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ECON 2020—Macroeconomics
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Question 1: Distinguish between the short run and the long run as they relate to
macroeconomics. Why is the distinction important?
Answer:
For macroeconomists, the short run is a period in which wages (and other input prices) do not
respond to price level changes. There are at least two reasons why nominal wages may remain
constant for a while even though the price level has changed.
1. Workers may not be aware of price level changes, and thus have not adjusted their
demands.
2. Many employees are hired under fixed wage contracts.
Once sufficient time has elapsed for contracts to expire and nominal wage adjustments to occur,
the economy enters the long run a period in which nominal wages are fully responsive to changes
in the price level.
The economy will adjust itself to a long-run equilibrium, but in the short run there may be a
positive role for stabilization (fiscal and monetary) policy.
Question 2: Suppose the government misjudges the natural rate of unemployment to be
much lower than it actually is, and thus undertakes expansionary fiscal and monetary
policy to try to achieve the lower rate. Use the concept of the short-run Phillips Curve to
explain why these policies might at first succeed. Use the concept of the long-run Phillips
Curve to explain the long-run outcome of these policies.
Answer:
In the short-run there is probably a tradeoff between unemployment and inflation. The
government’s expansionary policy should reduce unemployment as aggregate demand increases.
However, the government has misjudged the natural rate and will continue its expansionary policy
beyond the point of the natural level of unemployment. As aggregate demand continues to rise,
prices begin to rise. In the long-run, workers demand higher wages to compensate for these
higher prices. Aggregate supply will decrease (shift leftward) toward the natural rate of
unemployment.
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ECON 2020—Macroeconomics
In other words, any reduction of unemployment below the natural rate is only temporary and
involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a decrease in
aggregate supply. The end result should be an equilibrium at the natural rate of unemployment
and a higher price level than the beginning level. The long-run Phillips curve is thus a vertical line
connecting the price levels possible at the natural rate of unemployment found on the horizontal
axis. (See Figure 35.11)
Question 3. According to mainstream economists what is the usual cause of macroeconomic
instability? What role does the spending-income multiplier play in creating instability?
How might adverse aggregate supply factors cause instability, according to mainstream
economists?
Answer:
The mainstream view of macroeconomic instability is Keynesian-based and focuses on aggregate
spending and its components. Particularly significant are changes in investment spending, which
change aggregate demand and, occasionally, adverse supply shocks which change aggregate
supply.
Investment spending is subject to wide variations, and a “multiplier effect” magnifies these
changes into even greater changes in aggregate demand, which can cause demand-pull inflation in
the forward direction or a recession if investment spending falls.
In the mainstream view, a second source of instability could arise on the supply side. Wars or
artificial supply restrictions boost may increase per unit production costs. The result is a sizable
decline in a nation’s aggregate supply, which could destabilize the economy by simultaneously
causing cost-push inflation and recession.
Question 4. State and explain the basic equation of monetarism. What is the major cause
of macroeconomic instability, as viewed by monetarists?
Answer:
The fundamental equation of monetarism is the equation of exchange. MV = PQ. The left side,
MV, represents the total amount spent [M, the money supply x V, the velocity of money, (the
number of times per year the average dollar is spent on final goods and services)]. The right side,
PQ, equals the nation’s nominal GDP [P is the price level or more specifically, the average price
at which each unit of output is sold]. Q is the physical volume of all goods and services
produced.
Monetarists believe changes in the money supply, in particular, inappropriate monetary policy, is
the single most important cause of macroeconomic stability.
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