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ECO102 Principles of Macroeconomics Problem Session-4-5-6 by Research Assistant Serkan Değirmenci 19.04.2012 03.05.201210.05.2012.

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Presentation on theme: "ECO102 Principles of Macroeconomics Problem Session-4-5-6 by Research Assistant Serkan Değirmenci 19.04.2012 03.05.201210.05.2012."— Presentation transcript:

1 ECO102 Principles of Macroeconomics Problem Session by Research Assistant Serkan Değirmenci

2 Today Mankiw (2008), Principles of Economics: - Chapter 28: Unemployment:  Questions for Review (QfR): 1-7 (page: 636)  Problem and Applications (P&A): 1-10 (page: )

3 Chapter 28: QfR-1 (page: 636) What are the three categories into which the Bureau of Labor Statistics divides everyone? How does it compute the labor force, the unemployment rate, and the labor force participation rate? ANSWER: The BLS categorizes each adult (16 years of age and older) as either employed, unemployed, or not in the labor force. The labor force consists of the sum of the employed and the unemployed. The unemployment rate is the percentage of the labor force that is unemployed. The labor-force participation rate is the percentage of the total adult population that is in the labor force.

4 Chapter 28: QfR-2 (page: 636) Is unemployment typically short-term or long-term? Explain. ANSWER: Unemployment is typically short term. Most people who become unemployed are able to find new jobs fairly quickly. But some unemployment is attributable to the relatively few workers who are jobless for long periods of time.

5 Chapter 28: QfR-3 (page: 636) Why is frictional unemployment inevitable? How might the government reduce the amount of frictional unemployment? ANSWER: Frictional unemployment is inevitable because the economy is always changing. Some firms are shrinking while others are expanding. Some regions are experiencing faster growth than other regions. Transitions of workers between firms and between regions are accompanied by temporary unemployment. The government could help to reduce the amount of frictional unemployment through public policies that provide information about job vacancies in order to match workers and jobs more quickly, and through public training programs that help ease the transition of workers from declining to expanding industries and help disadvantaged groups escape poverty.

6 Chapter 28: QfR-4 (page: 636) Are minimum-wage laws a better explanation for structural unemployment among teenagers or among college graduates? Why? ANSWER: Minimum-wage laws are a better explanation for unemployment among teenagers than among college graduates. Teenagers have fewer job-related skills than college graduates do, so their wages are low enough to be affected by the minimum wage. College graduates' wages generally exceed the minimum wage.

7 Chapter 28: QfR-5 (page: 636) How do unions affect the natural rate of unemployment? ANSWER: Unions may affect the natural rate of unemployment via the effect on insiders and outsiders. Because unions raise the wage above the equilibrium level, the quantity of labor demanded declines while the quantity supplied of labor rises, so there is unemployment. Insiders are those who keep their jobs. Outsiders, workers who become unemployed, have two choices: either get a job in a firm that is not unionized, or remain unemployed and wait for a job to open up in the union sector. As a result, the natural rate of unemployment is higher than it would be without unions.

8 Chapter 28: QfR-6 (page: 636) What claims do advocates of unions make to argue that unions are good for the economy? ANSWER: Advocates of unions claim that unions are good for the economy because they are an antidote to the market power of the firms that hire workers and they are important for helping firms respond efficiently to workers' concerns.

9 Chapter 28: QfR-7 (page: 636) Explain four ways in which a firm might increase its profits by raising the wages it pays. ANSWER: Four reasons why a firm's profits might increase when it raises wages are: (1) better paid workers are healthier and more productive; (2) worker turnover is reduced; (3) the firm can attract higher quality workers; and (4) worker effort is increased.

10 Chapter 28: P&A-1 (page: 636) As shown in Figure 3, the overall labor-force participation rate of men declined between 1970 and At the same time, the labor force participation rate of women increased sharply. This overall decline reflects different patterns for different age groups, however, as shown in the following tables. All MenMen Men Men 55 and older %69%96%56% All WomenWomen Women Women 55 and older %51%50%25%

11 Chapter 28: P&A-1 (page: 636)-cont. Given this information, what factor do you think played the key role in the decline in male labor-force participation over this period? What do you think explains the increase in labor-force participation for women? ANSWER: Men age 55 and over experienced the greatest decline in labor-force participation. This was because of increased Social Security benefits and retirement income, encouraging retirement at an earlier age. The rise in female labor force participation may be the result of changes in social attitudes, labor-saving devices in the home such as dishwashers and microwave ovens, and lower fertility rates.

12 Chapter 28: P&A-2 (page: 636) The Bureau of Labor Statistics announced that in February 2008, of all adult Americans, 145,993,000 were employed, 7,381,000 were unemployed, and 79,436,000 were not in the labor force. Use this information to calculate: a. the adult population b. the labor force c. the labor-force participation rate d. the unemployment rate ANSWER: The labor force consists of the number of employed (145,993,000) plus the number of unemployed (7,381,000), which equals 153,374,000. To find the labor-force participation rate, we need to know the size of the adult population. Adding the labor force (153,374,000) to the number of people not in the labor force (79,436,000) gives the adult population of 232,810,000. The labor- force participation rate is the labor force (153,374,000) divided by the adult population (232,810,000) times 100%, which equals 66%. The unemployment rate is the number of unemployed (7,381,000) divided by the labor force (153,374,000) times 100%, which equals 4.8%.

13 Chapter 28: P&A-3 (page: 636) Go to the website of the Turkish Statistical Institute (www.turkstat.gov.tr). What is the national unemployment rate right now? Find the unemployment rate for the demographic group that best fits a description of you (for example, based on age, sex, and race). Is it higher or lower than the national average? Why do you think this is so? ANSWER: Many answers are possible.

14 Chapter 28: P&A-4 (page: 636) Between 2004 and 2007, total U.S. employment increased by 6.8 million workers, but the number of unemployed workers declined by only 1.1 million. How are these numbers consistent with each other? Why might one expect a reduction in the number of people counted as unemployed to be smaller than the increase in the number of people employed? ANSWER: The fact that employment increased 6.8 million while unemployment declined 1.1 million is consistent with growth in the labor force of 5.7 million workers. The labor force constantly increases as the population grows and as labor-force participation increases, so the increase in the number of people employed may always exceed the reduction in the number unemployed.

15 Chapter 28: P&A-5 (page: ) Economists use labor-market data to evaluate how well an economy is using its most valuable resource-its people. Two closely watched statistics are the unemployment rate and the employment-population ratio. Explain what happens to each of these in the following scenarious. In your opinion, which statistic is the more meaningful gauge of how well the economy is doing? a. An auto company goes bankrupt and lays off its workers, who immediately start looking for new jobs. b. After an unsuccessful search, some of the laid-off workers quit looking for new jobs. c. Numerous students graduate from college but cannot find work. d. Numerous students graduate from college and immediately begin new jobs. e. A stock market boom induces newly enriched 60-year-old workers to take early retirement. f. Advances in health care prolong the life of many retirees.

16 Chapter 28: P&A-5 (page: )-cont. ANSWER: a. If an auto company goes bankrupt and its workers immediate begin looking for work, the unemployment rate will rise and the employment-population ratio will fall. b. If some of the unemployed auto workers give up looking for a job, the unemployment rate will fall and the employment-population ratio will remain the same. c. If numerous students graduate from college and cannot find work, the unemployment rate will rise and the employment-population ratio will remain unchanged. d. If numerous students graduate from college and immediately begin new jobs, the unemployment rate will fall and the employment-population ratio will rise. e. If a stock market boom induces earlier retirement, the unemployment rate will rise and the employment-population ratio will fall. f. Advances in health care that prolong the life of retirees will not affect the unemployment rate and will lower the employment-population ratio.

17 Chapter 28: P&A-6 (page: 637) Are the following workers more likely to experience short-term or long-term unemployment? Explain. a. a construction worker laid off because of bad weather b. a manufacturing worker who loses her job at a plant in an isolated area c. a stagecoach-industry worker laid off because of competition from railroads d. a short-order cook who loses his job when a new restaurant opens across the street e. an expert welder with little formal education who loses her job when the company installs automatic welding machinery ANSWER: a. A construction worker who is laid off because of bad weather is likely to experience short-term unemployment, because the worker will be back to work as soon as the weather clears up. b. A manufacturing worker who loses her job at a plant in an isolated area is likely to experience long-term unemployment, because there are probably few other employment opportunities in the area. She may need to move somewhere else to find a suitable job, which means she will be out of work for some time. c. A worker in the stagecoach industry who was laid off because of the growth of railroads is likely to be unemployed for a long time. The worker will have a lot of trouble finding another job because his entire industry is shrinking. He will probably need to gain additional training or skills to get a job in a different industry. d. A short-order cook who loses his job when a new restaurant opens is likely to find another job fairly quickly, perhaps even at the new restaurant, and thus will probably have only a short spell of unemployment. e. An expert welder with little education who loses her job when the company installs automatic welding machinery is likely to be without a job for a long time, because she lacks the technological skills to keep up with the latest equipment. To remain in the welding industry, she may need to go back to school and learn the newest techniques.

18 Chapter 28: P&A-7 (page: 637) Using a diagram of the labor market, show the effect of an increase in the minimum wage on the wage paid to workers, the number of workers supplied, the number of workers demanded, and the amount of unemployment. ANSWER: Figure 2 shows a diagram of the labor market with a binding minimum wage. At the initial minimum wage (m 1 ), the quantity of labor supplied L 1 S is greater than the quantity of labor demanded L 1 D, and unemployment is equal to L 1 S − L 1 D. An increase in the minimum wage to m 2 leads to an increase in the quantity of labor supplied to L 2 S and a decrease in the quantity of labor demanded to L 2 D. As a result, unemployment increases as the minimum wage rises.

19 Chapter 28: P&A-8 (page: 637) Consider an economy with two labor markets-one for manufacturing workers and one for service workers. Suppose initially that neither is unionized. a. If manufacturing workers formed a union, what impact on the wages and employment in manufacturing would you predict? b. How would these changes in the manufacturing labor market affect the supply of labor in the market for service workers? What would happen to the equilibrium wage and employment in this labor market?

20 Chapter 28: P&A-8 (page: 637)-cont. ANSWER: a. Figure 3 illustrates the effect of a union being established in the manufacturing labor market. In the figure on the left, the wage rises from w 1 U to w 2 U and the quantity of labor demanded declines from U 1 to U 2 D. Because the wage is higher, the quantity supplied of labor increases to U 2 S, so there are U 2 S − U 2 D unemployed workers in the unionized manufacturing sector. b. When those workers who become unemployed in the manufacturing sector seek employment in the service labor market, shown in the figure on the right, the supply of labor shifts to the right from S 1 to S 2. The result is a decline in the wage in the nonunionized service sector from w 1 N to w 2 N and an increase in employment in the nonunionized service sector from N 1 to N 2.

21 Chapter 28: P&A-9 (page: 637) Structural unemployment is sometimes said to result from a mismatch between the job skills that employers want and the job skills workers have. To explore this idea, consider an economy with two industries: auto manufacturing and aircraft manufacturing. a. If workers in these two industries require similar amounts of training, and if workers at the beginning of their careers could choose which industry to train for, what would you expect to happen to the wages in these two industries? How long would this process take? Explain. b. Suppose that one day the economy opens itself to international trade and, as a result, starts importing autos and exporting aircradt. What would happen to demand for labor in these two industries? c. Suppose that workers in one industry cannot be quickly retrained for the other. How would these shifts in demand affect equilibrium wages both in the short run and in the long run? d. If for some reason wages fail to adjust to the new equilibrium level, what would occur?

22 Chapter 28: P&A-9 (page: 637)-cont. ANSWER: a. Wages between the two industries would be equal. If not, new workers would choose the industry with the higher wage, pushing the wage in that industry down. b. If the country begins importing autos, the demand for domestic auto workers will fall. If the country begins to export aircraft, there would be an increase in the demand for workers in the aircraft industry. c. In the short run, wages in the auto industry will fall, while wages in the aircraft industry will rise. Over time, new workers will move into the aircraft industry bringing its wage down until wages are equal across the two industries. d. If the wage does not adjust to its equilibrium level, there would be a shortage of workers in the aircraft industry and a surplus of labor (unemployment) in the auto industry.

