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AD/AS Models and
Macro Policy Debates
Phillips Curve
Adaptive vs. Rational Expectations
Policy Impotency Hypothesis
Ricardian Equivalence
Introduction
 In previous models, we assumed the price level
P was “stuck” in the short run.
 This implies a horizontal SRAS curve.
 Now, we consider two prominent models of
aggregate supply in the short run:
 Sticky-price model
 Imperfect-information model
Introduction
 Both models imply:
Y  Y   (P  EP )
expected
price level
agg.
output
natural rate
of output
a positive
parameter
actual
price level
 Other things equal, Y and P are positively
related, so the SRAS curve is upward-sloping.
The sticky-price model
 Reasons for sticky prices:
 long-term contracts between firms and
customers
 menu costs
 firms not wishing to annoy customers with
frequent price changes
 Assumption:
 Firms set their own prices
(i.e., firms have some market power)
The sticky-price model
 An individual firm’s desired price is:
p  P  a(Y  Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p  EP  a( EY  EY )
The sticky-price model
p  EP  a( EY  EY )
 Assume sticky price firms expect that output will
equal its natural rate. Then,
p  EP
 To derive the aggregate supply curve,
first find an expression for the overall price level.
s=
fraction of firms with sticky prices.
Then, we can write the overall price level as…
The sticky-price model
P  s[ EP ]  (1  s )[ P  a(Y  Y )]
price set by sticky
price firms
price set by flexible
price firms
 Subtract (1s)P from both sides:
sP  s[ EP ]  (1  s )[a(Y  Y )]
 Divide both sides by s :
(1 s )a
P  EP 
(Y  Y )
s
The sticky-price model
(1 s )a
P  EP 
(Y  Y )
s
 High EP  High P
If firms expect high prices, then firms that must set
prices in advance will set them high.
Other firms respond by setting high prices.
 High Y  High P
When income is high, the demand for goods is high.
Firms with flexible prices set high prices.
The greater the fraction of flexible price firms,
the smaller is s and the bigger is the effect of Y
on P.
The sticky-price model
(1 s )a
P  EP 
(Y  Y )
s
 Finally, derive AS equation by solving for Y :
Y  Y   (P  EP ),
s
where  
 0
(1  s )a
The imperfect-information model
Assumptions:
 All wages and prices are perfectly flexible,
so that all markets clear.
 Each supplier produces one good, consumes
many goods.
 Each supplier knows the nominal price of the
good she produces, but does not know the
overall price level.
The imperfect-information model
 Supply of each good depends on its relative
price: the nominal price of the good divided by
the overall price level.
 Supplier does not know price level at the time
she makes her production decision, so uses EP.
Lucas Island Metaphor
PB = 1
PA = 1
2
PD = 1
PE = 1
PC = 1
 Suppose P rises but EP
does not.
 Supplier thinks her relative
price has risen,
so she produces more.
 With many producers
thinking this way,
Y will rise whenever P
rises above EP.
Summary & implications
P
LRAS
Y  Y   (P  EP)
P  EP
SRAS
P  EP
P  EP
Y
Y
Both models
of agg. supply
imply the
relationship
summarized
by the SRAS
curve &
equation.
Summary & implications
SRAS equation: Y  Y   (P  EP)
Suppose a positive
AD shock moves
SRAS2
P
LRAS
output above its
natural rate and
SRAS1
P above the level
people had
P3  EP3
expected.
P2
Over time,
EP2  P1  EP1
EP rises,
SRAS shifts up,
and output returns
to its natural rate.
AD2
AD1
Y
Y3  Y1  Y
Y2
Inflation Rate
5.0
The 1960s
1969
4.5
4.0
1968
3.5
1967
3.0
2.5
1966
2.0
1964
1.5
1961
1960
1965
1.0
1963
1962
0.5
0.0
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
Unemployment Rate
Inflation, Unemployment,
and the Phillips Curve
The Phillips curve states that  depends on
 expected inflation, E.
 cyclical unemployment: the deviation of the
actual rate of unemployment from the natural rate
 supply shocks,  (Greek letter “nu”).
