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Short Answer Questions: Chapter 13
Q1. Explain what the Taylor rule is.
Q2. Explain the difference between actual and potential GDP.
Q3. What is the main difference between a short-run and a long-run Phillips curve?
Q4. What is the difference between nominal and real wages?
Q5. What will a central bank that targets inflation do if inflation is above the target?
Essay questions
E1. Explain what is potential output and which factors may change it.
E2. Explain why monetary and fiscal policy should react to deflation despite adjustment to
full employment that can be reached in the long-run.
ANSWERS:
Short Answer Questions
Q1. Explain what the Taylor rule is.
A: The Taylor rule is a monetary rule named after the Stanford economist John
Taylor which links interest rate changes to short term deviations in both inflation
and output from long term equilibrium values.
Q2. Explain the difference between actual and potential GDP.
A. At the full employment level, an economy is producing at its potential GDP.
Therefore, if an economy is in long run equilibrium, there is little need to correct a
recession, by providing a boost to spending. Similarly, there is little need to slow
the economy, by increasing taxes or interest rates. In simple and clear terms,
because long run equilibrium results in full employment, fiscal and monetary policy
should be neutral, neither increasing, or reducing aggregate demand. In the short
run, by contrast, an economy can be shown to be in equilibrium, but the level of
GDP can differ from potential GDP. Short run, equilibrium GDP is referred to as
actual GDP. When the short run and the long run coincide, then actual and potential
GDP are equivalent. However, when actual GDP is greater than potential GDP, then
the economy is in a boom. Whereas, when actual GDP is less than potential GDP,
the economy is in a recession. The difference between potential and actual GDP is
referred to as the output gap.
Q3. What is the main difference between a short-run and a long-run Phillips curve?
A. The short run Phillips curve is negatively sloped and shows that lower
unemployment is associated with higher inflation. The long-run Phillips curve is
vertical and shows that there is no long-run trade-off between inflation and
unemployment.
Q4. What is the difference between nominal and real wages?
A. Real wages are earnings adjusted for inflation. Nominal wages are earnings
unadjusted for inflation.
Q5. What will a central bank that targets inflation do if inflation is above the target?
A. As inflation rises above the central bank’s target rate, then interest rates are
increased. Through the transmission mechanism, explained in chapter 12, higher
interest rates lead to a reduction in consumption and investment. This fall in
demand leads to a reduction in GDP.
Essay questions
E1. Explain what is potential output and which factors may change it.
Answer guidelines. First, you should define potential GDP in terms of output that
can be produced when all factors of production are fully employed. Potential output
is then a long run equilibrium value of output. Then you need to highlight that
potential output depends on the level of economic endowments. Hence, it is not
fixed but may change when an economy attracts more economic resource. A rising
birth rate, an inflow of migrant workers, or the discovery of oil and gas, are all
examples of increased economic endowments, which would result in the long run
aggregate supply schedule moving to the right. Equally, if a new technology
reduced the costs of economic transactions. Finally, a rise in productivity, such as
that brought about by more workers engaging in university education, can also lead
to an increase in the full employment level of the economy.
E2. Explain why monetary and fiscal policy should react to deflation despite adjustment to
full employment that can be reached in the long-run.
Answer guidelines. You need to highlight three major factors. The first issue is time
to adjust. If adjustment to full employment is slow, then unemployment will be high
for a prolonged amount of time. It is then better to act quickly with monetary and
fiscal packages. The second issue relates to the impact of deflation on
consumption. If consumers postpone consumption of high ticket items in the
expectation of cheaper prices in the future, then consumption today falls further.
The macroeconomic demand schedule moves further to the left. This generates a
bigger recession, more unemployment and more deflation. The risk then is that
further deflation motivates households to withhold yet more consumption, which
simply repeats the cycle and exacerbates the overall macroeconomic problem.
Third, deflation raises the real value of debt. If prices fall, then the value of labour
falls and wage growth should fall and perhaps even become negative. This makes
previously incurred debts less affordable. Households transfer earnings from
consumption to debt repayment. The macroeconomic demand schedule shifts to
the left and we observe more deflation, a larger fall in GDP and greater
unemployment.