net effect is that this institution will have a
huge glut of deposits (on which it is paying interest) that it is unable to lend out. It will
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Answers to questions in Economics by Sloman and Norris
thus make a large loss. The institution will thus be forced to lower its interest rate in
line with the other institutions.
The elasticity of supply will be infinite (if the market for loanable funds is perfect) or at
any rate highly elastic (if it is not perfect).
386  What would have happened if countries in deficit had not responded to an outflow of
gold by reducing total expenditure?
They would run out of gold.
388  Assuming that Y rises each year as a result of increases in productivity, can money
supply rise without causing inflation? Would this destroy the validity of the quantity
theory?
Yes. If V does not change, then for every one% that output (Y) rises, so M can also rise
by one% without causing the price level (P) to rise.
This does not destroy the validity of the quantity theory. Although the theory states that
changes in money supply will not cause changes in output, it still allows for changes in
output occurring independently of changes in money supply, in which case there can be
an accommodating rise in the money supply without it being inflationary.
390  (Box 16.2) Could resource crowding out take place at less than full employment?
Yes. Increased government expenditure on certain projects could divert key workers
and other resources that were in short supply away from the private sector, even though
there was a surplus of other resources. The problem is that labour and other resources
are not homogeneous and not perfectly mobile. The point still remains, however, that
the amount of resource crowding out that occurs, for any given increase in government
expenditure, will be less, the greater the degree of slack in the economy (i.e. the further
away the economy is from full employment).
392  Demonstrate this argument on an aggregate demand and supply diagram.
See Figure 16.7 in the text (page 393). If the economy is initially at GDP1 (i.e there is a
lot of slack in the economy), a rise in money supply that results in an increase in
aggregate demand from AD1 to AD2 will lead to a rise in output (from GDP1 to GDP2)
with little increase in the level of prices.
395  What would be the classical economists' criticisms of this argument?
That the increases in money supply would simply lead to higher prices in the private
sector, and that the public works would thus still lead to crowding out – both financial
and resource crowding out. Given that the cause of the problem, to classical
economists, was the rigidities in markets, the solution was to free-up markets: to
encourage workers to accept lower wages, and producers to charge lower prices.
395  Might the AS curve shift to the right in the meantime? If it did how would this influence
the effects of the rises in aggregate demand?
GDPp (and hence AS) will shift to the right over time as potential growth takes place
(new resources discovered and new technologies invented). Also the rise in aggregate
demand and in output may lead to increased investment and hence a bigger capital
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Chapter 16
stock: this too will shift GDPp and AS to the right.
The rightward shift of GDPp and AS will allow the rise in aggregate demand to lead to a
bigger increase actual output (GDP) and a smaller increase in the price level (if any at
all).
398  What effects, according to monetarists, would successful supply-side policies have on
the Phillips curve?
If the supply-side policies reduced the natural level of unemployment by improving the
working of the labour market (e.g. by improving information on jobs), then the
(vertical) Phillips curve would shift to the left. If, however, the supply-side policies
merely affected output, the Phillips curve would be unaffected.
400  Two economists disagree over the best way of tackling the problem of unemployment.
For what reasons might they disagree? Are these reasons positive or normative?
One might view unemployment as disequilibrium in nature while the other might see it
as demand deficient. This would be a ‘positive’ reason for disagreement.
An example of a normative reason is as follows. One might view the unemployed as
lazy, deliberately avoiding work. He/she would then advocate cutting unemployment
benefit. The other thinks the unemployed do wish to work – they are victims of
circumstance. He/she would advocate other methods such as wage subsidies or job
creation schemes.
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