23 Chapter 28: P&A-10 (page: 637) Suppose that Congress passes a law requiring employers to provide employees some benefit (such as health care) that raises the cost of an employee by $4 per hour. a. What effect does this employer mandate have on the demand for labor? (In answering this and the following questions, be quantitative when you can.) b. If employees place a value on this benefit exactly equal to its cost, what effect does this employer mandate have on the supply of labor? c. If the wage is free to balance supply and demand, how does this law affect the wage and the level of employment? Are employers better or worse off? Are employees better or worse off? d. Suppose that, before the mandate, the wage in this market was $3 above the minimum wage. In this case, how does the employer mandate affect the wage, the level of employment, and the level of unemployment? e. Now suppose that workers do not value the mandated benefit at all. How does this alternative assumption change your answers to parts (b) and (c)?

24 Chapter 28: P&A-10 (page: 637)-cont. ANSWER: a. If a firm was not providing such benefits prior to the legislation, the curve showing the demand for labor would shift down by exactly $4 at each quantity of labor, because the firm would not be willing to pay as high a wage given the increased cost of the benefits. b. If employees value the benefit by exactly $4 per hour, they would be willing to work the same amount for a wage that's $4 less per hour, so the supply curve of labor shifts down by exactly $4.

25 Chapter 28: P&A-10 (page: 637)-cont. ANSWER: c. Figure 4 shows the equilibrium in the labor market. Because the demand and supply curves of labor both shift down by $4, the equilibrium quantity of labor is unchanged and the wage rate declines by $4. Both employees and employers are just as well off as before. d. If the minimum wage prevents the wage from falling, the result will be increased unemployment, as Figure 5 shows. Initially, the equilibrium quantity of labor is L 1 and the equilibrium wage is w 1, which is $3 lower than the minimum wage w m. After the law is passed, demand falls to D 2 and supply rises to S 2. Because of the minimum wage, the quantity of labor demanded (L 2 D ) will be smaller than the quantity supplied (L 2 S ). Thus, there will be unemployment equal to L 2 S – L 2 D.

26 Chapter 28: P&A-10 (page: 637)-cont. ANSWER: e. If the workers do not value the mandated benefit at all, the supply curve of labor does not shift down. As a result, the wage rate will decline by less than $4 and the equilibrium quantity of labor will decline, as shown in Figure 6. Employers are worse off, because they now pay a greater total wage plus benefits for fewer workers. Employees are worse off, because they get a lower wage and fewer are employed.

27 Today Mankiw (2008), Principles of Economics - Chapter 31: Open-Economy Macroeconomics: Basic Concepts  Questions for Review (QfR): 1-5 (page: 713)  Problems and Applications (P&A): 1-12 (page: )

28 Chapter 31: QfR-1 (page: 713) Define net exports and net capital outflow. Explain how and why they are related. ANSWER: (SEE PAGE 692 & ) The net exports of a country are the value of its exports minus the value of its imports. Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports are equal to net capital outflow by an accounting identity, because exports from one country to another are matched by payments of some asset from the second country to the first.

29 Chapter 31: QfR-2 (page: 713) Explain the relationship among saving, investment, and net capital outflow. ANSWER: (SEE PAGE 699) Saving equals domestic investment plus net capital outflow, because any dollar saved can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad. Y = C + I + G + NX Y – C – G = I + NX S = I + NX NX = NCO S = I + NCO

30 Chapter 31: QfR-3 (page: 713) If Japanese car costs 500,000 yen, a similar American car costs $10,000, and a dollar can buy 100 yen, what are the nominal and real exchange rates? ANSWER: (SEE PAGE ) If a dollar can buy 100 yen, the nominal exchange rate is 100 yen per dollar. The real exchange rate equals the nominal exchange rate times the domestic price divided by the foreign price, which equals 100 yen per dollar times $10,000 per American car divided by 500,000 yen per Japanese car, which equals two Japanese cars per American car.

31 Chapter 31: QfR-4 (page: 713) Describe the economic logic behind the theory of purchasing-power parity? ANSWER: (SEE PAGE 707) The economic logic behind the theory of purchasing- power parity is that a good must sell for the same price in all locations. Otherwise, people would profit by engaging in arbitrage.

32 Chapter 31: QfR-5 (page: 713) If the Fed started printing large quantities of U.S. Dollars, what would happen to the number of Japanese yen a dollar could buy? Why? ANSWER: (SEE PAGE 709) If the Fed started printing large quantities of U.S. dollars, the U.S. price level would increase, and a dollar would buy fewer Japanese yen.

33 Chapter 31: P&A-1 (page: 713) Would each of the following transactions be included in net exports or net capital outflow? Be sure to say whether it would represent an increase or a decrease in that variable. a.An American buys a Sony TV. b. An American buys a share of Sony stock. c. The Sony pension fund buys a bond from the U.S. treasury. d. A worker at Sony plant in Japan buys some Georgia peaches from an American farmer.

34 Chapter 31: P&A-1-cont. (page: 713) a.When an American buys a Sony TV, there is a decrease in net exports. b.When an American buys a share of Sony stock, there is an increase in net capital outflow. c.When the Sony pension fund buys a U.S. Treasury bond, there is a decrease in net capital outflow. d.When a worker at Sony buys some Georgia peaches from an American farmer, there is an increase in net exports.

35 Chapter 31: P&A-2 (page: 713) International trade in each of the following products has increased over time. Suggest some reasons this might be so. a.wheat b. banking services c. computer software d. automobiles

36 Chapter 31: P&A-2-cont. (page: 713) a.Wheat is traded more internationally than in the past because shipping costs have declined, as have trade restrictions. b.Banking services are traded more internationally than in the past because communications costs have declined, as have trade restrictions. c.Computer software is traded more internationally than in the past because the computer industry has grown and the software is easier to transport (because it can now be downloaded electronically). d.Automobiles are traded more internationally than in the past because transportation costs have declined, as have tariffs and quotas.

37 Chapter 31: P&A-3 (page: 713) How would the following transactions affect U.S. exports, imports, and net exports? a. An American art professor spends the summer touring museums in Europe. b. Students in Paris flock to see the latest movie from Hollywood. c. Your uncle buys a new Volvo. d. The student bookstore at Oxford University in England sells a pair of Levi’s 501 jeans. e. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales taxes.

38 Chapter 31: P&A-3-cont. (page: 713) a.When an American art professor spends the summer touring museums in Europe, he spends money buying foreign goods and services, so U.S. exports are unchanged, imports increase, and net exports decrease. b.When students in Paris flock to see the latest movie from Hollywood, foreigners are buying a U.S. good, so U.S. exports rise, imports are unchanged, and net exports increase. c.When your uncle buys a new Volvo, an American is buying a foreign good, so U.S. exports are unchanged, imports rise, and net exports decline. d.When the student bookstore at Oxford University sells a pair of Levi's 501 jeans, foreigners are buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. e.When a Canadian citizen shops in northern Vermont to avoid Canadian sales taxes, a foreigner is buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase.

39 Chapter 31: P&A-4 (page: 713) Describe the difference between foreign direct investment and foreign portfolio investment. Who is more likely to engage in foreign direct investment-a corporation or an individual investor? Who is more likely to engage in foreign portfolio investment?

40 Chapter 31: P&A-4-cont. (page: 713) Foreign direct investment requires actively managing an investment, for example, by opening a retail store in a foreign country. Foreign portfolio investment is passive, for example, buying corporate stock in a retail chain in a foreign country. As a result, a corporation is more likely to engage in foreign direct investment, while an individual investor is more likely to engage in foreign portfolio investment.

41 Chapter 31: P&A-5 (page: 713) How would the following transactions affect U.S. Net capital outflow? Also, state whether each involves direct investment or portfolio investment. a. An American cellular phone company establishes an office in the Czech Republic. b. Harrod’s of London sells stock to the General Electric pension fund. c. Honda expands its factory in Marysville, Ohio. d. A Fidelity mutual fund sells its Volkswagen stock to a French investor.

42 Chapter 31: P&A-5-cont. (page: 713) a.When an American cellular phone company establishes an office in the Czech Republic, U.S. net capital outflow increases, because the U.S. company makes a direct investment in capital in the foreign country. b.When Harrod's of London sells stock to the General Electric pension fund, U.S. net capital outflow increases, because the U.S. company makes a portfolio investment in the foreign country. c.When Honda expands its factory in Marysville, Ohio, U.S. net capital outflow declines, because the foreign company makes a direct investment in capital in the United States. d.When a Fidelity mutual fund sells its Volkswagen stock to a French investor, U.S. net capital outflow declines (if the French investor pays in U.S. dollars), because the U.S. company is reducing its portfolio investment in a foreign country.

43 Chapter 31: P&A-6 (page: 714) Holding national saving constant, does an increase in net capital outflow increase, decrease, or have no effect on a country’s accumulation of domestic capital? ANSWER: If national saving is constant and net capital outflow increases, domestic investment must decrease, because national saving equals domestic investment plus net capital outflow. If domestic investment declines, the country's accumulation of domestic capital declines.

44 Chapter 31: P&A-7 (page: 714) The business section of most major newspapers contains a table of showing U.S. exchange rates. Find such a table in a paper or online and use it to answer the following questions. a. Does this table show nominal or real exchange rates? Explain. b. What are the exchange rates between the United States and Canada and the United States and Japan? Calculate the exchange rate between Canada and Japan. c. If U.S. inflation exceeds Japanese inflation over the next year, would you expect the U.S. Dollar to appreciate or depreciate relative to the Japanese yen?

45 Chapter 31: P&A-7-cont. (page: 714) a.The newspaper shows nominal exchange rates, because it shows the number of units of one currency that can be exchanged for another currency. b.Many answers are possible. c.If U.S. inflation exceeds Japanese inflation over the next year, you would expect the dollar to depreciate relative to the Japanese yen because a dollar would decline in value (in terms of the goods and services it can buy) more than the yen would.

46 Chapter 31: P&A-8 (page: 714) Would each of the following groups be happy or unhappy if the U.S. Dollar appreciated? Explain. a. Dutch pension funds holding U.S. Government bonds b. U.S. Manufacturing industries c. Australian tourists planning a trip to the United States. d. An American firm trying to purchase property overseas.

47 Chapter 31: P&A-8-cont. (page: 714) a.Dutch pension funds holding U.S. government bonds would be happy if the U.S. dollar appreciated. They would then get more Dutch guilders for each dollar they earned on their U.S. investment. In general, if you have an investment in a foreign country, you are better off if that country's currency appreciates. b.U.S. manufacturing industries would be unhappy if the U.S. dollar appreciated because their prices would be higher in terms of foreign currencies, which will reduce their sales. c.Australian tourists planning a trip to the United States would be unhappy if the U.S. dollar appreciated because they would get fewer U.S. dollars for each Australian dollar, so their vacation will be more expensive. d.An American firm trying to purchase property overseas would be happy if the U.S. dollar appreciated because it would get more units of the foreign currency and could thus buy more property.

48 Chapter 31: P&A-9 (page: 714) What is happening to the U.S. real exchange rate in each of the following situations? Explain. a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad. b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States. c. The U.S. nominal exchange rate declines, and prices are unchanged in the United States and abroad. d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in the United States.

49 Chapter 31: P&A-9-cont. (page: 714) All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level. a.If the U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad, the real exchange rate rises. b.If the U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States, the real exchange rate declines. c.If the U.S. nominal exchange rate declines and prices are unchanged in the United States and abroad, the real exchange rate declines. d.If the U.S. nominal exchange rate declines and prices rise faster abroad than in the United States, the real exchange rate declines.

50 Chapter 31: P&A-10 (page: 714) A can of soda costs $0.75 in the United States and 12 pesos in Mexico. What would the peso-dollar exchange rate be if purchasing-power parity holds? If a monetary expansion caused all prices in Mexico to double, so that soda rose to 24 pesos, what would happen to the peso-dollar exchange rate? ANSWER: If purchasing-power parity holds, then 12 pesos per soda divided by $0.75 per soda equals the exchange rate of 16 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 32 pesos per dollar.

