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Solutions to Problems
Chapter 34
1.
Anything that slows investment in physical or human capital or slows the pace of technological change will create a
productivity growth slowdown.
The main factors at work during the Australian productivity growth slowdown in the 1970s and 80s were:
1.
Energy price shocks drastically raised the price of energy, which motivated technological innovation to produce goods
and services with less energy. Thus innovation essentially was devoted to saving energy and not increasing
productivity.
2.
Environmental protection laws were passed. Pollution abating investment raised the quality of life but did not increase
(measured) GDP, so (measured) productivity did not increase.
3.
High inflation discouraged saving and the purchase of productivity-enhancing capital equipment.
Improvements in incentives to invest in physical or human capital or to innovate and speed up the pace of technological
change will counteract a productivity growth slowdown. Policies that can be advanced to speed economic growth:
1.
Stimulate saving. Higher saving rates increase the growth rate of capital. Tax incentives might be provided to boost
saving.
2.
Stimulate research and development. Because everyone can use new discoveries, not all the benefit of a discovery falls
to the initial discoverer. Thus the tendency is to invest too little in research and development activity. Government
subsidies might be an incentive for more investment.
3.
Target high-technology firms. The ones that should be subsidized are high-technology industries in which the nation
can enjoy a temporary advantage over its competitors.
4.
Encourage international trade. If a nation enjoys an advantage in some industries, free international trade allows it to
exploit all the potential profit opportunities.
5.
Improve the quality of education. Education is similar to basic research insofar as benefits from education spread
beyond the person being educated so investment in education tends to be too small.
3a. Real GDP is $600 billion and the price level is 110.
These values are determined at the intersection of AD0 and SAS.
3b. Real GDP falls to $590 billion and the price level falls to 100. Then, as aggregate demand returns to AD0, the price level and
real GDP return to their initial levels.
3c. Real GDP falls to $590 billion and the price level falls to 100. The government increases aggregate demand to AD0, and the
price level and real GDP return to their initial levels. Aggregate demand then increases (because the decrease is temporary),
and real GDP rises above potential GDP. An inflationary gap arises. The money wage rate rises and so does the price level.
Real GDP moves back toward potential GDP.
3d. Real GDP falls to $590 billion, and the price level falls to 100. The economy is stuck at this point until the money wage rate
falls, short-run aggregate supply increases, and the economy moves back to potential GDP at an even lower price level. This
move will likely take a long time.
3e. Real GDP falls to $590 billion, and the price level falls to 100. The government increases aggregate demand to AD0, and the
price level and real GDP return to their initial levels. Because the decrease in aggregate demand is permanent, this is the end
of the action.
5a. The economy is experiencing stagflation caused by a supply-side shock such as an increase in the world price of oil. Cost
shocks such as these become inflationary if they are accommodated by an increase in the quantity of money. Such an
increase in the quantity of money can occur if a monetary policy feedback rule is used. In figure 1 the economy has
experienced a cost shock and there has been a fall in short run aggregate supply and the SAS curve moves leftward from
SAS0 to SAS1. If the Reserve Bank follows a fixed rule and does nothing to change aggregate demand the economy will stay
at point b until costs fall again. If the Reserve Bank uses a feed back rule and increases the money supply when there is a fall
in real GDP the aggregate demand curve moves rightward from AD0 to AD1 and the price level is pushed higher. Workers
increase wage demands to maintain real wages and the SAS curve moves to the left and a wage –price spiral begins.
Workers and employers will eventually anticipate the expansion of aggregate demand and build in inflationary expectations
to wage negotiations.
5b. To reduce inflation a Reserve Bank that lacks credibility will need to reduce inflationary expectations by a surprise increase
in interest rates so that the AD curve does not move to the right as expected. This creates unemployment in the short run but
if the Reserve Bank remains committed nominal wages will fall and the SAS curve will move back to the right.
A credible announced inflation reduction from the Reserve Bank would reduce inflationary expectations little or no
unemployment.
5c. In figure 2 nominal wages increased because employers and workers anticipated an expansion of aggregate demand from
AD to EAD at current interest rates. The Reserve Bank unexpectedly increases interest rates and aggregate demand does not
expand, actual aggregate demand stays at AD. This is deflationary, in the short run there is above the natural rate of
unemployment but eventually wages will fall and the economy will move back to full employment real GDP. Once
inflationary expectations are ‘squeezed out’ of the economy there is increased productivity because the costs of inflation
have been reduced. There is now increased growth in potential real GDP and a lowering of the natural rate of
unemployment. If the Reserve Bank is seen to be independent of political interference and can maintain a reputation for low
inflation it is able to reduce inflationary expectations with credible inflation reduction announcements with out the cost of
high unemployment.
LAS
•
115
SAS2
Price level
Price level
Cost-Push Inflation  Problem 5
SAS1
LAS
SAS2
SAS1
SAS0
d
SAS0
•c
110
•b
105
•b
•a
100
•a
AD1
AD0
Ye
Figure 1
Yp
EAD
AD
Ye
Real GDP
Yp
Real GDP
Figure 2
7.
If inflation is beginning to rise there is excess demand and the economy is at an above potential real GDP
equilibrium Ye in figure 4. If the Reserve Bank uses a fixed rule it will not react to the rising inflation and
aggregate, demand will fall from AD1 to AD1/, from peak to trough over the business cycle. If the Reserve Bank
uses a feedback rule it will increase interest rates due to rising inflation amplifying the fall in aggregate demand
from AD/to AD//, and pushing the economy deeper into recession. Because of poor timing the policy has been procyclic rather than anti-cyclic.
The above answer assumes the Reserve Bank uses current inflation rates as the feedback mechanism. In fact the
Reserve Bank is forward looking and attempts to be pre-emptive with monetary policy. If it is “widely” agreed that a
recession is just around the corner the Reserve Bank can be expected to lower interest rates and limit the size the
downturn. Policy will be anti-cyclical rather than pro-cyclical.
The recovery  Problem 8
LAS
SAS
•c
•
Price level
Price level
The down-turn  Problem 7
LAS
SAS
•a
b
•a
AD1
•
•c
AD1//
b
AD1/
AD0
AD1//
Ye/ Yp
Figure 4
Ye
AD0
AD1/
AD1
Ye Yp
Real GDP
Figure 5
Ye/
Real GDP