  E   ( u  u )  
n
where  > 0 is an exogenous constant.
Comparing SRAS and the Phillips Curve
SRAS:
Phillips curve:
Y  Y   (P  EP )
  E   ( u  u n )  
 SRAS curve:
Output is related to
unexpected movements in the price level.
 Phillips curve:
Unemployment is related to
unexpected movements in the inflation rate.
Adaptive expectations
 Adaptive expectations: an approach that
assumes people form their expectations of future
inflation based on recently observed inflation.
 A simple version:
Expected inflation = last year’s actual inflation
E   1
 Then, P.C. becomes
   1   (u  un )  
Inflation inertia
   1   (u  u )  
n
In this form, the Phillips curve implies that
inflation has inertia:
 In the absence of supply shocks or
cyclical unemployment, inflation will
continue indefinitely at its current rate.
 Past inflation influences expectations of
current inflation, which in turn influences
the wages & prices that people set.
Two causes of rising & falling inflation
   1   (u  u )  
n
 cost-push inflation:
inflation resulting from supply shocks
Adverse supply shocks typically raise production
costs and induce firms to raise prices,
“pushing” inflation up.
 demand-pull inflation:
inflation resulting from demand shocks
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which “pulls” the inflation rate up.
Graphing the Phillips curve
In the short
run, policymakers
face a tradeoff
between  and u.

  E   ( u  u n )  

1
The short-run
Phillips curve
E  
u
n
u
Inflation Rate
The 1970s
13.0
1975
12.0
11.0
1974
10.0
1979
9.0
8.0
1978
7.0
1976
1970
1971
6.0
1977
5.0
1973
4.0
1972
3.0
2.0
1.0
0.0
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
Unemployment Rate
Inflation Rate
15.0
The 1980s
1980
14.0
13.0
1981
12.0
11.0
10.0
1982
9.0
8.0
7.0
6.0
1989
1988
5.0
1986
1984
1983
4.0
1985
3.0
1987
2.0
1.0
0.0
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
10.0 10.5
Unemployment Rate
Inflation Rate
The 1990s
1991
6.0
1990
5.0
4.0
1993
1997
1996
3.0
1995
1992
1994
1999 1998
2.0
1.0
0.0
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
Unemployment Rate
Inflation Rate
5.0
The 2000s
2008
4.5
2006
4.0
2001
3.5
2005
2000
3.0
2.5
2007
2003
2004
2.0
2002
1.5
1.0
0.5
0.0
3.0
3.5
4.0
4.5
5.0
5.5
6.0
Unemployment Rate
6.5
Inflation Rate
15.0
1980
14.0
13.0
1981
12.0
1975
11.0
10.0
1974
1979
9.0
1982
8.0
1978
7.0
1976
1970
6.0
1990 1971
5.0
1969
4.0
2006
2001
1973
1968
3.0
1967
2000
2.0
1966
19972005
1972
19961995
2007
1999 1998
1977
1986
1985
1993
2003
1994
1984
1983
1992
2004
1964
1965
1.0
1989
2008
1988
1991
1963
1987
1960
2002
1961
1962
0.0
3
4
5
6
7
8
9
10
11
Unemployment Rate
Shifting the Phillips curve
People adjust
their
expectations
over time,
so the tradeoff
only holds in
the short run.

  E   ( u  u n )  
E 2  
E 1  
E.g., an increase
in E shifts the
short-run P.C.
upward.
u
n
u
The sacrifice ratio
 To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
 The sacrifice ratio measures
the percentage of a year’s real GDP
that must be foregone to reduce inflation
by 1 percentage point.
 A typical estimate of the ratio is 5.
