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C h a p t e r 29 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. © 2014 Pearson Education, Inc. 190 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 191 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? © 2014 Pearson Education, Inc. 192 CHAPTER 12 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. © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 193 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, © 2014 Pearson Education, Inc. 194 CHAPTER 12 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. © 2014 Pearson Education, Inc. 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 © 2014 Pearson Education, Inc. 196 CHAPTER 12 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. © 2014 Pearson Education, Inc. 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 © 2014 Pearson Education, Inc. 198 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 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. © 2014 Pearson Education, Inc. 200 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 201 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. © 2014 Pearson Education, Inc. 202 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 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. © 2014 Pearson Education, Inc. 204 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 205 (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. © 2014 Pearson Education, Inc. 206 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 207 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. © 2014 Pearson Education, Inc. 208 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 209 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. © 2014 Pearson Education, Inc. 210 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 211 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. © 2014 Pearson Education, Inc. 212 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 213 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. © 2014 Pearson Education, Inc. 214 CHAPTER 12 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 © 2014 Pearson Education, Inc. INFLATION, JOBS, AND THE BUSINESS CYCLE 215 Phillips curve. The inflation rate rises and the unemployment rate decreases. © 2014 Pearson Education, Inc.