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INFLATION, JOBS,
AND THE BUSINESS
CYCLE**
Answers to the Review Quizzes
Page 301
1.
(page 707 in Economics)
How does demand-pull inflation begin?
Demand-pull inflation begins with an increase in aggregate demand.
The increase in aggregate demand increases real GDP and the price
level.
2.
What must happen to create a demand-pull inflation spiral?
When the economy is at an above full-employment equilibrium, the
money wage rate rises which decreases the short-run aggregate supply.
The decrease in the short-run aggregate supply decreases real GDP
and raises the price level. If nothing else changes, the price level
eventually stops rising. To create a demand-pull inflation spiral,
aggregate demand must persistently increase, and the only way in
which aggregate demand can persistently increase is if the quantity
of money persistently increases.
3.
How does cost-push inflation begin?
Cost-push inflation begins with an increase in the money wage rate
or an increase in the money prices of raw materials, which decreases
short-run aggregate supply. The decrease in short-run aggregate
supply raises the price level and decreases real GDP.
4.
What must happen to create a cost-push inflation spiral?
If the Fed responds to each decrease in short-run aggregate supply
by increasing the quantity of money, aggregate demand increases and
freewheeling cost-push inflation ensues.
5.
What is stagflation and why does cost-push inflation cause
stagflation?
Stagflation occurs when real GDP decreases and the price level rises.
Cost-push inflation causes stagflation when short-run aggregate
supply decreases because a decrease in short-run aggregate supply
raises the price level and decreases real GDP.
6.
How does expected inflation occur?
Expected increases in aggregate demand or expected decreases in
short-run aggregate supply create expected inflation because they
change the expected price level. For example, in anticipation of an
increase in aggregate demand, the money wage rate rises by the same
*
* This is Chapter 12 in Macroeconomics.
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CHAPTER 12
percentage as the price level is expected to rise. With the correct
expectation, real GDP remains equal to potential GDP and
unemployment remains at its natural rate.
7.
How do real GDP and the price level change if the forecast of
inflation is incorrect?
If the actual inflation rate exceeds the forecasted inflation rate,
the price level rises by more than expected and real GDP exceeds
potential GDP. If the actual inflation rate falls short of the
expected inflation rate, the price level rises by less than expected
and real GDP is less than potential GDP.
Page 304
1.
(page 710 in Economics)
How would you use the Phillips curve to illustrate an unexpected
change in inflation?
An unexpected change in inflation results in a movement along the
short-run Phillips curve. In particular, an unexpected increase in
the inflation rate lowers the unemployment rate and an unexpected
decrease in the inflation rate raises the unemployment rate.
2.
If the expected inflation rate increases by 10 percentage points,
how do the short-run Phillips curve and the long-run Phillips
curve change?
A 10 percentage point increase in the expected inflation rate shifts
the short-run Phillips curve vertically upward by 10 percentage
points. (Each point on the new short-run Phillips curve lies 10
percentage points above the point on the old Phillips curve directly
below it). A 10 percentage point increase in the expected inflation
rate does not change the long-run Phillips curve.
3.
If the natural unemployment rate increases, what happens to the
short-run Phillips curve and the long-run Phillips curve?
An increase in the natural unemployment rate shifts both the shortrun and long-run Phillips curves rightward by an amount equal to the
increase in the natural unemployment rate.
4.
Does the United States have a stable short-run Phillips curve?
Explain why or why not.
The United States does not have a stable short-run Phillips curve.
The U.S. short-run Phillips curve shifts with changes in the
expected inflation rate and the natural unemployment rate, so it is
not stable.
Page 309
1.
(page 715 in Economics)
Explain the mainstream theory of the business cycle.
Mainstream business cycle theory attributes business cycles to
fluctuations in aggregate demand growth. According to the mainstream
view, potential GDP grows steadily and aggregate demand, while
generally growing slightly faster that potential GDP, at times grows
more slowly than potential GDP and at other times grows
significantly more rapidly than potential GDP. When aggregate demand
grows more slowly than potential GDP, the price level falls below
its expected level and the economy slides into a recession so that
real GDP is less than potential GDP. When aggregate demand grows
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more rapidly than potential GDP, the price level rises above its
expected level and the economy moves into a strong expansion
accompanied by inflation.
2.
What are the four special forms of the mainstream theory of the
business cycle and how do they differ?
The four special forms of the mainstream theory are the Keynesian
cycle theory, the monetarist cycle theory, the new classical cycle
theory, and the new Keynesian cycle theory. These theories differ
according to the factors they believe are the most responsible for
causing fluctuations in the growth of aggregate demand. Keynesian
cycle theory asserts that fluctuations in aggregate demand growth
are the result of fluctuations in investment driven by fluctuations
in business confidence. The monetarist cycle theory says that
fluctuations in both investment and consumption expenditure lead to
fluctuations in aggregate demand growth and that the basic source of
the fluctuations in investment and consumption expenditure is
fluctuations in the growth rate of the quantity of money. New
classical cycle theory claims that the money wage rate and the
position of the short-run aggregate supply curve are determined by
the rational expectation of the price level, which in turn is
determined by potential GDP and the expected aggregate demand. As a
result, only unexpected changes in aggregate demand growth lead to
business cycles. Finally, new Keynesian cycle theory says that money
wage rates and the position of the short-run aggregate supply are
determined by rational expectations of the price level from the past.