51 Chapter 31: P&A-11 (page: 714) Assume that American rice sells for $100 per bushel, Japanese rice sells for 16,000 yen per bushel, and the nominal exchange rate is 80 yen per dollar. a. Explain how could make a profit from this situation. What could be your profit per bushel of rice? If other people exploit the same opportunity, what would happen to the price of rice in Japan and the price of rice in the United States? b. Suppose that rice is the only commodity in the world. What would happen to the real exchange rate between the United States and Japan?

52 Chapter 31: P&A-11-cont. (page: 714) a.To make a profit, you would want to buy rice where it is cheap and sell it where it is expensive. Because American rice costs 100 dollars per bushel, and the exchange rate is 80 yen per dollar, American rice costs 100 x 80 equals 8,000 yen per bushel. So American rice at 8,000 yen per bushel is cheaper than Japanese rice at 16,000 yen per bushel. So you could take 8,000 yen, exchange them for 100 dollars, buy a bushel of American rice, then sell it in Japan for 16,000 yen, making a profit of 8,000 yen. As people did this, the demand for American rice would rise, increasing the price in America, and the supply of Japanese rice would rise, reducing the price in Japan. The process would continue until the prices in the two countries were the same. b.If rice were the only commodity in the world, the real exchange rate between the United States and Japan would start out too low, then rise as people bought rice in America and sold it in Japan, until the real exchange became one in long-run equilibrium.

53 Chapter 31: P&A-12 (page: 714) A case study in the chapter analyzed purchasing-power parity for several countries using the price of Big Macs. Here are for a few more countries: CountryPrice of a Big Mac Predicted Exchange Rate Actual Exchange Rate Indonesia15,900 rupiah9,015 rupiah/$ Hungary600 forints180 forints/$ Czech Republic 52.9 korunas21.1 korunas/$ Brazil6.90 real1.91 real/$ Canada3.88 C$1.05 C$/$

54 Chapter 31: P&A-12 (page: 714) a. For each country, compute the predicted exchange rate of the local currency per U.S. Dollar. (Recall that the U.S. price of a Big Mac was $3.41.) b. According to purchasing-power parity, what is the predicted exchange rate between the Hungarian forint and the Canadian dollar? What is the actual exchange rate? c. How well does the theory of purchasing-power parity explain exchange rates?

55 Chapter 31: P&A-12 (page: 714) If you take X units of foreign currency per Big Mac divided by 3.41 dollars per Big Mac, you get X/3.06 units of the foreign currency per dollar; that is the predicted exchange rate. a.Indonesia: 15,900/3.41 = 4,663 rupiah/$ Hungary: 600/3.41 = 176 forint/$ Czech Republic: 52.9/3.41 = 15.5 koruna/$ Brazil: 6.9/3.41 = 2.02 real/$ Canada: 3.88/3.41 = 1.14C$/$ b.Under purchasing-power parity, the exchange rate of the Hungarian forint to the Canadian dollar is 600 forints per Big Mac divided by 3.88 Canadian dollars per Big Mac equals 155 forints per Canadian dollar. The actual exchange rate is 180 forints per dollar divided by 1.05 Canadian dollars per dollar equals 171 forints per Canadian dollar. c.The exchange rate predicted by the Big Mac index (155 forints per Canadian dollar) is somewhat close to the actual exchange rate of 171 forints per Canadian dollar.

56 Today Mankiw (2008), Principles of Economics - Chapter 32: A Macroeconomic Theory of the Open Economy  Questions for Review (QfR): 1-4 (page: 734)  Problems and Applications (P&A): 1-13 (page: )

57 Chapter 32: QfR-1 (page: 734) Describe supply and demand in the market for loanable funds and the market for foreign-currency exchange. How are these markets linked? ANSWER: (SEE PAGE 721) The supply of loanable funds comes from national saving; the demand for loanable funds comes from domestic investment and net capital outflow. (SEE PAGES ) The supply of dollars in the market for foreign exchange comes from net capital outflow; the demand for dollars in the market for foreign exchange comes from net exports. (SEE PAGE 718) The link between the two markets is net capital outflow.

58 Chapter 32: QfR-2 (page: 734) Why are budget deficits and trade deficits sometimes called the twin deficits? ANSWER: (SEE PAGES )-see FIGURE 5 Government budget deficits and trade deficits are sometimes called the twin deficits because a government budget deficit often leads to a trade deficit. The government budget deficit leads to reduced national saving, causing the interest rate to increase, and reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars, raising the real exchange rate. Thus, the trade balance will move toward deficit.

59 Chapter 32: QfR-3 (page: 734) Suppose that a textile workers’ union encourages people to buy only American-made clothes. What would this policy do to the trade balance and the real exchange rate? What is the impact on the textile industry? What is the impact on the auto industry?

60 Chapter 32: QfR-3 (page: 734)-cont. ANSWER: (SEE PAGES )-SIMILAR TO FIGURE 6 If a union of textile workers encourages people to buy only American-made clothes, imports would be reduced, so net exports would increase for any given real exchange rate. This would cause the demand curve in the market for foreign exchange to shift to the right, as shown in Figure 2. The result is a rise in the real exchange rate, but no effect on the trade balance. The textile industry would import less, but other industries, such as the auto industry, would import more because of the higher real exchange rate.

61 Chapter 32: QfR-3 (page: 734) -cont. Figure 2

62 Chapter 32: QfR-4 (page: 734) What is capital flight? When a country experiences capital flight, what is the effect on its interest rate and exchange rate? ANSWER: (SEE PAGES )-SEE FIGURE 7 Capital flight is a large and sudden movement of funds out of a country. Capital flight causes the interest rate to increase and the exchange rate to depreciate. SEE FIGURE 7.

63 Chapter 32: P&A-1 (page: 735) An article in USA Today (December 16, 2004) began “President Bush said Wednesday that the White House will shore up the sliding dollar by working to cut record budget and trade deficits.” a.According to the model in this chapter, would a reduction in the budget deficit reduce the trade deficit? Would it raise the value of dollar? Explain. b. Suppose that a reduction in the budget deficit made international investors more confident in the U.S. economy. How would this increase in confidence affect the value of the dollar? How would it affect the trade deficit?

64 Chapter 32: P&A-1 (page: 735)-cont. ANSWER: a.A reduction in the U.S. government budget deficit would increase national saving, shifting the supply curve of loanable funds to the right in Figure 3. This would reduce the real interest rate in the United States, thus increasing net capital outflow, and reducing the real exchange rate. The real value of the dollar would decline, not increase as the president suggested. However, the trade deficit will decline.

65 Chapter 32: P&A-1 (page: 735) -cont. Figure 3

66 Chapter 32: P&A-1 (page: 735)-cont. ANSWER: b.The increased confidence would lead to a reduction in net capital outflow as shown in Figure 4. The demand for loanable funds will fall, along with the real interest rate. The decline in net capital outflow will also reduce the supply of dollars, increasing the real exchange rate. Thus, the trade balance will move toward deficit.

67 Chapter 32: P&A-1 (page: 735) -cont. Figure 4

68 Chapter 32: P&A-2 (page: 735) Suppose that Congress is considering an investment tax credit, which subsidizes domestic investment. a.How does this policy affect national saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and the trade balance? b. Representatives of several large exporters oppose the policy. Why might that be the case?

69 Chapter 32: P&A-2 (page: 735)-cont. ANSWER: a.If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as shown in Figure 5. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also moves toward deficit, because net capital outflow, hence net exports, is lower. The higher real interest rate also increases the quantity of national saving. In summary, saving increases, domestic investment increases, net capital outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance moves toward deficit.

70 Chapter 32: P&A-2 (page: 735) -cont. Figure 5

71 Chapter 32: P&A-2 (page: 735)-cont. ANSWER: b. A rise in the real exchange rate reduces exports.

72 Chapter 32: P&A-3 (page: 735) Japan generally runs a significant trade surplus. Do you think this is most related to high foreign demand for Japanese goods, low Japanese demand for foreign goods, a high Japanese saving rate relative to Japanese investment, or structural barriers against imports into Japan? Explain your answer. ANSWER: Japan generally runs a trade surplus because the Japanese savings rate is high relative to Japanese domestic investment. The result is high net capital outflow, which is matched by high net exports, resulting in a trade surplus. The other possibilities (high foreign demand for Japanese goods, low Japanese demand for foreign goods, and structural barriers against imports into Japan) would affect the real exchange rate, but not the trade surplus.

73 Chapter 32: P&A-4 (page: 735) The chapter notes that the rise in the U.S. trade deficit during the 1980s was due largely to the rise in the U.S. budget deficit. On the other hand, the popular press sometimes claims that the increased trade deficit resulted from a decline in the quality of U.S. products relative to foreign products. a. Assume that U.S. products did decline in relative quality during the 1980s. How did this affect net exports at any given exchange rate? b. Draw a three-panel diagram to show the effect of this shift in net exports on the U.S. real exchange rate and trade balance. c. Is the claim in the popular press consistent with the model in this chapter? Does a decline in the quality of U.S. products have any effect on our standard of living? (Hint: When we sell our goods to foreigners, what do we receive in return?)

74 Chapter 32: P&A-4 (page: 735)-cont. ANSWER: a.A decline in the quality of U.S. goods at a given real exchange rate would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange, as shown in Figure 6. b.The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. c.The claim in the popular press is incorrect. A change in the quality of U.S. goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that we get fewer foreign goods in exchange for our goods, so our standard of living may decline.

75 Chapter 32: P&A-4 (page: 735) -cont. Figure 6

76 Chapter 32: P&A-5 (page: 735) An economist discussing trade policy in The New Republic wrote: “One of the benefits of the United States removing its trade restrictions [is] the gain to U.S. industries that produce goods for export. Export industries would find it easier to sell their goods abroad—even if other countries didn’t follow our example and reduce their trade barriers.” Explain in words why U.S. export industries would benefit from a reduction in restrictions on imports to the United States. ANSWER: A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the demand curve for dollars to the left. The shift of the demand curve for dollars leads to a decline in the real exchange rate, which increases net exports. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. But both imports and exports rise, so export industries benefit.

77 Chapter 32: P&A-6 (page: 735) Suppose the French suddenly develop a strong taste for California wines. Answer the following questions in words and using a diagram. a. What happens to the demand for dollars in the market for foreign-currency exchange? b. What happens to the value of dollars in the market for foreign-currency exchange? c. What happens to the quantity of net exports?

78 Chapter 32: P&A-6 (page: 735)-cont. ANSWER: a.When the French develop a strong taste for California wines, the demand for dollars in the foreign-currency market increases at any given real exchange rate, as shown in Figure 7. b.The result of the increased demand for dollars is a rise in the real exchange rate. c.The quantity of net exports is unchanged.

79 Chapter 32: P&A-6 (page: 735) -cont. Figure 7

80 Chapter 32: P&A-7 (page: 735) A senator renounces her past support for protectionism: “The U.S. trade deficit must be reduced, but import quotas only annoy our trading partners. If we subsidize U.S. exports instead, we can reduce the deficit by increasing our competitiveness.” Using a three-panel diagram, show the effect of an export subsidy on net exports and the real exchange rate. Do you agree with the senator?

81 Chapter 32: P&A-7 (page: 735)-cont. ANSWER: An export subsidy increases net exports at any given real exchange rate. This causes the demand for dollars to shift to the right in the market for foreign exchange, as shown in Figure 8. The effect is a higher real exchange rate, but no change in net exports. So the senator is wrong; an export subsidy will not reduce the trade deficit.

82 Chapter 32: P&A-7 (page: 735) -cont. Figure 8

83 Chapter 32: P&A-8 (page: 735) Suppose the United States decides to subsidize the export of U.S. agricultural products, but it does not increase taxes or decrease any other government spending to offset this expenditure. Using a three-panel diagram, show what happens to national saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and the trade balance. Also explain in words how this U.S. policy affects the amount of imports, exports, and net exports.

