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Transcript
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.