As a result, both expected and unexpected fluctuations in aggregate
demand growth lead to business cycles.
3. According to RBC theory, what is the source of the business cycle?
What is the role of fluctuations in the rate of technological
change?
Real business cycle (RBC) theory says that economic fluctuations are
caused by technological change that makes productivity growth
fluctuate. Fluctuations in the rate of technological change are the
impulse that creates the business cycle.
4.
According to RBC theory, how does a fall in productivity growth
influence investment demand, the market for loanable funds, the
real interest rate, the demand for labor, the supply of labor,
employment, and the real wage rate?
According to real business cycle theory, a fall in productivity
growth decreases investment demand and the demand for labor. The
decrease in investment demand decreases the demand for loanable
funds and lowers the real interest rate. Via the intertemporal
substitution effect, the lower real interest rate decreases the
supply of labor. Because both the demand for labor and the supply of
labor decrease, employment decreases. The real wage rate also falls
because the decrease in the demand for labor exceeds the decrease in
the supply of labor.
5.
What are the main criticisms of RBC theory and how do its
supporters defend it?
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Critics of the real business cycle theory level three criticisms at
it: 1) the money wage rate is sticky; 2) the intertemporal
substitution effect is small so that the small changes in the real
wage rate cannot account for large changes in employment; and, 3)
measured productivity shocks are likely to be caused by changes in
aggregate demand so that business cycle fluctuations cause the
measured productivity shocks. Real business cycle supporters respond
that 1) the real business cycle theory is consistent with the facts
about economic growth and it explains the facts about business
cycles; and 2) real business cycle theory is consistent with a wide
range of microeconomic evidence about labor supply, labor demand,
investment demand, and the distribution of income between labor and
capital.
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Answers to the Study Plan Problems and Applications
1.
Best to Get Used to High Food and Energy Prices—They’re Here to
Stay
Rising energy and food costs are slowing the economy at a time
when it is already facing severe headwinds. Just as Western
Europe and North America are showing a bit of sparkle, along
comes another oil price shock or food price shock to put out the
light.
On top of rising energy prices, a severe U.S. drought, a poor
monsoon season in Asia, and a bad harvest in Russia and Ukraine
have sent grain prices soaring. Globally, this is the third major
food price shock in five years.
Source: The Telegraph, August 29, 2012
Explain what type of inflation the news clip is describing and
provide a graphical analysis of it.
The news clip is describing a
cost-push inflation. The costs of
important inputs, such as oil, as
well as the cost of other raw
materials, such as grain, have
all risen. Figure 12.1
illustrates a cost-push inflation.
In it the short-run aggregate
supply curve has shifted leftward,
from SAS0 to SAS1 and the price
level has risen from 122 to 124.
Use Figure 12.2 to answer Problems 2,
3, 4, and 5. In each question, the
economy starts out on the curves AD0
and SAS0.
2. Some events occur and the economy
experiences a demand-pull
inflation.
a. List the events that might cause
a demand-pull inflation.
Anything that increases aggregate
demand can be the factor that
starts a demand-pull inflation.
For instance, an increase in the
quantity of money, an increase in
government expenditure, a tax cut,
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or an increase in exports could all be the start of a demand-pull
inflation. To sustain the inflation, the quantity of money must keep
increasing.
b. Describe the initial effects of a demand-pull inflation.
Starting at the intersection of AD0 and SAS0, the price level is 120
and real GDP is at potential GDP of $10 trillion. Aggregate demand
increases and the AD curve shifts rightward to AD1. The new
equilibrium is at the intersection of AD1 and SAS0, so the price
level rises and real GDP increases. There is an inflationary gap.
c.Describe what happens as a demand-pull inflation spiral proceeds.
Starting at the intersection of AD1 and SAS0, there is an
inflationary gap so the money wage rate rises and short-run
aggregate supply decreases. The SAS curve starts to shift leftward
toward SAS1. The price level keeps rising, but real GDP now decreases.
If the central bank responds with persistent increases in the
quantity of money, the process repeats: AD shifts to AD2, an
inflationary gap opens again, the money wage rate rises again, and
the SAS curve shifts toward SAS2.
3.
Some events occur and the economy experiences a cost-push
inflation.
a. List the events that might cause a cost-push inflation.
Anything that decreases short-run aggregate supply can set off a
cost-push inflation. For instance, an increase in the money wage
rate or an increase in the money price of raw materials could be the
start of a cost-push inflation. But to sustain such an inflation,
the quantity of money must keep increasing.
b. Describe the initial effects of a cost-push inflation.
Starting at the intersection of AD0 and SAS0, the price level is 120
and real GDP is at potential GDP of $10 trillion. Short-run
aggregate supply decreases and the SAS curve shifts leftward to SAS1.
The price level rises and real GDP decreases. There is now a
recessionary gap.
c. Describe what happens as a cost-push inflation spiral proceeds.