84 Chapter 32: P&A-8 (page: 735)-cont. ANSWER: If the government increases its spending without increasing taxes, public saving will fall (as will national saving). As Figure 9 shows, this will raise the real interest rate, reducing investment. Net capital outflow will fall. The real exchange rate will rise, causing exports to fall and imports to rise, moving the trade balance toward deficit.

85 Chapter 32: P&A-8 (page: 735) -cont. Figure 9

86 Chapter 32: P&A-9 (page: ) Suppose that real interest rates increase across Europe. Explain how this development will affect U.S. net capital outflow. Then explain how it will affect U.S. net exports by using a formula from the chapter and by drawing a diagram. What will happen to the U.S. real interest rate and real exchange rate?

87 Chapter 32: P&A-9 (page: )-cont. ANSWER: Higher real interest rates in Europe lead to increased U.S. net capital outflow. Higher net capital outflow leads to higher net exports, because in equilibrium net exports equal net capital outflow (NX = NCO ). Figure 10 shows that the increase in net capital outflow leads to a lower real exchange rate, higher real interest rate, and increased net exports.

88 Chapter 32: P&A-9 (page: ) -cont. Figure 10

89 Chapter 32: P&A-10 (page: 736) Suppose that Americans decide to increase their saving. a. If the elasticity of U.S. net capital outflow with respect to the real interest rate is very high, will this increase in private saving have a large or small effect on U.S. domestic investment? b. If the elasticity of U.S. exports with respect to the real exchange rate is very low, will this increase in private saving have a large or small effect on the U.S. real exchange rate?

90 Chapter 32: P&A-10 (page: 736)-cont. ANSWER: a.If the elasticity of U.S. net capital outflow with respect to the real interest rate is very high, the lower real interest rate that occurs because of the increase in private saving will increase net capital outflow a great deal, so U.S. domestic investment will not increase much. b.Because an increase in private saving reduces the real interest rate, inducing an increase in net capital outflow, the real exchange rate will decline. If the elasticity of U.S. exports with respect to the real exchange rate is very low, it will take a large decline in the real exchange rate to increase U.S. net exports by enough to match the increase in net capital outflow.

91 Chapter 32: P&A-11 (page: 736) Over the past decade, some of Chinese saving has been used to finance American investment. That is, the Chinese have been buying American capital assets. a. If the Chinese decided they no longer wanted to buy U.S. assets, what would happen in the U.S. market for loanable funds? In particular, what would happen to U.S. interest rates, U.S. saving, and U.S. investment? b. What would happen in the market for foreign currency exchange? In particular, what would happen to the value of the dollar and the U.S. trade balance?

92 Chapter 32: P&A-11 (page: 736)-cont. ANSWER: a.If the Chinese decided they no longer wanted to buy U.S. assets, U.S. net capital outflow would increase, increasing the demand for loanable funds, as shown in Figure 11. The result is a rise in U.S. interest rates, an increase in the quantity of U.S. saving (because of the higher interest rate), and lower U.S. domestic investment. b.In the market for foreign exchange, the real exchange rate declines and the balance of trade moves toward surplus.

93 Chapter 32: P&A-11 (page: 736) -cont. Figure 11

94 Chapter 32: P&A-12 (page: 736) In 1998 the Russian government defaulted on its debt payments, leading investors worldwide to raise their preference for U.S. government bonds, which are considered very safe. What effect do you think this “flight to safety” had on the U.S. economy? Be sure to note the impact on national saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and the trade balance.

95 Chapter 32: P&A-12 (page: 736)-cont. ANSWER: The flight to safety led to a desire by foreigners to buy U.S. government bonds, resulting in a decline in U.S. net capital outflow, as shown in Figure 12. The decline in net capital outflow also means a decline in the demand for loanable funds. As the figure shows, the shift to the left in the demand curve results in a decline in the real interest rate in the United States. In addition, the decrease in net capital outflow decreases the supply of dollars in the foreign-exchange market, causing the dollar to appreciate, shown as a rise in the real exchange rate. The lower real interest rate causes national saving to decline, but increases domestic investment. Because net capital outflow is lower, net exports are lower, thus the trade balance moves toward deficit.

96 Chapter 32: P&A-12 (page: 736) -cont. Figure 12

97 Chapter 32: P&A-13 (page: 736) Suppose that U.S. mutual funds suddenly decide to invest more in Canada. a. What happens to Canadian net capital outflow, Canadian saving, and Canadian domestic investment? b. What is the long-run effect on the Canadian capital stock? c. How will this change in the capital stock affect the Canadian labor market? Does this U.S. investment in Canada make Canadian workers better off or worse off? d. Do you think this will make U.S. workers better off or worse off? Can you think of any reason why the impact on U.S. citizens generally may be different from the impact on U.S. workers?

98 Chapter 32: P&A-13 (page: 736)-cont. ANSWER: a.When U.S. mutual funds become more interested in investing in Canada, Canadian net capital outflow declines as the U.S. mutual funds make portfolio investments in Canadian stocks and bonds. The demand for loanable funds shifts to the left and the net capital outflow curve shifts to the left, as shown in Figure 13. As the figure shows, the real interest rate declines, thus reducing Canada’s private saving, but increasing Canada’s domestic investment. In equilibrium, Canadian net capital outflow declines. b.Because Canada's domestic investment increases, in the long run, Canada's capital stock will increase. c.With a higher capital stock, Canadian workers will be more productive (the value of their marginal product will increase) so wages will rise. Thus, Canadian workers will be better off. d.The shift of investment into Canada means increased U.S. net capital outflow. As a result, the U.S. real interest rises, leading to less domestic investment, which in the long run reduces the U.S. capital stock, lowers the value of marginal product of U.S. workers, and therefore decreases the wages of U.S. workers. The impact on U.S. citizens would be different from the impact on U.S. workers because some U.S. citizens own capital that now earns a higher real interest rate.

99 Chapter 32: P&A-13 (page: 736) -cont. Figure 13

100 Today Mankiw (2008), Principles of Economics - Chapter 33: Aggregate Demand and Aggregate Supply (PAGES BTW: )  Questions for Review (QfR): 1-7 (page: 773)  Problems and Applications (P&A): 1-14 (page: )

101 Chapter 33: QfR-1 (page: 773) Name two macroeconomic variables that decline when the economy goes into a recession. Name one macroeconomic variable that rises during a recession. ANSWER: (SEE PAGES )-see FIGURE-1 Two macroeconomic variables that decline when the economy goes into a recession are real GDP and investment spending (many other answers are possible). A macroeconomic variable that rises during a recession is the unemployment rate.

102 Chapter 33: QfR-2 (page: 773) Draw a diagram with aggregate demand, short-run aggregate supply, and long-run aggregate supply. Be careful to label the axes correctly. ANSWER: (SEE FIGURE-7 ON PAGE 762) Figure 3 shows aggregate demand, short-run aggregate supply, and long-run aggregate supply.

103 Chapter 33: QfR-2 (page: 773)-cont. Figure 3

104 Chapter 33: QfR-3 (page: 773) List and explain the three reasons why the aggregate demand curve is downward sloping. ANSWER: (SEE PAGES: )-see FIGURE-3 The aggregate-demand curve is downward sloping because: (1) a decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more, so there is a larger quantity of goods and services demanded; (2) a lower price level reduces the interest rate, encouraging greater spending on investment, so there is a larger quantity of goods and services demanded; (3) a fall in the U.S. price level causes U.S. interest rates to fall, so the real exchange rate depreciates, stimulating U.S. net exports, so there is a larger quantity of goods and services demanded. The Wealth Effect The Interest -Rate Effect The Exchange -Rate Effect

105 Chapter 33: QfR-4 (page: 773) Explain why the long-run aggregate-supply curve is vertical. ANSWER: (SEE PAGES: )-see FIGURE-4 The long-run aggregate supply curve is vertical because in the long run, an economy's supply of goods and services (its real GDP) depends on its supplies of capital, labor, and natural resources and on the available production technology used to turn these resources into goods and services. does not affect The price level does not affect these long-run determinants of real GDP.

106 Chapter 33: QfR-5 (page: 773) the three theories List and explain the three theories for why the short-run aggregate-supply curve is upward sloping. ANSWER: (SEE PAGES: )-see FIGURE-6 (1) the sticky-wage theory (2) the sticky-price theory (3) the misperceptions theory Three theories explain why the short-run aggregate-supply curve is upward sloping: (1) the sticky-wage theory, in which a lower price level makes employment and production less profitable because wages do not adjust immediately to the price level, so firms reduce the quantity of goods and services supplied; (2) the sticky-price theory, in which an unexpected fall in the price level leaves some firms with higher-than- desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce; and (3) the misperceptions theory, in which a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

107 Chapter 33: QfR-6 (page: 773) left What might shift the aggregate-demand curve to the left? the short-run and long-run effects of such a shift on output and the price level. Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the price level. ANSWER: (SEE PAGES: )-see TABLE-1; CHP-34 (other than a rise in the price level) The aggregate-demand curve might shift to the left when something (other than a rise in the price level) causes a reduction in consumption spending (such as a desire for increased saving), a reduction in investment spending (such as increased taxes on the returns to investment), decreased government spending (such as a cutback in defense spending), or reduced net exports (such as when foreign economies go into recession).

108 Chapter 33: QfR-6 (page: 773)-cont. Figure 4 traces through the steps of such a shift in aggregate demand. The economy begins in equilibrium, with short-run aggregate supply, AS 1, intersecting aggregate demand, AD 1, at point A. AD 2 reducing the price level and the quantity of output. When the aggregate-demand curve shifts to the left to AD 2, the economy moves from point A to point B, reducing the price level and the quantity of output. AS 2 back has a lower price level. Over time, people adjust their perceptions, wages, and prices, shifting the short-run aggregate-supply curve down to AS 2, and moving the economy from point B to point C, which is back on the long-run aggregate-supply curve and has a lower price level.

109 Chapter 33: QfR-6 (page: 773)-cont. Figure 4

110 Chapter 33: QfR-7 (page: 773) left What might shift the aggregate-supply curve to the left? the short-run and long-run effects of such a shift on output and the price level. Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the price level. ANSWER: (SEE PAGES: )-see TABLE-2 a decline in the economy's capital stock, labor supply, or productivity, or an increase in the natural rate of unemployment left The aggregate-supply curve might shift to the left because of a decline in the economy's capital stock, labor supply, or productivity, or an increase in the natural rate of unemployment, all of which shift both the long-run and short-run aggregate-supply curves to the left. An increase in the expected price level shifts just the short- run aggregate-supply curve to the left. An increase in the expected price level shifts just the short- run aggregate-supply curve (not the long-run aggregate- supply curve) to the left.

111 Chapter 33: QfR-7 (page: 773)-cont. Figure 5 traces through the effects of a shift in short- run aggregate supply. The economy starts in equilibrium at point A. The aggregate-supply curve shifts to the left from AS 1 to AS 2. The new equilibrium is at point B, the intersection of the aggregate-demand curve and AS 2. because the short-run aggregate-supply curve shifts back to its original position. As time goes on, perceptions and expectations adjust and the economy returns to long-run equilibrium at point A, because the short-run aggregate-supply curve shifts back to its original position.

112 Chapter 33: QfR-7 (page: 773)-cont. Figure 5

113 Chapter 33: P&A-1 (page: 773) on long-run aggregate supply. Explain whether each of the following events will increase, decrease, or have no effect on long-run aggregate supply. a. The United States experiences a wave of immigration. b. Congress raises the minimum wage to $10 per hour. c. Intel invents a new and more powerful computer chip. d. A severe hurricane damages factories along the East Coast.

114 Chapter 33: P&A-1 (page: 773)-cont. ANSWER: (SEE PAGES: ) a.When the United States experiences a wave of immigration, the labor force increases, so long-run aggregate supply shifts to the right. b.When Congress raises the minimum wage to $10 per hour, the natural rate of unemployment rises, so the long-run aggregate-supply curve shifts to the left. c.When Intel invents a new and more powerful computer chip, productivity increases, so long-run aggregate supply increases because more output can be produced with the same inputs. d.When a severe hurricane damages factories along the East Coast, the capital stock is smaller, so long-run aggregate supply declines.