The sacrifice ratio
 Example: To reduce inflation from 6 to 2 percent,
must sacrifice 20 percent of one year’s GDP:
GDP loss = (inflation reduction) x (sacrifice ratio)
=
4
x
5
 This loss could be incurred in one year or spread
over several, e.g., 5% loss for each of four years.
 The cost of disinflation is lost GDP.
One could use Okun’s law to translate this cost
into unemployment.
Rational expectations
Ways of modeling the formation of expectations:
 adaptive expectations:
People base their expectations of future inflation
on recently observed inflation.
 rational expectations:
People base their expectations on all available
information, including information about current
and prospective future policies.
Painless disinflation?
 Proponents of rational expectations believe
that the sacrifice ratio may be very small:
 Suppose u = un and  = E = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
 If the announcement is credible,
then E will fall, perhaps by the full 4 points.
 Then,  can fall without an increase in u.
Calculating the sacrifice ratio
for the Volcker disinflation
 1981:  = 9.7%
Total disinflation = 6.7%
1985:  = 3.0%
year
u
un
uu n
1982
9.5%
6.0%
3.5%
1983
9.5
6.0
3.5
1984
7.4
6.0
1.4
1985
7.1
6.0
1.1
Total 9.5%
Calculating the sacrifice ratio
for the Volcker disinflation
 From previous slide: Inflation fell by 6.7%,
total cyclical unemployment was 9.5%.
 Okun’s law:
1% of unemployment = 2% of lost output.
 So, 9.5% cyclical unemployment
= 19.0% of a year’s real GDP.
 Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 percentage points of GDP were lost
for each 1 percentage point reduction in inflation.
The natural rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters,
is based on the natural rate hypothesis:
Changes in aggregate demand affect output
and employment only in the short run.
In the long run, the economy returns to
the levels of output, employment,
and unemployment described by
the classical model (Chaps. 3-8).
Stabilization Policy
 Should policy be active or passive?
 Should policy be by rule or discretion?
Should policy be active or passive?
Growth rate of U.S. real GDP
Percent
change
from 4
quarters
earlier
10
8
6
Average
growth
rate
4
2
0
-2
-4
1970
1975
1980
1985
1990
1995
2000
2005
2010
Increase in unemployment during recessions
peak
trough
increase in # of
unemployed persons
(millions)
July 1953
May 1954
2.11
Aug 1957
April 1958
2.27
April 1960
February 1961
1.21
December 1969
November 1970
2.01
November 1973
March 1975
3.58
January 1980
July 1980
1.68
July 1981
November 1982
4.08
July 1990
March 1991
1.67
March 2001
November 2001
1.50
Increase from 12/2007 thru 6/2009: 7.2 million!!!
Arguments for active policy
 Recessions cause economic hardship for millions
of people.
 The Employment Act of 1946:
“It is the continuing policy and responsibility of the
Federal Government to…promote full employment
and production.”
 The model of aggregate demand and supply
(Chaps. 9-13) shows how fiscal and monetary
policy can respond to shocks and stabilize the
economy.
Arguments against active policy
Policies act with long & variable lags, including:
inside lag:
the time between the shock and the policy response.
 takes time to recognize shock
 takes time to implement policy,
especially fiscal policy
outside lag:
the time it takes for policy to affect economy.
If conditions change before policy’s impact is felt,
the policy may destabilize the economy.
Automatic stabilizers
 definition:
policies that stimulate or depress the economy
when necessary without any deliberate policy
change.
 Designed to reduce the lags associated with
stabilization policy.
 Examples:
 income tax
 unemployment insurance
 welfare
Forecasting the macroeconomy
Because policies act with lags, policymakers must
predict future conditions.
Two ways economists generate forecasts:
 Leading economic indicators
data series that fluctuate in advance of the
economy
 Macroeconometric models
The LEI index and real GDP, 1990s
annual percentage change
15
10
5
0
-5
-10
-15
1990
source of LEI data:
The Conference Board
1992
1994
1996
1998
2000
Leading Economic Indicators
Real GDP
2002
Forecasting the macroeconomy
Because policies act with lags, policymakers must
predict future conditions.