Starting out at the intersection of AD0 and SAS1, there is a
recessionary gap so real GDP is below potential GDP and unemployment
is above the natural rate. In an attempt to restore full employment,
the central bank increases the quantity of money. The aggregate
demand curve shifts rightward to AD1. Real GDP returns to $10
trillion and the price level rises to 160. A further cost increase
occurs, which shifts the short-run aggregate supply curve to SAS2 and
a recessionary gap opens up again. The economy is again below
potential GDP. In an attempt to restore full employment, the central
bank increases the quantity of money. The aggregate demand curve
shifts rightward to AD2. Real GDP returns to $10 trillion and the
price level rises to 200.
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INFLATION, JOBS, AND THE BUSINESS CYCLE
4.
195
Some events occur and the economy is expected to experience
inflation.
a. List the events that might cause an expected inflation.
Anything that increases aggregate demand can set off an expected
inflation as long as the event is expected. For instance, an
expected increase in the quantity of money, an increase in
government expenditure, a tax cut, or an increase in exports could
all be the start of an expected inflation. But to sustain such an
expected inflation, the quantity of money must keep increasing along
its expected path.
b. Describe the initial effects of an expected inflation.
Starting at the intersection of AD0 and SAS0, the price level is 120
and real GDP is at potential GDP of $10 trillion. Aggregate demand
increases, and the AD curve shifts rightward to AD1. The increase in
aggregate demand is expected so the money wage rate rises and the
SAS curve shifts to SAS1. The price level rises, and real GDP remains
equal to potential GDP.
c. Describe what happens as an expected inflation proceeds.
Starting at the intersection of AD1 and SAS1, a further expected
increase in aggregate demand occurs. The AD curve shifts to AD2, and
because the increase in aggregate demand is expected, the money wage
rate rises again and the SAS curve shifts to SAS2. Again, the price
level rises and real GDP remains equal to potential GDP.
5.
Suppose that people expect deflation (a falling price level), but
aggregate demand remains at AD0.
a. What happens to the short-run and long-run aggregate supply
curves? (Draw some new curves if you need to.)
People expect that the price level will fall. The money wage rate
falls in expectation of the lower price level. The short-run
aggregate supply curve shifts rightward. There is no change in
potential GDP. The long-run aggregate supply curve does not shift.
b. Describe the initial effects of an expected deflation.
Starting at the intersection of AD0 and SAS0, the price level is 120
and real GDP is equal to potential GDP of $10 trillion. Short-run
aggregate supply increases, and the SAS curve shifts rightward. The
aggregate demand curve does not shift. The price level falls, but by
less than people expected. The real wage rate falls because the
money wage rate has fallen by more than the price level. Real GDP
increases. Real GDP is greater than potential GDP and an
inflationary gap opens.
c. Describe what happens as it becomes obvious to everyone that the
expected deflation is not going to occur.
The
The
and
120
money wage rate rises to reflect the higher expected price level.
rise in the money wage rate decreases short-run aggregate supply
the SAS curve shift leftward to SAS0. The price level rises to
and the economy returns to its potential GDP.
Use the following news clip to work Problems 6 to 8.
Official: China May Face Heavy Inflation Pressure
China is expected to face great inflationary pressure in the future
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due to higher costs and an abundant global money supply, a senior
Chinese official said in an article published Tuesday. He said
inflation in China is also the result of excessive global liquidity
from loose monetary policies adopted by developed nations, China’s
lending expansion, and a pile-up of outstanding foreign exchange
funds.
China’s consumer price index (CPI), a main gauge of inflation, rose
4.9 percent year on year in February, the same level as in January.
The CPI data for March is scheduled to be released this week and is
estimated to show a rise above 5 percent.
Source: China Daily, April 12, 2011
6. Is China experiencing demand-pull
or cost-push inflation? Explain.
Even though the official
mentioned “higher costs,” all the
reasons advanced for the
inflation create demand-pull
inflation, so China is
experiencing a demand-pull
inflation.
7.
Draw a graph to illustrate the
initial rise in the price level
and the money wage rate response
to a one-time rise in the price
level.
Figure 12.3 shows the effect of a
one-time increase in the price
level that results from a onetime increase in aggregate demand.
The aggregate demand curve shifts
rightward from AD0 to AD1 and
initially the price level rises from 130 to 132. Real GDP also
increases, from 25.0 trillion yuan to 25.4 trillion yuan. In
response to the tight labor market, the money wage rate rises.
Aggregate supply decreases so that the SAS curve shifts leftward
from SAS0 to SAS1. The price level rises still more from 132 to 134.
Once at 134, the price level stops rising so there is not an ongoing inflation.
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INFLATION, JOBS, AND THE BUSINESS CYCLE
8.
197
Draw a graph to illustrate and explain how China might experience
an inflation spiral.
Figure 12.4 shows how the
situation in part b can change
into a demand-pull inflation.
After the short-run aggregate
supply decreases to SAS1 and the
economy is back at full
employment, an increase in the
quantity of money by the central
bank increases aggregate demand
and the aggregate demand curve,
shifts rightward to AD2. The
price level rises to 136 and,
just as in part b, the money wage
rate rises again so that the
short-run aggregate supply once
more decreases. After the
decrease in short-run aggregate
supply to SAS2 the price level
rises still higher to 138. As
long as the quantity of money continues to increase, the inflation
spiral will continue with aggregate demand increasing and short-run
aggregate supply decreasing.