115 Chapter 33: P&A-2 (page: ) Suppose an economy is in long-run equilibrium. a.Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium (call it point A). Be sure to include both short-run and long-run aggregate supply. b.The central bank raises the money supply by 5 percent. Use your diagram to show what happens to output and the price level as the economy moves from the initial to the new short-run equilibrium (call it point B). c.Now show the new long-run equilibrium (call it point C). What causes the economy to move from point B to point C?

116 Chapter 33: P&A-2 (page: )-cont. d.According to the sticky-wage theory of aggregate supply, how do nominal wages at point A compare to nominal wages at point B? How do nominal wages at point A compare to nominal wages at point C? e.According to the sticky-wage theory of aggregate supply, how do real wages at point A compare to real wages at point B? How do real wages at point A compare to real wages at point C? f.Judging by the impact of the money supply on nominal and real wages, is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run?

117 Chapter 33: P&A-2 (page: )-cont. ANSWER: a.The current state of the economy is shown in Figure 7. The aggregate-demand curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate- supply curve. (SEE PAGE: 762-see FIGURE-7) Figure 7

118 Chapter 33: P&A-2 (page: )-cont. ANSWER: aggregate demand shifts to the rightIn the short run, there is an increase in output and the price level. b.If the central bank increases the money supply, aggregate demand shifts to the right (to point B). In the short run, there is an increase in output and the price level. Over time, nominal wages, prices, and perceptions will adjust to this new price level. c.Over time, nominal wages, prices, and perceptions will adjust to this new price level. As a result, the short-run aggregate-supply curve will shift to the left. The economy will return to its natural rate of output (point C). nominal wages at points A and B are equal.nominal wages at point C are higher. d.According to the sticky-wage theory, nominal wages at points A and B are equal. However, nominal wages at point C are higher. real wages at point B are lower than real wages at point Areal wages at points A and C are equal. e.According to the sticky-wage theory, real wages at point B are lower than real wages at point A. However, real wages at points A and C are equal. this analysis is consistent with long-run monetary neutrality. f.Yes, this analysis is consistent with long-run monetary neutrality. In the long run, an increase in the money supply causes an increase in the nominal wage, but leaves the real wage unchanged.

119 Chapter 33: P&A-3 (page: 774) Suppose the economy is in a long-run equilibrium. a.Draw a diagram to illustrate the state of the economy. Be sure to show aggregate demand, short-run aggregate supply, and long-run aggregate supply. b.Now suppose that a stock-market crash causes aggregate demand to fall. b.Now suppose that a stock-market crash causes aggregate demand to fall. Use your diagram to show what happens to output and the price level in the short run. What happens to the unemployment rate? c.Use the sticky-wage theory of aggregate supply to explain what will happen to output and the price level in the long run (assuming there is no change in policy). c.Use the sticky-wage theory of aggregate supply to explain what will happen to output and the price level in the long run (assuming there is no change in policy). What role does the expected price level play in this adjustment? Be sure to illustrate your analysis in a graph.

120 Chapter 33: P&A-3 (page: 774)-cont. ANSWER: a.The current state of the economy is shown in Figure 6. The aggregate-demand curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate- supply curve. Figure 6

121 Chapter 33: P&A-3 (page: 774)-cont. ANSWER: (SEE PAGES: )-see FIGURE-8 A stock market crash leads to a leftward shift of aggregate demand. b.A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level of output and the price level will fall. Because the quantity of output is less than the natural rate of output, the unemployment rate will rise above the natural rate of unemployment. c.If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time as expectations adjust, the short-run aggregate- supply curve will shift to the right, moving the economy back to the natural rate of output.

122 Chapter 33: P&A-4 (page: 774) In 1939, with the U.S. economy not yet fully recovered from the Great Depression In 1939, with the U.S. economy not yet fully recovered from the Great Depression, President Roosevelt proclaimed that Thanksgiving would fall a week earlier than usual so that the shopping period before Christmas would be longer. Explain what President Roosevelt might have been trying to achieve, using the model of aggregate demand and aggregate supply. ANSWER: The idea of lengthening the shopping period between Thanksgiving and Christmas was to increase aggregate demand. As Figure 8 shows, this could increase output back to its long- run equilibrium level.

123 Chapter 33: P&A-4 (page: 774)-cont. Figure 8

124 Chapter 33: P&A-5 (page: 774) Explain why the following statements are false. a. “The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods.” b. “The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply.” c. “If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal.” d. “Whenever the economy enters a recession, its long- run aggregate-supply curve shifts to the left.”

125 Chapter 33: P&A-5 (page: 774)-cont. ANSWER: a.The statement that "the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods" is false. The aggregate- demand curve slopes downward because a fall in the price level raises the overall quantity of goods and services demanded through the wealth effect, the interest- rate effect, and the exchange-rate effect. b.The statement that "the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" is false. Economic forces of various kinds (such as population and productivity) do affect long-run aggregate supply. The long-run aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply. c.The statement that "if firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal" is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the short- run aggregate-supply curve, then the short-run aggregate-supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed. d.The statement that "whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" is false. An economy could enter a recession if either the aggregate-demand curve or the short-run aggregate-supply curve shifts to the left.

126 Chapter 33: P&A-6 (page: 774) For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully explain the following: a. How the economy recovers from a recession and returns to its long-run equilibrium without any policy intervention. b. What determines the speed of that recovery.

127 Chapter 33: P&A-6 (page: 774)-cont. ANSWER: a.According to the sticky-wage theory, the economy is in a recession because the price level has declined so that real wages are too high, thus labor demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment. According to the sticky-price theory, the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the economy returns to the long- run aggregate-supply curve. According to the misperceptions theory, the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate-supply curve.

128 Chapter 33: P&A-6 (page: 774)-cont. ANSWER: b.The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust.

129 Chapter 33: P&A-7 (page: 774) Suppose the Fed expands the money supply, but because the public expects this Fed action, it simultaneously raises its expectation of the price level. What will happen to output and the price level in the short run? Compare this result to the outcome if the Fed expanded the money supply but the public didn’t change its expectation of the price level.

130 Chapter 33: P&A-7 (page: 774)-cont. If the Fed increases the money supply and people expect a higher price level, the aggregate-demand curve shifts to the right and the short-run aggregate-supply curve shifts to the left, as shown in Figure 9. The economy moves from point A to point B, with no change in output and a rise in the price level (to P 2 ). If the public does not change its expectation of the price level, the short-run aggregate-supply curve does not shift, the economy ends up at point C, and output increases along with the price level (to P 3 ).

131 Chapter 33: P&A-7 (page: 774)-cont. Figure 9

132 Chapter 33: P&A-8 (page: 774) Suppose that the economy is currently in a recession. If policymakers take no action, how will the economy evolve over time? Explain in words and using an aggregate- demand/aggregate-supply diagram. ANSWER: Figure 10 depicts an economy in a recession. The short-run aggregate-supply curve is AS 1 and the economy is at equilibrium at point A, which is to the left of the long-run aggregate-supply curve. If policymakers take no action, the economy will return to the long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts to the right to AS 2. The economy's new equilibrium is at point B.

133 Chapter 33: P&A-8 (page: 774)-cont. Figure 10

134 Chapter 33: P&A-9 (page: 774) The economy begins in long-run equilibrium. Then one day, the president appoints a new chairman of the Federal Reserve. This new chairman is well-known for his view that inflation is not a major problem for an economy. a. How would this news affect the price level that people would expect to prevail? b. How would this change in the expected price level affect the nominal wage that workers and firms agree to in their new labor contracts? c. How would this change in the nominal wage affect the profitability of producing goods and services at any given price level? d. How does this change in profitability affect the short-run aggregate- supply curve? e. If aggregate demand is held constant, how does this shift in the aggregate-supply curve affect the price level and the quantity of output produced? f. Do you think this Fed chairman was a good appointment?

135 Chapter 33: P&A-9 (page: 774)-cont. a.People will likely expect that the new chairman will not actively fight inflation so they will expect the price level to rise. b.If people believe that the price level will be higher over the next year, workers will want higher nominal wages. c.Higher labor costs lead to reduced profitability. d.The short-run aggregate-supply curve will shift to the left as shown in Figure 11. Figure 11

136 Chapter 33: P&A-9 (page: 774)-cont. e.A decline in short-run aggregate supply leads to reduced output and a higher price level. f.No, this choice was probably not wise. The end result is stagflation, which provides limited choices in terms of policies to remedy the situation.

137 Chapter 33: P&A-10 (page: 774) Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate demand curve, both, or neither. For each event that does shift a curve, draw a diagram to illustrate the effect on the economy. a. Households decide to save a larger share of their income. b. Florida orange groves suffer a prolonged period of below-freezing temperatures. c. Increased job opportunities overseas cause many people to leave the country.

138 Chapter 33: P&A-10 (page: 774)-cont. ANSWER: a.If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure 12. The equilibrium changes from point A to point B, so the price level declines and output declines. Figure 12

139 Chapter 33: P&A-10 (page: 774)-cont. ANSWER: b.If Florida orange groves suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This decline in the natural rate of output is represented in Figure 13 by a shift to the left in both the short-run and long-run aggregate-supply curves. The equilibrium changes from point A to point B, so the price level rises and output declines. Figure 13

140 Chapter 33: P&A-10 (page: 774)-cont. ANSWER: c.If increased job opportunities cause people to leave the country, the long-run and short-run aggregate-supply curves will shift to the left because there are fewer people producing output. The aggregate-demand curve will shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 14 shows. Whether the price level rises or declines depends on the relative sizes of the shifts in the aggregate-demand curve and the aggregate-supply curves. Figure 14

141 Chapter 33: P&A-11 (page: ) For each of the following events, explain the short- run and long-run effects on output and the price level, assuming policymakers take no action. a. The stock market declines sharply, reducing consumers’ wealth. b. The federal government increases spending on national defense. c. A technological improvement raises productivity. d. A recession overseas causes foreigners to buy fewer U.S. goods.

142 Chapter 33: P&A-11 (page: )-cont. ANSWER: a.When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 15. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate- supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. Figure 15

143 Chapter 33: P&A-11 (page: )-cont. ANSWER: b.When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 16. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A. Figure 16

144 Chapter 33: P&A-11 (page: )-cont. ANSWER: c.When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 17. The economy moves from point A to point B, as output rises and the price level declines. Figure 17

145 Chapter 33: P&A-11 (page: )-cont. ANSWER: d.When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 18. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. Figure 18

146 Chapter 33: P&A-12 (page: 775) Suppose the U.S. economy begins in long-run equilibrium. Concerns about global climate change cause the government to significantly restrict the production of electricity from fossil fuels. Because of this change in policy, foreign investors lose confidence in the economy, and the dollar falls in foreign-exchange markets. Draw a diagram to show the short-run effect of these events, and explain why these changes occur.

147 Chapter 33: P&A-12 (page: 775)-cont. ANSWER: If the value of the dollar falls in foreign exchange markets, U.S. exports will rise and imports will fall. This will cause the aggregate-demand curve to shift to the right (as shown in Figure 19). The price level and output will both rise in the short run. Figure 19

148 Chapter 33: P&A-13 (page: 775) Suppose that firms become very optimistic about future business conditions and invest heavily in new capital equipment. a. Draw an aggregate-demand/aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplied changes? b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now, assume there is no change in the long-run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run. c. How might the investment boom affect the long-run aggregate-supply curve? Explain.

