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Ch30 Regan/Lipsey
Question 5
a) The announcement of an increase in the money supply should lead households, workers
and firms to expect an increase in the price level (eventually by the full 5 percent). This
expected inflation should lead some wages and other factor prices to rise now, thus shifting
the AS curve upward and to the left. The extent to which this shift occurs depends on how
forward-looking are peoples’ expectations and how credible the announcement by the
central bank is.
b) If the central bank’s announcement is not believed, then there is no reason to expect
future inflation because there is no reason to believe that the money supply will increase.
Conversely, if the announcement is fully credible, then inflationary expectations should rise
and the AS curve should shift up immediately and by the full amount (5 percent).
c) A sustained and constant rate of inflation of, say, 5 percent per year appears in an AD/AS
diagram with both the AD curve and the AS curve shifting up by 5 percent per year, with
the macroeconomic equilibrium moving up along a vertical Y* curve. Output is stable at Y*
and the inflation rate is also constant. The AD curve is shifting up because of the ongoing
increase in the money supply. The AS curve is shifting up because of the entrenched
inflationary expectations. In equilibrium, these expectations are being fulfilled.
d) As we explained in the text, actual inflation equals expected inflation plus excessdemand inflation plus supply-shock inflation. In the absence of supply shocks, constant
inflation means that expectations will eventually converge to actual inflation. But with
actual and expected inflation being equal, excess-demand inflation must be zero. Thus a
constant, sustained inflation is only possible when there is neither excess demand nor
excess supply — that is, when output equals Y*.
Question 6
a) If the Bank of Canada does not respond to the positive AD shock, then the economy’s
natural adjustment process comes into play. The excess demand for factors occurring
because of the inflationary output gap (when Y=Y1) leads factor prices to rise. As factor
prices rise, firms’ costs rise and the AS curve shifts up. This adjustment will continue until
the price level equals P2 and output returns to Y*.
b) Once output gets to Y1, the Bank of Canada can attempt to keep output constant by
expanding the money supply. In this situation, however, both inflation expectations and
excess demand will be driving inflation. In the diagram, as the AS curve begins to shift
upward due to the inflationary expectations and the rising factor prices, the AD curve must
shift enough to keep the macroeconomic equilibrium at Y1. Then, in the next period, when
the AS curve shifts again, the AD curve must also shift once more. This process must
continue, keeping the level of output constant at Y1.
c) The only way the Bank of Canada can maintain output at Y1 is to ensure that actual
inflation is greater than expected inflation (because there also is positive excess-demand
inflation). But when actual inflation exceeds expected inflation, expectations will adjust
upward. For actual inflation to remain above expected inflation, the actual rate of inflation
must therefore be ever increasing, which means ever-increasing rates of money growth.
Question 7
a) If the Bank of Canada does not respond to the negative AS shock, then the economy’s
natural adjustment process comes into play. The excess supply for factors occurring
because of the recessionary output gap (with Y=Y1) leads factor prices to fall. As factor
prices fall, firms’ costs fall and the AS curve shifts downward and to the right. This
adjustment will continue until the price level returns to its starting point, at the initial longrun equilibrium.
b) Once output gets to Y1, the Bank of Canada can attempt to offset the effect of the shock
by expanding the money supply. In the diagram, the AD curve must shift enough to return
the level of output to Y*, but the price level will rise to where AS1 intersects the vertical Y*
curve.
c) The danger of validating negative supply shocks is that it may lead to an increase in
inflation expectations. After all, both the negative shock and the monetary expansion lead
to transitional inflation, and so firms and households may think that the central bank has
decided permanently to aim toward a higher inflation rate. Thus, it is important when
validating negative supply shocks for the central bank to signal that it is not aiming for
permanently higher inflation but instead is simply offsetting the one-time shock. The
alternative to validating the shock is to do nothing, thus allowing the economy’s natural
adjustment mechanism to operate. The problem here is that wages and other factor prices
may fall only slowly, thereby permitting a protracted recessionary period.