Use the following news clip to work Problems 9 to 11.
Getting a Raise: Why It’s Not Happening
Didn’t get a raise this year? Blame inflation. American wages didn’t
budge last month, according to Labor Department data released
Wednesday. And with inflation remaining at near zero, experts say it
could be quite a while before many workers see their next raise.
While stagnant prices are a boon for consumers on supermarket
checkout lines, they can be hard on workers’ bottom lines. Wages
typically track inflation, soaring higher when prices take off. In
fact, some say wages tend to feed inflation. That was the case in the
1970s, when wage growth picked up after prices soared. But pricing
pressures are weaker today, with the consumer price index, a measure
of inflation, unchanged in July from the previous month.
Source: Huffington Post, August 16, 2012
9. a. Explain why the inflation rate and the rate at which wages rise
are connected.
The inflation rate and the rate at which money wages rise are
connected because in the long run the economy returns to its longrun aggregate supply curve. Along the long-run aggregate supply
curve the economy is at its natural unemployment rate. If the
inflation rate exceeds the rate at which the money wage rate is
rising, the economy moves along its short-run aggregate supply curve
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and temporarily the unemployment rate is less than natural
unemployment rate. But in the long run, the money wage rate will
grow more rapidly to catch up to the inflation rate and the economy
returns to its long-run aggregate supply curve. The reverse occurs
if the money wage rate grows more rapidly than the inflation rate:
The unemployment rate is greater than the natural unemployment rate,
so in the long-run the growth rate of the money wage rate slows to
equal the inflation rate and the economy returns to its natural
unemployment rate.
b. Explain in what type of inflation wages are “soaring higher when
prices take off.”
Wages are “soaring higher” when the inflation starts in a cost-push
inflation started by a higher money wage rate.
10. Explain in what type of inflation “wages tend to feed inflation.”
“Wages tend to feed inflation” in a demand-pull inflation.
11. If “pricing pressures are weaker today,” compared to the 1970s,
what does that suggest about the expected inflation rate in the
1970s and today? Draw a graph to illustrate an expected inflation
during the 1970s.
If “pricing pressures are weaker
today” compared to the 1970s,
the expected inflation rate is
lower today compared to the
1970s. The lower inflation rate
means that the short-run
aggregate supply curve today
does not shift leftward as
rapidly as it did in the 1970s.
Figure 12.5 illustrates the
large leftward shift of the
short-run aggregate supply curve
in the 1970s with the shift from
SAS0 to SAS1.
12. Iran Postpones Cutting Gasoline Subsidies
Inflation is about 10 percent and the unemployment rate is about
14 percent. Earlier this month Iran’s main audit body slammed the
government's plan to scrap gasoline subsidies, warning that
implementing such a reform might result in unrest. The government
also intends to scrap subsidies on natural gas, which most
Iranians use for cooking and heating, as well as electricity, but
the new prices are still not known. However, in recent weeks some
households have received electricity bills with nearly sevenfold
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199
price increases.
Source: AFP, September 15, 2010
a. If Iran removes the subsidies
on necessities and consumers
don’t know what the higher
prices will be, draw a graph to
show the most likely path of
inflation and unemployment.
If consumers do not know that the
prices will rise, the inflation
is unexpected. In this case the
Iranian economy is likely to move
upward along an unchanging shortrun Phillips curve. Figure 12.6
illustrates this situation. The
Iranian natural unemployment rate
is assumed to be 10 percent.
Initially the economy is at point
A, with an inflation rate of 10
percent and an unemployment rate
of 14 percent. Then the burst of
unexpected inflation occurs. The economy moves along its short-run
Phillips curve, SRPC0, from point A to point B. The inflation rate
rises, to 13 percent in the figure, and the unemployment rate falls,
to 8 percent in the figure.
b. If Iran removes the subsidies and announces the new prices so
that consumers know what they are, draw a graph to show the most
likely path of inflation and unemployment.
If consumers know that prices
will rise, the inflation is
expected. In this case people
revise upward their inflation
expectations and the short-run
Phillips curve shifts upward.
Figure 12.7 illustrates this
outcome. Once again the Iranian
natural unemployment rate is
assumed to be 10 percent.
Initially the economy is at point
A, with an inflation rate of 10
percent and an unemployment rate
of 14 percent. Then the burst of
expected inflation occurs. The
short-run Phillips curve shifts
upward, from SRPC0 to SRPC1. The
economy moves from point A on its
initial short-run Phillips curve to point B on the new short-run
Phillips curve. The inflation rate rises, to 13 percent in the
figure, but because the inflation was expected the unemployment rate
does not change.
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13. Eurozone Unemployment Hits Record High As Inflation Rises
Unexpectedly
Spain is suffering mass unemployment with a 25 percent
unemployment rate and half of those out of work under 25.
Eurozone unemployment as a whole rose to 10.7 percent. At the
same time, eurozone inflation unexpectedly rose to 2.7 percent a
year, up from the previous month’s 2.6 percent a year.