149 Chapter 33: P&A-13 (page: 775)-cont. ANSWER: a.If firms become optimistic about future business conditions and increase investment, the result is shown in Figure 20. The economy begins at point A with aggregate-demand curve AD 1 and short-run aggregate-supply curve AS 1. The equilibrium has price level P 1 and output level Y 1. Increased optimism leads to greater investment, so the aggregate-demand curve shifts to AD 2. Now the economy is at point B, with price level P 2 and output level Y 2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

150 Chapter 33: P&A-13 (page: 775)-cont. Figure 20

151 Chapter 33: P&A-13 (page: 775)-cont. ANSWER: b.Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate-supply curve shifts up to AS 2 and the economy gets to equilibrium at point C, with price level P 3 and output level Y 1. The quantity of output demanded declines as the price level rises. The investment boom might increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output. c.The investment boom might increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output.

152 Chapter 33: P&A-14 (page: 775) In economy A, all workers agree in advance on the nominal wages that their employers will pay them. In economy B, half of all workers have these nominal wage contracts, while the other half have indexed employment contracts, so their wages rise and fall automatically with the price level. According to the sticky-wage theory of aggregate supply, which economy has a more steeply sloped short-run aggregate-supply curve? In which economy would a 5 percent increase in the money supply have a larger impact on output? In which economy would it have a larger impact on the price level? Explain.

153 Chapter 33: P&A-14 (page: 775)-cont. ANSWER:  Economy B would have a more steeply sloped short-run aggregate-supply curve than would Economy A, because only half of the wages in Economy B are “sticky.”  A 5% increase in the money supply would have a larger effect on output in Economy A and a larger effect on the price level in Economy B.

154 Today Mankiw (2008), Principles of Economics - Chapter 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand (PAGES )  Questions for Review (QfR): 1-5 (page: 799)  Problems and Applications (P&A): 1-13 (pages: )

155 Chapter 34: QfR-1 (page: 799) What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate demand curve? ANSWER: (SEE PAGE SEE FIGURE 2 (P. 783)) The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-demand curve slopes downward because: (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus, the price level has a negative relationship with the quantity of goods and services demanded.

156 The money market and the slope of the aggregate-demand curve Interest rate An increase in the price level from P 1 to P 2 shifts the money-demand curve to the right, as in panel (a). This increase in money demand causes the interest rate to rise from r 1 to r 2. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y 1 to Y 2. This negative relationship between the price level and quantity demanded is represented with a downward-sloping aggregate-demand curve, as in panel (b). Quantity of money 0 (a) The Money Market Price level Quantity of output 0 (b) The Aggregate-Demand Curve Aggregate demand P2P2 Money demand at price level P 1, MD 1 Money supply Quantity fixed by the Fed Money demand at price level P 2, MD 2 r2r2 r1r1 Y2Y2 P1P1 Y1Y1 1. An increase in the price level increases the demand for money which increases equilibrium interest rate which in turn reduces the quantity of goods and services demanded.

157 Chapter 34: QfR-2 (page: 799) Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate demand curve. ANSWER: (SEE PAGES: )-(REVERSE OF FIG. 3) A decrease in the money supply shifts the money- supply curve to the left. The equilibrium interest rate will rise. The higher interest rate reduces consumption and investment, so aggregate demand falls. Thus, the aggregate-demand curve shifts to the left.

158 A monetary injection Interest rate In panel (a), an increase in the money supply from MS 1 to MS 2 reduces the equilibrium interest rate from r 1 to r 2. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level from Y 1 to Y 2. Thus, in panel (b), the aggregate- demand curve shifts to the right from AD 1 to AD 2. Quantity of money 0 (a) The Money Market Price level Quantity of output 0 (b) The Aggregate-Demand Curve Aggregate demand, AD 1 Money demand at price level P Money supply, MS 1 r1r1 Y1Y1 P 1. When the Fed increases the money supply... MS 2 r2r2 AD 2 Y2Y the equilibrium interest rate falls which increases the quantity of goods and services demanded at a given price level.

159 Chapter 34: QfR-3 (page: 799) The government spends $3 billion to buy police cars. Explain why aggregate demand might increase by more than $3 billion. Explain why aggregate demand might increase by less than $3 billion. ANSWER: the multiplier effect If the government spends $3 billion to buy police cars, aggregate demand might increase by more than $3 billion because of the multiplier effect on aggregate demand. the crowding-out effect Aggregate demand might increase by less than $3 billion because of the crowding-out effect on aggregate demand.

160 The multiplier effect Price level Quantity of Output Aggregate demand, AD 1 An increase in government purchases of $20 billion can shift the aggregate-demand curve to the right by more than $20 billion. This multiplier effect arises because increases in aggregate income stimulate additional spending by consumers. AD 2 AD 3 $20 billion 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion but the multiplier effect can amplify the shift in aggregate demand.

161 The crowding-out effect Interest rate Panel (a) shows the money market. When the government increases its purchases of goods and services, the resulting increase in income raises the demand for money from MD 1 to MD 2, and this causes the equilibrium interest rate to rise from r 1 to r 2. Panel (b) shows the effects on aggregate demand. The initial impact of the increase in government purchases shifts the aggregate-demand curve from AD 1 to AD 2. Yet because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods. This crowding out of investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD 3. Quantity of money 0 (a) The Money Market Price level Quantity of output 0 (b) The Aggregate-Demand Curve Aggregate demand, AD 1 Money demand, MD 1 Money supply Quantity fixed by the Fed MD 2 r2r2 r1r1 1. When an increase in government purchases increases aggregate demand the increase in spending increases money demand which increases the equilibrium interest rate which in turn partly offsets the initial increase in aggregate demand. AD 2 AD 3 $20 billion

162 Chapter 34: QfR-4 (page: 799) Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the country. If policymakers do nothing, what will happen to aggregate demand? What should the Fed do if it wants to stabilize aggregate demand? If the Fed does nothing, what might Congress do to stabilize aggregate demand? ANSWER: If pessimism sweeps the country, households reduce consumption spending and firms reduce investment, so aggregate demand falls. If the Fed wants to stabilize aggregate demand, it must increase the money supply, reducing the interest rate, which will induce households to save less and spend more and will encourage firms to invest more, both of which will increase aggregate demand. If the Fed does not increase the money supply, Congress could increase government purchases or reduce taxes to increase aggregate demand.

163 Chapter 34: QfR-5 (page: 799) Give an example of a government policy that acts as an automatic stabilizer. Explain why this policy has this effect. ANSWER: Government policies that act as automatic stabilizers include the tax system and government spending through the unemployment-benefit system. The tax system acts as an automatic stabilizer because when incomes are high, people pay more in taxes, so they cannot spend as much. When incomes are low, so are taxes; thus, people can spend more. The result is that spending is partly stabilized. Government spending through the unemployment-benefit system acts as an automatic stabilizer because in recessions the government transfers money to the unemployed so their incomes do not fall as much and thus their spending will not fall as much.

164 Chapter 34: P&A-1 (page: 799) Suppose banks install automatic teller machines on every block and, by making cash readily available, reduce the amount of money people want to hold. a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand? b. If the Fed wants to stabilize aggregate demand, how should it respond?

165 Chapter 34: P&A-1 (page: 799)-cont. ANSWER: a.When more ATMs are available, money demand is reduced and the money-demand curve shifts to the left from MD 1 to MD 2, as shown in Figure 6. If the Fed does not change the money supply, which is at MS 1, the interest rate will decline from r 1 to r 2. The decline in the interest rate shifts the aggregate-demand curve to the right, as consumption and investment increase. b.If the Fed wants to stabilize aggregate demand, it should reduce the money supply to MS 2, so the interest rate will remain at r 1 and aggregate demand will not change.

166 Chapter 34: P&A-1 (page: 799)-cont.

167 Chapter 34: P&A-2 (page: 799) Explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate. Illustrate your answers with diagrams. a. The Fed’s bond traders buy bonds in open-market operations. b. An increase in credit card availability reduces the cash people hold. c. The Federal Reserve reduces banks’ reserve requirements. d. Households decide to hold more money to use for holiday shopping. e. A wave of optimism boosts business investment and expands aggregate demand.

168 Chapter 34: P&A-2 (page: 799)-cont. ANSWER: a.When the Fed’s bond traders buy bonds in open-market operations, the money-supply curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The result is a decline in the interest rate. Figure 1

169 Chapter 34: P&A-2 (page: 799)-cont. ANSWER: b.When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD 1 to MD 2, as shown in Figure 2. The result is a decline in the interest rate. Figure 2

170 Chapter 34: P&A-2 (page: 799)-cont. ANSWER: c.When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS 1 to MS 2, as shown in Figure 1. The result is a decline in the interest rate. d.When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD 1 to MD 2, as shown in Figure 3. The result is a rise in the interest rate. Figure 3

171 Chapter 34: P&A-2 (page: 799)-cont. ANSWER: e. When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD 1 to MD 2 in Figure 3. The increase in money demand increases the interest rate. Figure 3

172 Chapter 34: P&A-3 (page: 799) The Federal Reserve expands the money supply by 5 percent. a.Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate. b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short-run. c. When the economy makes the transition from its short-run equilibrium to its long-run equilibrium, what will happen to the price level? d. How will this change in the price level affect the demand for money and the equilibrium interest rate? e. Is this analysis consistent with the proposition that money has real effects in the short-run but is neutral in the long- run?

173 Chapter 34: P&A-3 (page: 799)-cont. ANSWER: a.The increase in the money supply will cause the equilibrium interest rate to decline, as shown in Figure 4. Households will increase spending and will invest in more new housing. Firms too will increase investment spending. This will cause the aggregate demand curve to shift to the right as shown in Figure 5. Figure 4 Figure 5

174 Chapter 34: P&A-3 (page: 799)-cont. ANSWER: b.As shown in Figure 5, the increase in aggregate demand will cause an increase in both output and the price level in the short run. c.When the economy makes the transition from its short-run equilibrium to its long-run equilibrium, short-run aggregate supply will decline, causing the price level to rise even further. d.The increase in the price level will cause an increase in the demand for money, raising the equilibrium interest rate. e.Yes. While output initially rises because of the increase in aggregate demand, it will fall once short-run aggregate supply declines. Thus, there is no long-run effect of the increase in the money supply on real output.

175 Chapter 34: P&A-4 (page: 799) Consider two policies—a tax cut that will last for only one year, and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers? Which policy will have the greater impact on aggregate demand? Explain. ANSWER: A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much.

176 Chapter 34: P&A-5 (page: ) The economy is in a recession with high unemployment and low output. a.Draw a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure to include the aggregate- demand curve, the short-run aggregate-supply curve, and the long-run aggregate-supply curve. b.Identify an open-market operation that would restore the economy to its natural level. c. Draw a graph of the money market to illustrate the effect of this open-market operation. Show the resulting change in the interest rate. d. Draw a graph similar to the one in part (a) to show the effect of the open-market operation on output and the price level. Explain in words why the policy has the effect that you have shown in the graph.

177 Chapter 34: P&A-5 (page: )-cont. ANSWER: a.The current situation is shown in Figure 7. Figure 7

178 Chapter 34: P&A-5 (page: )-cont. ANSWER: b.The Fed will want to stimulate aggregate demand. Thus, it will need to lower the interest rate by increasing the money supply. This could be achieved if the Fed purchases government bonds from the public. c.As shown in Figure 8, the Fed's purchase of government bonds shifts the supply of money to the right, lowering the interest rate. Figure 8

179 Chapter 34: P&A-5 (page: )-cont. ANSWER: d.The Fed's purchase of government bonds will increase aggregate demand as consumers and firms respond to lower interest rates. Output and the price level will rise as shown in Figure 9. Figure 9

180 Chapter 34: P&A-6 (page: 800) In the early 1980s, new legislation allowed banks to pay interest on checking deposits, which they could not do previously. a. If we define money to include checking deposits, what effect did this legislation have on money demand? Explain. b. If the Federal Reserve had maintained a constant money supply in the face of this change, what would have happened to the interest rate? What would have happened to aggregate demand and aggregate output? c. If the Federal Reserve had maintained a constant market interest rate (the interest rate on nonmonetary assets) in the face of this change, what change in the money supply would have been necessary? What would have happened to aggregate demand and aggregate output?

