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Chapter 29: Inflation and the Phillips Curve
Chapter 29: Inflation and the Phillips Curve
Questions for Thought and Review
2.
Adaptive expectations.
4.
The three assumptions are that velocity is constant, real income is independent of the
money supply, and the direction of causation is from money to prices.
6.
Financial institutions have changed enormously and financial markets have become
increasingly connected internationally, increasing the flow of money among countries.
8.
Governments and central banks sometimes increase money supply even when they know
the consequences because sometimes the political ramifications of not increasing the
money supply (which can include a collapse of government) are thought to be worse.
10.
Quantity theorists are more likely to support rules because they have less trust in
government undertaking beneficial actions and believe that the long-run effects of
monetary policy are on the price level while the short run effects cannot be predicted.
12.
The insider/outsider theory of inflation divides workers into insiders and outsiders. It is
an example of an institutionalist theory of inflation, which says that social pressures
prevent economic pressures from working. In it, insiders push up wages and outsiders
find themselves experiencing unemployment; because the costs of raising wages are not
borne by those who make the decision, there is little pressure on insiders not to raise
wages
14.
The short-run Phillips curve is illustrated on page 696 of the text in Figure 29-3(a). The
short-run curve shows the trade-off between inflation and unemployment when
expectations of inflation are constant. The long run Phillips curve is shown in Figure 294(b) as the vertical curve. The long-run curve shows the trade-off (or lack thereof) when
expectations of inflation equal actual inflation.
16.
It depends. With short-run, long-run, and shifting curves, just about any combination of
inflation and unemployment rates can fit some Phillips curve. So, yes, the Phillips curve
is a figment of economists' imaginations. But then again, aren't all models simply
structures imposed on reality and doesn't reality only get interpreted through imaginary
imposed structures? If so, to suggest that the Phillips curve is "nothing but a figment" is
incorrect. Reality is itself a figment of imagination. (If you follow this answer, you might
consider shifting to a philosophy major.)
Chapter 29: Problems and Exercises
18. a. Answers may differ. Five goods we buy frequently are newspapers, soda, gas, shirts, and
coffee.
b. This requires research by the student. Answers will depend on goods chosen.
c. Answer will depend on goods chosen.
20. a. Stopping inflation tends to transfer money from debtors to creditors. Creditors are
generally rich, and can golf regardless of their wealth. Debtors, faced with a decrease in
their wealth, must cut back on discretionary expenditures, of which golf is one.
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Chapter 29: Inflation and the Phillips Curve
b. Since the exchange rate was fixed, any differential in inflation rates between the two
countries could not be offset a change in the exchange rate. The fact that goods in dollar
equivalent pesos in Argentina were higher than in NYC suggests that the Argentinean
inflation rate remained greater than in the U.S. and the high prices of goods were serving
as an anchor on the economy.
c. In an inflation (with interest rates falling behind inflation), people look for real assets to
buy to protect their wealth. This increases the demand for goods relative to services,
increasing their price. When the inflation is stopped, the opposite occurs.
d. One reason why luxury auto dealers were shutting down was the same as the argument
given in (a). A second reason is equivalent to that given in (c). A third reason is that
wealthy Argentineans who would most likely purchase such a car also probably had
foreign bank accounts denominated in dollars. The car in dollars was cheaper because the
peso was overvalued at the fixed exchange rate. The demand for luxury cars fell as
Argentineans substituted dollar-denominated luxury cars for peso-denominated cars.
22. a. One would expect real output to decline.
b. One would expect unemployment to rise.
c. One would expect inflation to fall.
24. a. Increases in productivity shift the long-run aggregate supply curve to the right as shown
below on the left. This allows policy makers to increase aggregate demand (perhaps
through expansionary policy, which would keep interest rates low, as desired) without
increasing the price level. In this example, the economy moves from point A to point B.
b. Increase in productivity shifts the long-run Philips curve to the left because it allows a
lower unemployment rate at every rate of inflation. This is shown below on the right.
Policymakers, therefore are able to increase aggregate demand, shifting the short-run
Phillips curve to the left, resulting in lower unemployment and the same inflation rate. In
this example, the economy moves from point A to point B.
LP 1
SAS 0
SAS1
P0
i0
B
A
LP 0
Inflation
Price level
LAS 0 LAS 1
B
A
AD1
SP 0
AD0
Y0
Y1
Real output
SP 1
U1
U0
Unemployment
Chapter 29: Web Questions
2. a.
Inflation reduces business investment and the efficiency with which productive factors
are put to use.
b. Reducing inflation by one percentage point when the rate is 20 percent may increase
growth by 0.5 percent. At lower inflation rates, a one percentage point reduction may
increase growth by more than 1 percent.
c. It affects growth more when inflation is low.
As the authors point out, their analysis leaves little room for interpretation.
Inflation is not neutral, and in no case does it favor rapid economic growth. Higher
inflation never leads to higher levels of income in the medium and long run, which is the
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Chapter 29: Inflation and the Phillips Curve
time period they analyze. This negative correlation persists even when other factors are
added to the analysis, including the investment rate, population growth, schooling rates,
and the constant advances in technology. Even when the authors factor in the effects of
supply shocks characteristic of a part of the analyzed period, there is still a significant
negative correlation between inflation and growth.
Inflation not only reduces the level of business investment, but also the efficiency
with which productive factors are put to use. The benefits of lowering inflation are great,
according to the authors, but also dependent on the rate of inflation. The lower the
inflation rate, the greater are the productive effects of a reduction. For example, reducing
inflation by one percentage point when the rate is 20 percent may increase growth by 0.5
percent. But, at a 5 percent inflation rate, output increases may be 1 percent or higher. It
is therefore more costly for a low inflation country to concede an additional point of
inflation than it is for a country with a higher starting rate. Given their detailed analysis,
the authors conclude that "efforts to keep inflation under control will sooner or later pay
off in terms of better long-run performance and higher per capita income."
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