Chapter 25
Questions
4. Expansionary gaps tend to raise inflation, and recessionary gaps tend to reduce it. If an
expansionary gap exists, for example, firms are producing above normal capacity.
Eventually they will respond by attempting to raise their relative price (that is, raising their
own price faster than the rate of inflation). As all firms try to do this, inflation will tend to
speed up. Likewise, a recessionary gap implies that firms are producing below normal
capacity. To stimulate demand for their products, firms will try to reduce their relative
prices, leading to an overall slowdown in inflation.
The AS curve captures the relationship between output gaps and inflation through its
upward-sloping shape. As output rises above potential, an expansionary gap opens and
inflation rises, and as output falls below potential, a recessionary gap opens and inflation
falls. See Figure 25.8.
5. See Figure 25.10. The economy is initially in equilibrium with output Y1 and inflation π1. At
this point, there is an expansionary gap (i.e., Y1 is greater than Y2.) The AD curve remains at
AD1 as long as there is no change in the Fed’s monetary policy rule. Since the AD curve does
not move, workers and firms know that the only way to restore long-run equilibrium is for
inflation to rise from π1 to π2 so they increase the level of expected inflation from π1 to π2.
This shifts the AS curve to the left from AS1 to AS2 and causes actual inflation to rise. The
Fed follows its monetary policy rule and increases the real interest rate as inflation rises, so
spending and output fall as inflation rises and the economy moves along the AD curve to
long-run equilibrium at output Y2 and inflation π2.
Problems
1. Using the AD-AS diagram to show the short-run and long-run effects on output and inflation
of AD and AS shocks:
a. See Figure 25.12. An increase in consumer confidence that leads to higher consumption
spending shifts the AD curve to the right and increases output and inflation in the short
run. If the Fed does not change its monetary policy rule, output will return to potential
but inflation will be permanently higher.
b. See Figure 25.12. When the government reduces income taxes, this increases
disposable income, increases consumption spending, shifts the AD curve to the right and
increases output and inflation in the short run. If the Fed does not change its monetary
policy rule, output will return to potential but inflation will be permanently higher.
c. See Figure 25.12. When the Fed loosens monetary policy, the real interest falls at every
level of inflation, which increases both consumption and investment spending and shifts
the AD curve to the right. Output and inflation therefore rise in the short run. If the Fed
maintains this new policy rule, output will return to potential but inflation will be
permanently higher.
d. See the diagram below. A sharp decline in oil prices shifts the AS curve to the right; this
increases output and causes the inflation rate to fall. However, if the Fed does not
change its monetary policy rule, the expected inflation rate is still π1, so the AS curve will
shift back to its original position. In the long run, the drop in oil prices has no long run
effect on output and inflation.
e. See Figure 25.12. An increase in government purchases shifts the AD curve to the right
and increases output and inflation in the short run. If the Fed does not change its
monetary policy rule, output will return to potential but inflation will be permanently
higher.
3. Refer to the figure below:
a. The economy is initially in long-run equilibrium when it is hit by both an inflation shock
(shifting AS to the left) and a shock to potential output (reducing potential GDP from Y1
to Y2 and shifting LRAS to the left). The AD curve is unchanged. In the new long-run
equilibrium, output is lower and inflation is higher.
b. If the Fed responds to the oil price increase by tightening policy, the AD curve will shift
left, along with the leftward shift of both the AS and LRAS curves. Inflation will not
increase as much the long run, but the short-run decline in output could be even worse,
depending on how much the Fed tightens monetary policy. Output in the long run will
equal the new, lower level of potential output, whether the Fed responds or not
(monetary policy cannot affect potential output and thus cannot affect output in the
long run).