181 Chapter 34: P&A-6 (page: 800)-cont. ANSWER: a.Legislation allowing banks to pay interest on checking deposits increases the return to money relative to other financial assets, thus increasing money demand. b.If the money supply remained constant (at MS 1 ), the increase in the demand for money would have raised the interest rate, as shown in Figure 10. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate demand and output. c.To maintain a constant interest rate, the Fed would need to increase the money supply from MS 1 to MS 2. Then aggregate demand and output would be unaffected.

182 Chapter 34: P&A-6 (page: 800)-cont. Figure 10

183 Chapter 34: P&A-7 (page: 800) Suppose economists observe that an increase in government spending of $10 billion raises the total demand for goods and services by $30 billion. a. If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be? b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

184 Chapter 34: P&A-7 (page: 800)-cont. ANSWER: a.If there is no crowding out, then the multiplier equals 1/(1 – MPC ). Because the multiplier is 3, then MPC = 2/3. b.If there is crowding out, then the MPC would be larger than 2/3. An MPC that is larger than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the crowding-out effect.

185 Chapter 34: P&A-8 (page: 800) Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the marginal propensity to consume is 3/4. a. What is the initial effect of the tax reduction on aggregate demand? b. What additional effects follow this initial effect? What is the total effect of the tax cut on aggregate demand? c. How does the total effect of this $20 billion tax cut compare to the total effect of a $20 billion increase in government purchases? Why? d. Based on your answer to part (c), can you think of a way in which the government can increase aggregate demand without changing the government’s budget deficit?

186 Chapter 34: P&A-8 (page: 800)-cont. ANSWER: a.The initial effect of the tax reduction of $20 billion is to increase aggregate demand by $20 billion x 3/4 (the MPC ) = $15 billion. b.Additional effects follow this initial effect as the added incomes are spent. The second round leads to increased consumption spending of $15 billion x 3/4 = $11.25 billion. The third round gives an increase in consumption of $11.25 billion x 3/4 = $8.44 billion. The effects continue indefinitely. Adding them all up gives a total effect that depends on the multiplier. With an MPC of 3/4, the multiplier is 1/(1 – 3/4) = 4. So the total effect is $15 billion x 4 = $60 billion. c.Government purchases have an initial effect of the full $20 billion, because they increase aggregate demand directly by that amount. The total effect of an increase in government purchases is thus $20 billion x 4 = $80 billion. So government purchases lead to a bigger effect on output than a tax cut does. The difference arises because government purchases affect aggregate demand by the full amount, but a tax cut is partly saved by consumers, and therefore does not lead to as much of an increase in aggregate demand. d.The government could increase taxes by the same amount it increases its purchases.

187 Chapter 34: P&A-9 (page: 800) An economy is operating with output $400 billion below its natural rate, and fiscal policy-makers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5 and the price level is completely fixed in the short-run. a.In what direction and by how much would government spending need to change to close the recessionary gap? Explain your thinking. b. In what direction and by how much would taxes need to change to close the gap? Explain. c. If the central bank were to hold the money supply, rather than the interest rate, constant in response to change in fiscal policy, would your answers to the previous questions be larger, smaller, or the same? Explain. d. If the policymakers in this economy wanted to close the recessionary gap without increasing the government’s budget deficit, what are two ways they accomplish this goal?

188 Chapter 34: P&A-9 (page: 800)-cont. ANSWER: a.If the marginal propensity to consume is 0.8, the spending multiplier will be 1/(1-0.8) = 5. Therefore, the government would have to increase spending by $400/5 = $80 billion to close the recessionary gap. b.With an MPC of 0.8, the tax multiplier is (0.8)(1/(1-0.8)) = (0.8)(5) = 4. Therefore, the government would need to cut taxes by $400 billion/4 = $100 billion to close the recessionary gap. c.If the central bank was to hold the money supply constant, my answer would be larger because crowding out would occur. d.They would have to raise both government spending and taxes by $400 billion. The increase in government purchases would result in a boost of $2,000 billion, while the higher taxes would reduce spending by $1,600 billion. This leaves a $400 billion rise in aggregate spending.

189 Chapter 34: P&A-10 (page: 800) Suppose government spending increases. Would the effect on aggregate demand be larger if the Federal Reserve took no action in response, or if the Fed were committed to maintaining a fixed interest rate? Explain. ANSWER: If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and thus a decline in aggregate demand if the Fed does not respond. But if the Fed maintains a fixed interest rate, it will increase money supply, so aggregate demand will not decline. Thus, the effect on aggregate demand from an increase in government spending will be larger if the Fed maintains a fixed interest rate.

190 Chapter 34: P&A-11 (page: 800) In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run increase in investment? Explain. a. When the investment accelerator is large, or when it is small? b. When the interest sensitivity of investment is large, or when it is small? ANSWER: a.Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the investment accelerator is large. A large investment accelerator means that the increase in output caused by expansionary fiscal policy will induce a large increase in investment. Without a large accelerator, investment might decline because the increase in aggregate demand will raise the interest rate. b.Expansionary fiscal policy is more likely to lead to a short-run increase in investment if the interest sensitivity of investment is small. Because fiscal policy increases aggregate demand, thus increasing money demand and the interest rate, the greater the sensitivity of investment to the interest rate the greater the decline in investment will be, which will offset the positive accelerator effect.

191 Chapter 34: P&A-12 (page: 800) For various reasons, fiscal policy changes automatically when output and employment fluctuate. a. Explain why tax revenue changes when the economy goes into a recession. b. Explain why government spending changes when the economy goes into a recession. c. If the government were to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe? ANSWER: a.Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people's incomes and wages fall, as do firms' profits, so taxes on these things decline. b.Government spending rises when the economy goes into a recession because more people get unemployment-insurance benefits, welfare benefits, and other forms of income support. c.If the government were to operate under a strict balanced-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate demand, making the recession more severe.

192 Chapter 34: P&A-13 (page: 800) Some members of Congress have proposed a law that would make price stability the sole goal of monetary policy. Suppose such a law were passed. a. How would the Fed respond to an event that contracted aggregate demand? b.How would the Fed respond to an event that caused an adverse shift in short-run aggregate supply? In each case, is there another monetary policy that would lead to greater stability in output?

193 Chapter 34: P&A-13 (page: 800)-cont. ANSWER: a.If there were a contraction in aggregate demand, the Fed would need to increase the money supply to increase aggregate demand and stabilize the price level, as shown in Figure 11. By increasing the money supply, the Fed is able to shift the aggregate-demand curve back to AD 1 from AD 2. This policy stabilizes output and the price level. Figure 11

194 Chapter 34: P&A-13 (page: 800)-cont. ANSWER: b.If there were an adverse shift in short-run aggregate supply, the Fed would need to decrease the money supply to stabilize the price level, shifting the aggregate-demand curve to the left from AD 1 to AD 2, as shown in Figure 12. This worsens the recession caused by the shift in aggregate supply. To stabilize output, the Fed would need to increase the money supply, shifting the aggregate-demand curve from AD 1 to AD 3. However, this action would raise the price level. Figure 12

195 Today Mankiw (2008), Principles of Economics - Chapter 35: The Short-Run Trade-off between Inflation and Unemployment (PAGES )  Questions for Review (QfR): 1-5 (page: 824)  Problems and Applications (P&A): 1-11 (pages: )

196 Chapter 35: QfR-1 (page: 824) Draw the short-run tradeoff between inflation and unemployment. (SEE PAGE 803-FIGURE-1) How might the Fed move the economy from one point on this curve to another? (SEE PAGE 804-FIGURE-2) ANSWER: (see Figure-1 and Figure-2 on pages 803-4) Figure 5 shows the short-run trade-off between inflation and unemployment. The Fed can move from one point on this curve to another by changing the money supply. An increase in the money supply reduces the unemployment rate and increases the inflation rate, while a decrease in the money supply increases the unemployment rate and decreases the inflation rate.

197 Chapter 35: QfR-1 (page: 824)-cont. Figure 5

198 Chapter 35: QfR-2 (page: 824) Draw the long-run tradeoff between inflation and unemployment. (SEE PAGE 806-FIGURE-3) Explain how the short-run and long-run tradeoffs are related. (SEE PAGE 810-FIGURE-5) ANSWER: (see Figure-3 (806)+see Figure-5 (810) Figure 6 shows the long-run trade-off between inflation and unemployment. In the long run, there is no trade-off, as the economy must return to the natural rate of unemployment on the long-run Phillips curve. In the short run, the economy can move along a short-run Phillips curve, like SRPC 1 shown in the figure. But over time (as inflation expectations adjust) the short-run Phillips curve will shift to return the economy to the long-run Phillips curve, for example shifting from SRPC 1 to SRPC 2.

199 Chapter 35: QfR-2 (page: 824)-cont. Figure 6

200 Chapter 35: QfR-3 (page: 824) What’s so natural about the natural rate of unemployment? (SEE PAGE 807-THE MEANING OF “NATURAL) Why might the natural rate of unemployment differ across countries? ANSWER: The natural rate of unemployment is natural because it is beyond the influence of monetary policy. The rate of unemployment will move to its natural rate in the long run, regardless of the inflation rate. The natural rate of unemployment might differ across countries because countries have varying degrees of union power, minimum- wage laws, collective-bargaining laws, unemployment insurance, job-training programs, and other factors that influence labor-market conditions.

201 Chapter 35: QfR-4 (page: 824) Suppose a drought destroys farm crops and drives up the price of food. What is the effect on the short-run trade-off between inflation and unemployment? ANSWER: (SEE PAGE 813-FIGURE-8) If a drought destroys farm crops and drives up the price of food, the short-run aggregate-supply curve shifts up, as does the short-run Phillips curve, because the costs of production have increased. The higher short-run Phillips curve means the inflation rate will be higher for any given unemployment rate.

202 Chapter 35: QfR-5 (page: 824) The Fed decides to reduce inflation. Use the Phillips curve to show the short-run and long-run effects of this policy. How might the short-run costs be reduced? ANSWER: (SEE PAGE 816-FIGURE-10) When the Fed decides to reduce inflation, the economy moves down along the short-run Phillips curve, as shown in Figure 7. Beginning at point A on short-run Phillips curve SRPC 1, the economy moves down to point B as inflation declines. Once people's expectations adjust to the lower rate of inflation, the short-run Phillips curve shifts to SRPC 2, and the economy moves to point C. The short-run costs of disinflation, which arise because the unemployment rate is temporarily above its natural rate, could be reduced if the Fed's action was credible, so that expectations would adjust more rapidly.

203 Chapter 35: QfR-5 (page: 824)-cont. Figure 7

204 Chapter 35: P&A-1 (page: 825) Illustrate the effects of the following developments on both the short-run and long-run Phillips curves. Give the economic reasoning underlying your answers. a. a rise in the natural rate of unemployment b. a decline in the price of imported oil c. a rise in government spending d. a decline in expected inflation

205 Chapter 35: P&A-1 (page: 825)-cont. ANSWER: a.A rise in the natural rate of unemployment shifts the long-run Phillips curve to the right and the short-run Phillips curve up, as shown in Figure 9. The economy is initially on LRPC 1 and SRPC 1 at an inflation rate of 3%, which is also the expected rate of inflation. The increase in the natural rate of unemployment shifts the long-run Phillips curve to LRPC 2 and the short-run Phillips curve to SRPC 2, with the expected rate of inflation remaining equal to 3%. Figure 9

206 Chapter 35: P&A-1 (page: 825)-cont. ANSWER: b. A decline in the price of imported oil shifts the short-run Phillips curve down, as shown in Figure 10, from SRPC 1 to SRPC 2. For any given unemployment rate, the inflation rate is lower, because oil is such a significant aspect of production costs in the economy. Figure 10

207 Chapter 35: P&A-1 (page: 825)-cont. ANSWER: c.A rise in government spending represents an increase in aggregate demand, so it moves the economy along the short-run Phillips curve, as shown in Figure 11. The economy moves from point A to point B, with a decline in the unemployment rate and an increase in the inflation rate. Figure 11

208 Chapter 35: P&A-1 (page: 825)-cont. ANSWER: d.A decline in expected inflation causes the short-run Phillips curve to shift down, as shown in Figure 12. The lower rate of expected inflation shifts the short-run Phillips curve from SRPC 1 to SRPC 2. Figure 12

209 Chapter 35: P&A-2 (page: 825) Suppose that a fall in consumer spending causes a recession. a. Illustrate the immediate change in the economy using both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. On both graphs, label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B. What happens to inflation and unemployment in the short run? b. Now suppose that over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the short-run Phillips curve? After the recession is over, does the economy face a better or worse set of inflation– unemployment combinations?