Source: Huffington Post, March 1, 2012
a. How does the Phillips curve model account for a very high
unemployment rate?
The Phillips curve can account for very high unemployment either by
a very low inflation rate, which creates a movement along a
stationary short-run Phillips curve, or by a very high natural
unemployment rate, which shifts both the short-run and long-run
Phillips curves rightward.
b. Explain the change in unemployment and inflation in the eurozone
in terms of what is happening to the short-run and long-run
Phillips curves.
The small burst of unexpected inflation mentioned in the news clip
brought a movement up along the short-run Phillips curve. But a
large increase in the natural unemployment rate shifts both the
short-run and long-run Phillips curves rightward. So in the Eurozone,
the trade-off between inflation and unemployment worsened as the
short-run Phillips curve shifted rightward.
14. From the Fed’s Minutes
Members expected real GDP growth to be moderate over coming
quarters and then to pick up very gradually, with the
unemployment rate declining only slowly. With longer-term
inflation expectations stable, members anticipated that inflation
over the medium run would be at or below 2 percent a year.
Source: FOMC Minutes, June 2012
Are FOMC members predicting that the U.S. economy will move
rightward or leftward along a short-run Phillips curve or that
the short-run Phillips curve will shift up or down through 2012
and 2013?
The Fed is predicting that the U.S. economy will move leftward along
a generally flat short-run Phillips curve. The Fed expects that the
unemployment rate will fall. Because the Fed thinks longer-term
inflation expectations are stable, it does not expect the short-run
Phillips curve to shift.
15. Debate on Causes of Joblessness Grows
What is the cause of the high unemployment rate? One side says
more government spending can reduce it. The other says it’s a
structural problem—people who can’t move to take new jobs because
they are tied down to burdensome mortgages or firms that can’t
find workers with the requisite skills to fill job openings.
Source: The Wall Street Journal, September 4, 2010
Which business cycle theory would say that the rise in
unemployment is cyclical? Which would say it is an increase in
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the natural rate? Why?
It is likely that most of the mainstream business cycle theories say
that the rise in the unemployment rate is cyclical in nature.
Definitely the Keynesian cycle theory and new Keynesian cycle theory
agree that the rise is cyclical. It is also likely that the
monetarist cycle theory and new classical cycle theory agree. The
real business cycle theory, however, disagrees. It regards all
unemployment as natural and so it would assert that the rise in the
unemployment rate reflects a rise in the natural rate.
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Answers to Additional Problems and Applications
Use the following news clip to work Problems 16 and 17.
Inflation Should Be Feared
The Fed is trying as hard as it can to spur growth, and to create
some inflation. But the Fed must be careful. Inflation remains a
danger because U.S. debt is skyrocketing, with no visible plan to pay
it back. For the moment, foreigners are buying that debt. But they
are buying out of fear that their governments are worse. They are
short-term investors, waiting out the storm, not long-term investors
confident that the United States will pay back its debts. If their
fear passes, or they decide some other haven is safer, watch out.
Inflation will come with a vengeance. It’s not happening yet:
Interest rates are low now. But so were mortgage-backed security
rates and Greek government debt rates just a few years ago. But if it
happens, it will happen with little warning, the Fed will be
powerless to stop it, and it will bring stagnation rather than
prosperity.
Source: John H. Cochrane, The New York Times, August 22, 2012
16. What type of inflation process does John Cochrane warn could
happen? Explain the role that inflation expectations would play
if the outbreak of inflation were to “happen with little
warning.”
Mr. Cochrane is concerned that a cost-push inflation could occur. Mr.
Cochrane worries that if foreigners decide to sell their U.S.
government securities, the U.S. exchange rate will fall as
foreigners try to sell dollars to purchase their currency. With the
fall in the U.S. exchange rate, the costs of goods imported into the
United States will rise, thereby starting a cost-push inflation. If
the inflation starts with little warning, people’s inflation
expectations will not change so that inflation expectations will
play a small role in the inflation.
17. Explain why the inflation that John Cochrane fears would “bring
stagnation rather than prosperity.”
Mr. Cochrane is fearful of a cost-push inflation. In a cost-push
inflation, real GDP decreases and the unemployment rate rises, being
“stagnation rather than prosperity.”
Use the following information to work Problems 18 and 19.
The Reserve Bank of New Zealand signed an agreement with the New
Zealand government in which the Bank agreed to maintain inflation
inside a low target range. Failure to achieve the target would result
in the governor of the Bank (the equivalent of the chairman of the
Fed) losing his job.
18. Explain how this arrangement might have influenced New Zealand’s
short-run Phillips curve.
The Reserve Bank of New Zealand’s arrangement with New Zealand’s
government affected the short-run Phillips curve because it affected
people’s expectations of the inflation rate. In particular, since
the agreement was credible and had significant sanctions for the
governor of the Reserve Bank of New Zealand, the public likely kept
their expected inflation rates lower than might otherwise have been
the case. As a result, the short-run Phillips curve was lower than
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203
it otherwise would have been and, in addition, was probably less
likely to shift higher if the inflation rate temporarily rose.
19. Explain how this arrangement might have influenced New Zealand’s
long-run Phillips curve.