Two ways economists generate forecasts:
 Leading economic indicators
data series that fluctuate in advance of the
economy
 Macroeconometric models
Large-scale models with estimated parameters
that can be used to forecast the response of
endogenous variables to shocks and policies
Unemployment rate
Mistakes forecasting the 1982 recession
Forecasting the macroeconomy
Because policies act with lags, policymakers must
predict future conditions.
The preceding slides show that the
forecasts are often wrong.
This is one reason why some
economists oppose policy activism.
The Lucas critique
 Due to Robert Lucas
who won Nobel Prize in 1995 for rational
expectations.
 Forecasting the effects of policy changes has
often been done using models estimated with
historical data.
 Lucas pointed out that such predictions would not
be valid if the policy change alters expectations in
a way that changes the fundamental relationships
between variables.
An example of the Lucas critique
 Prediction (based on past experience):
An increase in the money growth rate will reduce
unemployment.
 The Lucas critique points out that increasing the
money growth rate may raise expected inflation,
in which case unemployment would not
necessarily fall.
The Jury’s out…
Looking at recent history does not clearly answer
Question 1:
 It’s hard to identify shocks in the data.
 It’s hard to tell how outcomes would have been
different had actual policies not been used.
The Great Moderation?
Question 2:
Should policy be conducted by
rule or discretion?
Rules and discretion:
Basic concepts
 Policy conducted by rule:
Policymakers announce in advance how
policy will respond in various situations,
and commit themselves to following through.
 Policy conducted by discretion:
As events occur and circumstances change,
policymakers use their judgment and apply
whatever policies seem appropriate at the time.
Arguments for rules
1. Distrust of policymakers and the political
process
 misinformed politicians
 politicians’ interests sometimes not the same
as the interests of society
Arguments for rules
2. The time inconsistency of discretionary
policy
 def: A scenario in which policymakers
have an incentive to renege on a
previously announced policy once others
have acted on that announcement.
 Destroys policymakers’ credibility, thereby
reducing effectiveness of their policies.
Examples of time inconsistency
1. To encourage investment,
govt announces it will not tax income from capital.
But once the factories are built,
govt reneges in order to raise more tax revenue.
Examples of time inconsistency
2. To reduce expected inflation,
the central bank announces it will tighten
monetary policy.
But faced with high unemployment,
the central bank may be tempted to cut interest
rates.
Examples of time inconsistency
3. Aid is given to poor countries contingent on fiscal
reforms.
The reforms do not occur, but aid is given
anyway, because the donor countries do not want
the poor countries’ citizens to starve.
Monetary policy rules
a. Constant money supply growth rate
 Advocated by monetarists.
 Stabilizes aggregate demand only if velocity
is stable.
Monetary policy rules
a. Constant money supply growth rate
b. Target growth rate of nominal GDP
 Automatically increase money growth
whenever nominal GDP grows slower than
targeted; decrease money growth when
nominal GDP growth exceeds target.
Monetary policy rules
a. Constant money supply growth rate
b. Target growth rate of nominal GDP
c. Target the inflation rate
 Automatically reduce money growth whenever
inflation rises above the target rate.
 Many countries’ central banks now practice
inflation targeting, but allow themselves a little
discretion.
Central bank independence
 A policy rule announced by central bank will
work only if the announcement is credible.
 Credibility depends in part on degree of
independence of central bank.
average inflation
Inflation and central bank independence
index of central bank independence
Government Debt and Budget Deficits
 The size of the U.S. government’s debt, and
how it compares to that of other countries.
 Problems with measuring the budget deficit.
 How does government debt affect the economy?