210 Chapter 35: P&A-2 (page: 825)-cont. ANSWERS: a.Figure 13 shows how a reduction in consumer spending causes a recession in both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. In both diagrams, the economy begins at full employment at point A. The decline in consumer spending reduces aggregate demand, shifting the aggregate-demand curve to the left from AD 1 to AD 2. The economy initially remains on the short-run aggregate-supply curve SRAS 1, so the new equilibrium occurs at point B. The movement of the aggregate-demand curve along the short-run aggregate-supply curve leads to a movement along short-run Phillips curve SRPC 1, from point A to point B. The lower price level in the aggregate-supply/aggregate-demand diagram corresponds to the lower inflation rate in the Phillips-curve diagram. The lower level of output in the aggregate- supply/aggregate-demand diagram corresponds to the higher unemployment rate in the Phillips-curve diagram.

211 Chapter 35: P&A-2 (page: 825)-cont. Figure 13

212 Chapter 35: P&A-2 (page: 825)-cont. ANSWERS: b.As expected inflation falls over time, the short-run aggregate-supply curve shifts down from AS 1 to AS 2, and the short-run Phillips curve shifts down from SRPC 1 to SRPC 2. In both diagrams, the economy eventually gets to point C, which is back on the long-run aggregate-supply curve and long-run Phillips curve. After the recession is over, the economy faces a better set of inflation-unemployment combinations.

213 Chapter 35: P&A-3 (page: 825) Suppose the natural rate of unemployment is 6 percent. On one graph, draw two Phillips curves that can be used to describe the four situations listed below. Label the point that shows the position of the economy in each case: a. Actual inflation is 5 percent and expected inflation is 3 percent. b. Actual inflation is 3 percent and expected inflation is 5 percent. c. Actual inflation is 5 percent and expected inflation is 5 percent. d. Actual inflation is 3 percent and expected inflation is 3 percent.

214 Chapter 35: P&A-3 (page: 825)-cont. ANSWER: Figure 8 shows two different short-run Phillips curves depicting these four points. Points A and D are on SRPC 1 because both have expected inflation of 3%. Points B and C are on SRPC 2 because both have expected inflation of 5%. Figure 8

215 Chapter 35: P&A-4 (page: 825) Suppose the economy is in a long-run equilibrium. a. Draw the economy’s short-run and long-run Phillips curves. b. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on your diagram from part (a). If the Fed undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate?

216 Chapter 35: P&A-4 (page: 825)-cont. c.Now suppose the economy is back in long-run equilibrium, and then the price of imported oil rises. Show the effect of this shock with a new diagram like that in part (a). If the Fed undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? If the Fed undertakes contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? Explain why this situation differs from that in part (b).

217 Chapter 35: P&A-4 (page: 825)-cont. ANSWERS: a.Figure 14 shows the economy in long-run equilibrium at point A, which is on both the long-run and short- run Phillips curves. Figure 14

218 Chapter 35: P&A-4 (page: 825)-cont. ANSWERS: b.A wave of business pessimism reduces aggregate demand, moving the economy to point B in the figure. The unemployment rate rises and the inflation rate declines. If the Fed undertakes expansionary monetary policy, it can increase aggregate demand, offsetting the pessimism and returning the economy to point A, with the initial inflation rate and unemployment rate.

219 Chapter 35: P&A-4 (page: 825)-cont. ANSWERS: c.Figure 15 shows the effects on the economy if the price of imported oil rises. The higher price of imported oil shifts the short- run Phillips curve up from SRPC 1 to SRPC 2. The economy moves from point A to point C, with a higher inflation rate and higher unemployment rate. If the Fed engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point D, but the inflation rate will be higher. If the Fed engages in contractionary monetary policy, it can return the economy to its original inflation rate at point E, but the unemployment rate will be higher. This situation differs from that in part (b) because in part (b) the economy stayed on the same short-run Phillips curve, but in part (c) the economy moved to a higher short-run Phillips curve, which gives policymakers a less favorable trade-off between inflation and unemployment.

220 Chapter 35: P&A-4 (page: 825)-cont. Figure 15

221 Chapter 35: P&A-5 (page: 825) The inflation rate is 10 percent, and the central bank is considering slowing the rate of money growth to reduce inflation to 5 percent. Economist Milton believes that expectations of inflation change quickly in response to new policies, whereas economist James believes that expectations are very sluggish. Which economist is more likely to favor the proposed change in monetary policy? Why?

222 Chapter 35: P&A-5 (page: 825)-cont. ANSWER: Economists who believe that expectations adjust quickly in response to changes in policy would be more likely to favor using contractionary policy to reduce inflation than economists with the opposite views. If expectations adjust quickly, the costs of reducing inflation (in terms of lost output) will be relatively small. Thus, Milton would be more in favor of following a policy to reduce inflation than would James.

223 Chapter 35: P&A-6 (page: 825) Suppose the Federal Reserve’s policy is to maintain low and stable inflation by keeping unemployment at its natural level. However, the Fed believes that the natural rate of unemployment is 4 percent when the actual natural rate is 5 percent. If the Fed based its policy decisions on its belief, what would happen to the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?

224 Chapter 35: P&A-6 (page: 825)-cont. ANSWER: If the Fed acts on its belief that the natural rate of unemployment is 4%, when the natural rate is in fact 5%, the result will be a spiraling up of the inflation rate, as shown in Figure 16. Starting from a point on the long-run Phillips curve, with an unemployment rate of 5%, the Fed will believe that the economy is in a recession, because the unemployment rate is greater than its estimate of the natural rate. Therefore, the Fed will increase the money supply, moving the economy along the short- run Phillips curve SRPC 1. The inflation rate will rise and the unemployment rate will fall to 4%. As the inflation rate rises over time, expectations of inflation will rise, and the short-run Phillips curve will shift up to SRPC 2. This process will continue, and the inflation rate will spiral upwards. The Fed may eventually realize that its estimate of the natural rate of unemployment is wrong by examining the rising trend in the inflation rate.

225 Chapter 35: P&A-7 (page: 825) Suppose the price of oil fell sharply (as it did in 1986 and again in 1998). a.Show the impact of such a change in both the aggregate-demand/aggregate-supply diagram and in the Phillips-curve diagram. What happens to inflation and unemployment in the short run? b. Do the effects of this event mean there is no short- run trade-off between inflation and unemployment? Why or why not?

226 Chapter 35: P&A-7 (page: 825)-cont. ANSWERS: a.Figure 17 shows the effects of a fall in the price of oil. The short-run aggregate-supply curve shifts to the right, reducing the price level and increasing the quantity of output. The short-run Phillips curve shifts to the left. In both diagrams, the economy moves from point A to point B. In equilibrium, both the inflation rate and the unemployment rate decline.

227 Chapter 35: P&A-7 (page: 825)-cont. Figure 17

228 Chapter 35: P&A-7 (page: 825)-cont. ANSWERS: b.The effects of this event do not mean there is no short-run trade-off between inflation and unemployment, as shifts in aggregate demand still move the economy along the short-run Phillips curve.

229 Chapter 35: P&A-8 (page: 825) Suppose the Federal Reserve announced that it would pursue contractionary monetary policy in order to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe? Explain. a. Wage contracts have short durations. b. There is little confidence in the Fed’s determination to reduce inflation. c.Expectations of inflation adjust quickly to actual inflation.

230 Chapter 35: P&A-8 (page: 825)-cont. ANSWERS: a.If wage contracts have short durations, a recession induced by contractionary monetary policy will be less severe, because wage contracts can be adjusted more rapidly to reflect the lower inflation rate. This will allow a more rapid movement of the short-run aggregate-supply curve and short-run Phillips curve to restore the economy to long-run equilibrium. b.If there is little confidence in the Fed's determination to reduce inflation, a recession induced by contractionary monetary policy will be more severe. It will take longer for people's inflation expectations to adjust downwards. c.If expectations of inflation adjust quickly to actual inflation, a recession induced by contractionary monetary policy will be less severe. In this case, people's expectations adjust quickly, so the short-run Phillips curve shifts quickly to restore the economy to long-run equilibrium at the natural rate of unemployment.

231 Chapter 35: P&A-9 (page: 826) Given the unpopularity of inflation, why don’t elected leaders always support efforts to reduce inflation? Many economists believe that countries can reduce the cost of disinflation by letting their central banks make decisions about monetary policy without interference from politicians. Why might this be so?

232 Chapter 35: P&A-9 (page: 826)-cont. ANSWER: Even though inflation is unpopular, elected leaders do not always support efforts to reduce inflation because of the short-run costs associated with disinflation. In particular, as disinflation occurs, the unemployment rate rises, and when unemployment is high people tend not to vote for incumbent politicians, blaming them for the bad state of the economy. Thus, politicians tend not to support disinflation. Economists believe that countries with independent central banks can reduce the cost of disinflation because in those countries politicians cannot interfere with central banks' disinflation efforts. People will believe the central bank when it announces a disinflation because they know politicians cannot stop the disinflation. In countries with central banks that are not independent, people know that politicians who are worried they will not be reelected could stop a disinflation. As a result, the credibility of the central bank is lower and the costs of disinflation are higher.

233 Chapter 35: P&A-10 (page: 826) As described in the chapter, the Federal Reserve in 2008 faced a decrease in aggregate demand caused by the housing and financial crises and a decrease in short-run aggregate supply caused by rising commodity prices. a.Starting from a long-run equilibrium, illustrate the effects of these two changes using both an aggregate-supply/aggregate- demand diagram and a Phillips-curve diagram. On both diagrams, label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B. For each of the following variables, state whether it rises or falls, or whether the impact is ambiguous: output, unemployment, the price level, the inflation rate.

234 Chapter 35: P&A-10 (page: 826)-cont. b.Suppose the Fed responds quickly to these shocks and adjusts monetary policy to keep unemployment and output at their natural rates. What action would it take? On the same set of graphs from part (a), show the results. Label the new equilibrium as point C. c.Why might the Fed choose not to pursue the course of action described in part (b)?

235 Chapter 35: P&A-10 (page: 826)-cont. ANSWERS: a.As shown in the left diagram of Figure 18, equilibrium output and employment will fall. However, the effects on the price level and inflation rate will be ambiguous. The fall in aggregate demand puts downward pressure on prices, while the decline in short-run aggregate supply pushes prices up. The diagram on the right side of Figure 18 assumes that the inflation rate rises. b.The Fed would have to use expansionary monetary policy to keep output and employment at their natural rates. Aggregate demand would shift back to AD 1. c.The Fed may not want to pursue this action because it will lead to a rise in the inflation rate as shown by point C.

236 Chapter 35: P&A-11 (page: 826) Suppose Federal Reserve policymakers accept the theory of the short-run Phillips curve and the natural-rate hypothesis and want to keep unemployment close to its natural rate. Unfortunately, because the natural rate of unemployment can change over time, they aren’t certain about the value of the natural rate. What macroeconomic variables do you think they should look at when conducting monetary policy? ANSWER: If policymakers are uncertain about the value of the natural rate of unemployment (as was clearly the case in the 1990s, when economists were continually revising their estimates of the natural rate downward), they need to look at other variables. Because there is a correspondence through the Phillips curve between inflation and unemployment, when unemployment is close to its natural rate, inflation should not change. Thus, policymakers can look at data on the inflation rate to judge how close unemployment is to its natural rate. In addition, they can look at other macroeconomic variables, including the components of GDP and interest rates, to try to disentangle shifts in aggregate supply from shifts in aggregate demand, which (when combined with information about inflation) can help them determine the appropriate stance for monetary policy.

237 ~ THE END ~


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