The long-run Phillips curve is independent of the inflation rate and
of people’s inflationary expectations, so the arrangement probably
had little direct effect on the long-run Phillips curve. The only
way in which the long-run Phillips curve could have been affected
was if the arrangement affected the natural unemployment rate. If
the agreement lowered the natural unemployment rate, the long-run
Phillips curve shifted leftward.
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Use the following information to work Problems 20 and 21.
An economy has an unemployment rate
of 4 percent and an inflation rate of
5 percent a year at point A in Figure
12.8. Some events occur that move the
economy in a clockwise loop from A to
B to D to C and back to A.
20. Describe the events that could
create this sequence. Has the
economy experienced demand-pull
inflation, cost-push inflation,
expected inflation, or none of
these?
First the inflation rate
increases from 5 percent a year
to 15 percent a year and the
unemployment rate does not change.
Then the unemployment rate
increases from 4 percent to 8
percent and the inflation rate
does not change. Next the inflation rate falls from 15 percent a
year to 5 percent a year and the unemployment rate does not change.
Finally the unemployment rate falls from 8 percent to 4 percent and
the inflation rate does not change. This set of changes could be the
result of an expected increase in the inflation rate from 5 percent
to 15 percent, followed by an increase in the natural unemployment
rate from 4 percent to 8 percent, followed by an expected fall in
the inflation rate from 15 percent to 5 percent, finally followed by
a decrease in the natural unemployment rate from 8 percent to 4
percent.
21. Draw in the figure the sequence of the economy’s short-run and
long-run Phillips curves.
Figure 12.9 shows these short-run
and long-run Phillips curves. The
initial increase in the expected
inflation rate moves the economy
up its (stationary) long-run
Phillips curve LRPC0 from point A
to point B. The short-run
Phillips curve shifts upward from
SRPC0 to SRPC1 and intersects the
long-run Phillips curve at point
B. Then the increase in the
natural unemployment rate shifts
both the long-run and short-run
Phillips curves rightward to
LRPC1 and SRPC2 so that they
intersect at point D. Next the
fall in the expected inflation
rate moves the economy along its
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(stationary) new long-run Phillips curve LRPC1 from point D to point
C. The short-run Phillips curve shifts downward from SRPC2 to SRPC3
and intersects the long-run Phillips curve at point C. Finally, the
fall in the natural unemployment rate shifts both the long-run and
short-run Phillips curves leftward back to LRPC0 and SRPC0 so that
they intersect at point A.
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Use the following news clip to work Problems 22 and 23.
Fed Pause Promises Financial Disaster
The indication is that inflationary expectations have become
entrenched and strongly footed in world markets. As a result, the
risk of global stagflation has become significant. A drawn-out
inflationary process always precedes stagflation, anathema to the socalled Phillips Curve. Following the attritional effect of inflation,
the economy starts to grow below its potential. It experiences a
persistent output gap, rising unemployment, and increasingly
entrenched inflationary expectations.
Source: Asia Times Online, May 20, 2008
22. Evaluate the claim that stagflation is anathema to the Phillips
Curve.
Moving along a short-run Phillips curve, a higher inflation rate
leads to a decrease in the unemployment rate. Stagflation occurs
when a higher inflation rate occurs along with higher unemployment.
On its face, stagflation is an “anathema” to the Phillips curve
because it appears that stagflation contradicts the Phillips curve.
But stagflation can occur when the short-run Phillips curve shifts
rightward or upward, possibly because of an increase in the natural
unemployment rate or higher expected inflation. In this situation,
higher inflation and higher unemployment can occur simultaneously.
23. Evaluate the claim made in the news clip that if “inflationary
expectations” become strongly “entrenched” an economy will
experience “a persistent output gap.”
The comment that inflationary expectations become strongly
entrenched likely means that the expected inflation rate becomes
high. The Phillips curve model, however, shows that even with high
expected inflation the economy will eventually return to the longrun Phillips curve and the natural rate of unemployment. Hence the
assertion that high expected inflation means that the economy will
experience a “persistent output gap” is incorrect.
Use the following information to work Problems 24 and 25.
Because the Fed doubled the monetary base in 2008 and the government
spent billions of dollars bailing out troubled banks, insurance
companies, and auto producers, some people are concerned that a
serious upturn in the inflation rate will occur, not immediately but
in a few years time. At the same time, massive changes in the global
economy might bring the need for structural change in the United
States.
24. Explain how the Fed’s doubling of the monetary base and
government bailouts might influence the short-run and long-run
unemployment–inflation tradeoffs. Will the influence come from
changes in the expected inflation rate, the natural unemployment
rate, or both?
The doubling of the monetary base might lead to significant
inflation at some point in the future. If the inflation is
unexpected, it will not change either the short-run Phillips curve
or the long-run Phillips curve. But if at some point the inflation
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becomes expected, the short-run Phillips curve will shift upward. In
either case, however, the long-run Phillips curve is not affected.
The government bailouts probably decreased the amount of cyclical
unemployment that otherwise would have occurred. In this case they
forestalled a movement downward along the short-run Phillips curve.
As long as the bailed out companies operate efficiently, the
bailouts by themselves did not affect the natural unemployment rate
and thereby did not change the long-run Phillips curve.