Deficit = G – T
Gov’t Debt = Σ Deficits
Indebtedness of the world’s governments
Country
Gov Debt
(% of GDP)
Country
Gov Debt
(% of GDP)
Japan
173
U.K.
59
Italy
113
Netherlands
55
Greece
101
Norway
46
Belgium
92
Sweden
45
U.S.A.
73
Spain
44
France
73
Finland
40
Portugal
71
Ireland
33
Germany
65
Korea
33
Canada
63
Denmark
28
Austria
63
Australia
14
Ratio of U.S. govt debt to GDP
1.2
1.0
WW2
0.8
0.6
Revolutionary
War
Civil War
Iraq
War
WW1
0.4
0.2
0.0
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
The U.S. experience in recent years
Early 1980s through early 1990s
 debt-GDP ratio: 25.5% in 1980, 48.9% in 1993
 due to Reagan tax cuts, increases in defense
spending & entitlements
Early 1990s through 2000
 $290b deficit in 1992, $236b surplus in 2000
 debt-GDP ratio fell to 32.5% in 2000
 due to rapid growth, stock market boom, tax
hikes
The U.S. experience in recent years
Early 2000s
 the return of huge deficits, due to Bush tax cuts,
2001 recession, Medicare expansion, Iraq war
The 2008-2009 recession
 fall in tax revenues
 huge spending increases (bailouts of financial
institutions and auto industry, stimulus package)
The troubling long-term fiscal outlook
 The U.S. population is aging.
 Health care costs are rising.
 Spending on entitlements like
Social Security and Medicare
is growing.
 Deficits and the debt are
projected to significantly
increase…
Percent of U.S. population age 65+
Percent 23
of pop.
actual
projected
20
17
14
11
8
2050
2040
2030
2020
2010
2000
1990
1980
1970
1960
1950
5
U.S. government spending on Medicare and
Social Security
Percent 8
of GDP
6
4
2
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
0
CBO projected U.S. federal govt debt in two
scenarios
Percent of GDP
300
250
200
150
pessimistic
scenario
100
50
optimistic scenario
0
2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
Problems measuring the deficit
1. Inflation
2. Capital assets
3. Uncounted liabilities
4. The business cycle
MEASUREMENT PROBLEM 1:
Inflation
 Suppose the real debt is constant, which implies a
zero real deficit.
 In this case, the nominal debt D grows at the rate
of inflation:
D/D = 
or
D =  D
 The reported deficit (nominal) is  D
even though the real deficit is zero.
 Hence, should subtract  D from the reported
deficit to correct for inflation.
MEASUREMENT PROBLEM 1:
Inflation
 Correcting the deficit for inflation can make a huge
difference, especially when inflation is high.
 Example: In 1979,
nominal deficit = $28 billion
inflation = 8.6%
debt = $495 billion
 D = 0.086  $495b = $43b
real deficit = $28b  $43b = $15b surplus
MEASUREMENT PROBLEM 2:
Capital Assets
 Currently, deficit = change in debt
 Better, capital budgeting:
deficit = (change in debt)  (change in assets)
 EX: Suppose govt sells an office building and
uses the proceeds to pay down the debt.
 under current system, deficit would fall
 under capital budgeting, deficit unchanged,
because fall in debt is offset by a fall in assets.
 Problem w/ cap budgeting: Determining which
govt expenditures count as capital expenditures.
MEASUREMENT PROBLEM 3:
Uncounted liabilities
 Current measure of deficit omits important
liabilities of the government:
 future pension payments owed to
current govt workers
 future Social Security payments
 contingent liabilities, e.g., covering federally
insured deposits when banks fail
(Hard to attach a dollar value to contingent
liabilities, due to inherent uncertainty.)
MEASUREMENT PROBLEM 4:
The business cycle
 The deficit varies over the business cycle due to
automatic stabilizers (unemployment insurance,
the income tax system).
 These are not measurement errors, but do make
it harder to judge fiscal policy stance.
 E.g., is an observed increase in deficit
due to a downturn or an expansionary shift
in fiscal policy?
MEASUREMENT PROBLEM 4:
The business cycle
 Solution: cyclically adjusted budget deficit
(aka “full-employment deficit”) – based on
estimates of what govt spending & revenues
would be if economy were at the natural rates of
output & unemployment.
The actual and cyclically adjusted
U.S. Federal budget surpluses/deficits
3
percentage of potential GDP
2
actual
1
0
cyclicallyadjusted
-1
-2
-3
-4
-5
-6
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
The bottom line
We must exercise care
when interpreting
the reported deficit figures.
Is the govt debt really a problem?
Consider a tax cut with corresponding increase
in the government debt.
Two viewpoints:
1. Traditional view
2. Ricardian view
The traditional view
 Short run: Y, u
 Long run:
 Y and u back at their natural rates
 closed economy: r, I
Crowding Out
The Ricardian view
 due to David Ricardo (1820),
more recently advanced by Robert Barro
 According to Ricardian equivalence,
a debt-financed tax cut has no effect on
consumption, national saving, the real interest
rate, investment, net exports, or real GDP,
even in the short run.
The logic of Ricardian Equivalence
 Consumers are forward-looking,
know that a debt-financed tax cut today
implies an increase in future taxes
that is equal – in present value – to the tax cut.
 The tax cut does not make consumers better off,
so they do not increase consumption spending.
Instead, they save the full tax cut in order to repay
the future tax liability.
 Result: Private saving rises by the amount public
saving falls, leaving national saving unchanged.
Problems with Ricardian Equivalence
 Myopia: Not all consumers think so far ahead,
some see the tax cut as a windfall.
 Borrowing constraints: Some consumers
cannot borrow enough to achieve their optimal
consumption, so they spend a tax cut.
 Future generations: If consumers expect that
the burden of repaying a tax cut will fall on future
generations, then a tax cut now makes them feel
better off, so they increase spending.
Evidence against Ricardian Equivalence?
Early 1980s:
Reagan tax cuts increased deficit.
National saving fell, real interest rate rose
1992:
Income tax withholding reduced to stimulate economy.
 This delayed taxes but didn’t make consumers
better off.
 Almost half of consumers increased consumption.
Evidence against Ricardian Equivalence?
 Proponents of R.E. argue that the Reagan tax cuts
did not provide a fair test of R.E.
 Consumers may have expected the debt to be
repaid with future spending cuts instead of
future tax hikes.
 Private saving may have fallen for reasons
other than the tax cut, such as optimism about
the economy.
 Because the data is subject to different
interpretations, both views of govt debt
survive.
OTHER PERSPECTIVES: Balanced budgets
vs. optimal fiscal policy
 Some politicians have proposed amending the
U.S. Constitution to require balanced federal
govt budget every year.
 Many economists reject this proposal, arguing
that deficit should be used to:
 stabilize output & employment
 smooth taxes in the face of fluctuating income
 redistribute income across generations when
appropriate
OTHER PERSPECTIVES:
Debt and politics
“Fiscal policy is not made by angels…”
– Greg Mankiw, p.487
 Some do not trust policymakers with deficit spending.
They argue that:
 policymakers do not worry about true costs of their
spending, since burden falls on future taxpayers
 since future taxpayers cannot participate in the
decision process, their interests may not be taken
into account
 This is another reason for the proposals for a balanced
budget amendment
OTHER PERSPECTIVES:
Fiscal effects on monetary policy
 Govt deficits may be financed by printing money
 A high govt debt may be an incentive for
policymakers to create inflation (to reduce real
value of debt at expense of bond holders)
Clicker Questions
In the sticky-price model, the relationship between
output and the price level depends on:
a) The target real wage rate
b) The target nominal wage rate
c) The proportion of firms with
d)
flexible prices
The implicit agreements between
workers and firms
54%
31%
15%
0%
a)
b)
c)
d)
Both models of aggregate supply discussed in Chapter 13
imply that if the price level is higher than expected, then
output ______ natural rate of output.