25. Explain how large scale structural change might influence the
short-run and long-run unemployment–inflation tradeoffs. Will the
influence come from changes in the expected inflation rate, the
natural unemployment rate, or both?
Large-scale structural changes increase structural unemployment,
thereby increasing the natural unemployment rate. The long-run and
short-run Phillips curves shift rightward, worsening the tradeoff
between unemployment and inflation.
Use the following information to work Problems 26 to 28.
Suppose that the business cycle in the United States is best
described by RBC theory and that a new technology increases
productivity.
26. Draw a graph to show the effect of the new technology in the
market for loanable funds.
The advance in technology makes
investment in industries that can
utilize the new technology more
profitable. Investment demand
increases, which increases the
demand for loanable funds. As
Figure 12.10 shows, the increase
in the demand for loanable funds
shifts the demand for loanable
funds curve rightward from DLF0 to
DLF1. The increase in the demand
for loanable funds raises the
equilibrium real interest rate
and increases the equilibrium
quantity of loanable funds. In
Figure 12.10 the real interest
rate rises from 4 percent a year
to 5 percent a year and the
quantity of loanable funds
increases from $2.5 trillion to $2.7 trillion.
27. Draw a graph to show the effect of the new technology in the
labor market.
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The advance in technology
directly increases the demand for
labor as firms look to hire more
workers to exploit the technology.
In addition, the supply of labor
increases as workers respond to
the higher real interest rate.
The increase in the supply of
labor, however, is less than the
increase in the demand for labor.
As Figure 12.11 shows, the demand
for labor curve shifts rightward
from LD0 to LD1 and the supply of
labor curve shifts rightward from
LS0 to LS1. Both changes increase
the equilibrium quantity of
employment. In Figure 12.11
employment increases from 300
billion hours to 330 billion
hours. The effect on the real wage rate is ambiguous, but if, as
illustrated in the figure, the increase in demand exceeds the
increase in supply, then the net effect raises the real wage rate.
In Figure 12.11 the real wage rate rises from $20 per hour to $30
per hour.
28. Explain the when-to-work decision when technology advances.
The when-to-work decision is an important part of the real business
cycle theory. As the answer to Problem 26 showed, the increase in
technology raises the real interest. Changes in the real interest
rate create an “intertemporal substitution effect,” which is the
“when-to-work” decision. If the real interest rate rises, the return
to current work increases because any funds saved reap a higher real
interest rate. (The effect is called “intertemporal” because in the
future the increased saving influences people to work less.) As a
result, a higher real interest rate increases the current supply of
labor, which shifts the supply of labor curve rightward and
increases equilibrium employment.
29. Real Wages Fail to Match a Rise in Productivity
For most of the last century, wages and productivity—the key
measure of the economy’s efficiency—have risen together,
increasing rapidly through the 1950s and ’60s and far more slowly
in the 1970s and ’80s. But in recent years, the productivity
gains have continued while the pay increases have not kept up.
Source: The New York Times, August 28, 2006
Explain the relationship between wages and productivity in this
news clip in terms of real business cycle theory.
Increases in productivity increase the demand for labor. By itself,
this effect raises the real wage rate. But the article suggests that
“the pay increases have not kept up,” that is, the real wage rate
has not increased. One reason that pay increases have not kept up
might be errors in measuring the wage. In particular, if pay hikes
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have taken the form of higher fringe benefits, then focusing on only
the wage rate itself might fail to capture the actual pay rise.
Alternatively, it might be that the supply of labor has increased by
more than the demand for labor. The real business cycle theory says
that the supply of labor increases when productivity increases. So
if the supply of labor increased by more when the demand for labor
increased—as the real business cycle theory predicts will occur as a
result of technological advances—then the effect on the real wage
rate would be small and possibly even negative.
Economics in the News
30. After you have studied Reading Between the Lines on pp. 310–311
(716–717 in Economics), answer the following questions.
a. What are the main features of U.S. inflation and unemployment
since 1948 that brought fluctuations in the misery index?
From 1948 to about 1981 the inflation rate trended higher. The
unemployment fluctuated but after 1972 generally rose until 1981.
Over this period the slowly trending higher inflation rate created a
gradual increase in the misery index. In 1973/1974 and 1980/1981 oil
prices soared. Because of the higher oil prices both the inflation
rate and unemployment rate spiked higher in 1973/1974 and 1980/1981,
which spiked the misery index higher. After 1981 the inflation rate
fell and generally remained low. Since its peak in 1980 the
unemployment rate gradually fell until 2008, except during
recessions when it rose. Until 2008 the lower inflation and the
lower unemployment during non-recession years meant that the misery
index was been low during those years. During recessions, such as
1990, the misery index rose. Since 2008 the persistently high
unemployment rate has pushed the misery index to approximate its
high point in 1981.
b. When the misery index was at its peak in 1980, did inflation or
unemployment contribute most to the high index?
In 1980 inflation contributed the most to the high index. The
inflation rate was 14.4 percent and the unemployment rate was (only)
7.6 percent.
c. Do you think the U.S. economy had a recessionary gap, an
inflationary gap, or no gap in 1980? How might you be able to
tell?