a)
b)
c)
d)
Exceeds the
Falls below the
Equals the
Moves to a different
54%
38%
8%
0%
a)
b)
c)
d)
The classical dichotomy breaks down for a Phillips curve,
which shows the relationship between a nominal variable,
_____, and a real variable, _____.
a)
b)
c)
d)
Output; prices
Money; output
Inflation; unemployment
Unemployment; inflation
85%
15%
0%
a)
0%
b)
c)
d)
According to the natural rate hypothesis,
fluctuations in aggregate demand affect output in:
a) Both the short run and
b)
c)
d)
100%
long run
Only in the short run
Only in the long run
In neither the short run
nor the long run
0%
a)
b)
0%
0%
c)
d)
The time between a shock to the economy and the
policy actions responding to that shock is called
the:
a)
b)
c)
d)
Automatic stabilizer
Time inconsistency of policy
Inside lag
Outside lag
62%
23%
15%
0%
a)
b)
c)
d)
The fact that traditional methods of policy evaluation do not
take into account the impact of policy on expectations is
known as:
a)
b)
c)
d)
The political business cycle
The Lucas critique
Okun’s Law
Stabilization policy
69%
15%
a)
b)
8%
8%
c)
d)
Policy is conducted by rule if policymakers:
a) Announce in advance how policy
b)
c)
d)
will respond to various situations
and commit themselves to following
through on this announcement
Are free to size up the situation case
by case and choose whatever policy
seems appropriate at the time
Set policy according to election
results
Manipulate policy to ensure both low
inflation and unemployment on
election day
100%
a)
0%
0%
0%
b)
c)
d)
A monetary policy rule that targets nominal GDP would
_____ money growth when nominal GDP rises above the
target and ______ money growth when nominal GDP falls
below the target.
100%
a)
b)
c)
d)
Reduce; raise
Raise; reduce
Reduce; reduce
Raise; raise
a)
0%
0%
0%
b)
c)
d)
The amount by which government spending exceeds
government revenues is called the _____, and the
accumulation of past government borrowing is called the
____.
a)
b)
c)
d)
Deficit; debt
Debt; deficit
Devaluation; deflation
Deflation; devaluation
92%
8%
a)
b)
0%
0%
c)
d)
Assume that the nominal interest rate is 11 percent, the
inflation rate is 8 percent, and government debt at the
beginning of the year equals $4 trillion. By how much is the
government budget deficit overstated as a result of
inflation?
a)
b)
c)
d)
$0.12 trillion
$0.32 trillion
$0.44 trillion
$0.80 trillion
62%
38%
a)
b)
0%
0%
c)
d)
The debt of the US government is underreported in the view
of many economists because all of the following liabilities
are excluded except:
a) Future pensions of
b)
c)
d)
government employees
Debt owed to foreigners
Future Social Security
benefits
Government guarantees
of student loans
77%
23%
0%
a)
0%
b)
c)
d)
According to the traditional viewpoint, a tax cut
without a cut in government spending:
a) Stimulates consumer spending
b)
c)
d)
and reduces national saving
Stimulates consumer spending
and increases national saving
Has no effect on consumer
spending but reduces national
saving
Has no effect on consumer
spending but reduces private
saving
92%
8%
a)
b)
0%
0%
c)
d)
According to the theory of Ricardian equivalence, if
consumers are forward-looking, they will view a tax cut that
has no plans to reduce government spending as ______, so
their consumption will ______.
a) Additional disposable income;
b)
c)
d)
increase
Additional disposable income;
remain unchanged
A rescheduling of taxes into the
future; increase
A rescheduling of taxes into the
future; remain unchanged
92%
8%
0%
a)
0%
b)
c)
d)