In 1980 the U.S. economy had a recessionary gap because the
unemployment rate was well above the natural unemployment rate.
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d. Use the AS-AD model to show the changes in aggregate demand and
aggregate supply that are consistent with the rise of the misery
index to its peak in June 1980.
Figure 12.12 shows the situation
in 1980. Before the misery index
soared, the economy was at point
A, on aggregate demand curve AD0
and short-run aggregate supply
curve SAS0. Then over the next two
years short-run aggregate supply
decreased and the short-run
aggregate supply curve shifted
leftward to SAS1. The decrease in
the short-run aggregate supply
was large because people’s
inflation expectations were high
and because the economy was hit
with significantly higher oil
prices. Aggregate demand
increased and the aggregate
demand curve shifted rightward to
AD1. But the increase in aggregate
demand was significantly less than the decrease in short-run
aggregate supply. The economy was at point B. From point A to point
B the price level skyrocketed, creating an extremely high inflation
rate. The economy had a severe recessionary gap (for simplicity the
LAS curve is assumed to have not changed over this time period) so
the unemployment rate rose. With these results, the misery index hit
its 60 year peak from 1950 to 2012.
e. Use the AS-AD model to show the changes in aggregate demand and
aggregate supply that are consistent with the rise of the misery
index since President Obama assumed office.
Figure 12.13 shows the situation
since President Obama took office.
When President Obama took office,
the economy was at point A, on
aggregate demand curve AD0 and
short-run aggregate supply curve
SAS0. The economy had a
recessionary gap, so the
unemployment rate, 8.3 percent,
exceeded the natural rate. The
inflation rate was zero. From
then until August, 2012,
aggregate supply decreased but
there was a larger increase in
aggregate demand. The aggregate
demand curve shifted rightward to
AD1 and the short-run aggregate
supply curve shifted leftward to
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SAS1. The economy was at point B. From point A to point B the price
level rose and the inflation rate was approximately 4 percent. The
recessionary gap decreased slightly from when President Obama took
office (again for simplicity the LAS curve is assumed to have not
changed over this time period) so the unemployment rate fell from
8.3 percent to 8.2 percent. The misery index hit 12.5.
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31. Germany Leads Slowdown in Eurozone
The pace of German economic growth has weakened “markedly,” but
the reason is the weaker global prospects. Although German
policymakers worry about the country’s exposure to a fall in
demand for its export goods, evidence is growing that the
recovery is broadening with real wage rates rising and
unemployment falling, which will lead into stronger consumer
spending.
Source: The Financial Times, September 23, 2010
a. How does “exposure to a fall in demand for its export goods”
influence Germany’s aggregate demand, aggregate supply,
unemployment and inflation?
If there is a severe decrease in
demand for Germany’s exports,
Germany’s aggregate demand
decreases. There is no impact on
aggregate supply. The decrease in
aggregate demand lowers the price
level and decreases real GDP. The
fall in the price level means
that the inflation rate falls;
the decrease in real GDP means
that unemployment rises.
b. Use the AS-AD model to
illustrate your answer to part
(a).
Figure 12.14 illustrates this
situation. Aggregate demand
decreases and the aggregate
demand curve shifts leftward,
from AD0 to AD1. The economy moves
from point A to point B. Real GDP decreases and the price level
falls.
c. Use the Phillips curve model to illustrate your answer to part
(a).
In part (a) the inflation rate
fell and the unemployment rate
increased. People’s inflation
expectations likely did not
change so the German economy
moved along its short-run
Phillips curve. In 2010, the
German inflation rate was 1
percent and the unemployment rate
was 7 percent. Figure 12.15 shows
the effect of the decrease in
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demand for exports as the movement from point A on the short-run
Phillips curve SRPC to point B on the same short-run Phillips curve.
The inflation rate falls and the unemployment rate rises.
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d. What do you think the news clip means by “the recovery is
broadening with real wage rates rising and unemployment falling,
which will lead into stronger consumer spending”?
The clip is implicitly talking about the multiplier effect. It is
predicting that aggregate demand will increase as a result of the
increase in consumption expenditure. Aggregate supply might also
change but the emphasis in the news clip is on aggregate demand. The
increase in aggregate demand increases real GDP and raises the price
level. The increase in real GDP lowers the unemployment rate and the
increase in the price level raises the inflation rate.
e. Use the AS-AD model to illustrate your answer to part (d).
Figure 12.16 illustrates this
situation. Aggregate demand
increases because of the higher
consumption expenditure and the
aggregate demand curve shifts
rightward, from AD0 to AD1. The
economy moves from point A to
point B. Real GDP increases and
the price level rises.
f. Use the Phillips curve model to illustrate your answer to part
(d).
In part e the inflation rate rose
and the unemployment rate
decreased. People’s inflation
expectations likely did not
change so the German economy
moved along its short-run
Phillips curve. In 2010, the
German inflation rate was 1
percent and the unemployment rate
was 7 percent. Figure 12.17 shows
the effect of the increase in
consumption expenditure as the
movement from point A on the
short-run Phillips curve SRPC to
point B on the same short-run
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Phillips curve. The inflation rate rises and the unemployment rate
decreases.
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