5. Working with the AD-AS model using equations, part 1:
a. In the short run, the equilibrium inflation rate and output level are given by the
intersection of the AD and AS curves. Algebraically, the short run equilibrium level of
output is found by substituting the current inflation rate into the AD equation. Doing
this, we have:
Y = 13,000 − 20,000π
Y = 13,000 − 20,000(0.04)
Y = 12,200
The economy has an expansionary gap since potential output is 12,000 and actual
output is 12,200.
b. In the long run, the equilibrium inflation rate and output level are given by the
intersection of the LRAS and AD curves. Algebraically, the long-run equilibrium inflation
rate is found by substituting the level of potential output (in this case, 12,000) into the
AD equation. Doing this, we have:
12,000 = 13,000 − 20,000π
− 1,000 = −20,000π
− 1,000
= π = 0.05 = 5%
− 20,000
6. Working with the AD-AS model using equations, part 2:
a. In the initial equilibrium inflation is 10%. Substituting into the AD curve,
Y = 1,000 - 1,000π
Y = 1,000 - 1,000(0.10)
Y = 900
The economy is experiencing a recessionary gap: current output (900) is less than
potential output (950). In the long run, the equilibrium output level is the level of
potential output, 950. The long run equilibrium inflation rate is found by substituting
potential output (in this case, 950) for Y in the AD curve equation and solving for the
inflation rate:
950 = 1000 − 1000π
− 50 = −1000π
− 50
= 0.05 = 5%
− 1000
b. The initial values for the inflation rate and the output level are listed below in the row
labeled “Quarter 0.” The resulting inflation rate and output level for each quarter (1
through 5) are listed. Note that in this example, “this quarter’s inflation rate” is
determined from last quarter’s inflation rate and the difference between actual and
potential output from the previous quarter (i.e. inflation occurs with a lag). Note that
over time the inflation rate appears to be converging on the long run equilibrium
inflation rate, 5%. Note also that the recessionary gap gets smaller each quarter as the
economy moves toward potential GDP.
Quarter
0
1
2
3
4
5
Inflation Rate
0.1000
0.0800
0.0680
0.0608
0.0565
0.0539
Y
900.000
920.000
932.000
939.200
943.520
946.112
Y*
950
950
950
950
950
950
Y –Y*
-50.000
-30.000
-18.000
-10.800
-6.480
-3.888
Chapter 26
Questions
1.
In the short run, a monetary tightening shifts the AD curve to the left. This reduces the both the
inflation rate and the short-run level of output. However, in itself this has little or no effect on
the inflation rate because of inflation inertia. Over time, as inflationary expectations are
reduced, the recessionary gap caused by the policy eventually causes inflation to decline, and it
will continue to fall until the economy returns to long-run equilibrium. At that point, actual
output has returned to potential and the inflation rate has been stabilized at the new, lower,
target inflation rate.
2.
An increase in taxes shifts the aggregate demand curve to the left. If the Fed does not change its
monetary policy rule, real GDP will fall, creating a recessionary gap and inflation will fall due to
the recessionary gap. Over time, the AS shifts to the right as inflationary expectations fall and,
as a result, actual inflation will begin to fall and output will return to potential.
The situation is different if the Fed chooses to adjust its target real interest rate to the new longrun real interest rate at which saving equals investment. Since taxes are higher, this implies that
government saving is higher (for a given level of government spending) and thus national saving
increases. This implies that, given a stable demand for investment, the long-run real interest
rate will be lower after the increase in taxes than it was before. Thus, the Fed needs to lower its
long-run target for the real interest rate, and to do this it must loosen monetary policy in
response to the tax increase. This will shift the AD curve to the right and offset some or the
entire leftward shift in AD caused by the tax increase. Output will eventually settle at its
potential level, but inflation will be higher than in the situation where the Fed does not adjust its
monetary policy rule.
3.
See Figures 26.4 and 26.5. The sudden increase in oil prices shifts the AS curve to the left and
the economy moves to a new equilibrium with higher inflation and a recessionary gap. At this
point if the Fed wants to avoid a recession, it can increase its target inflation rate, loosen
monetary policy, and shift the AD curve to the right. Output will return quickly to potential, but
inflation will be permanently higher. The initial increase in inflation following the supply shock
will be followed by a second round of inflation; in the second round, the initial increase in
inflation leads to a change in inflationary expectations. Workers and firms will then expect
prices to continue to rise, so they push for continued increases in wages and prices.
Consequently, the higher inflation rate will be sustained. (This process is shown in Figure 26.4.)
Alternatively, the Fed can prevent inflation from becoming permanently higher by maintaining
its original target inflation rate. By doing so, the Fed can preempt the second round of inflation
and prevent the bulge in inflation from becoming permanent. If the Fed does not change its
monetary policy, the AD curve does not shift and inflationary expectations will return to their
initial level. Inflation will return to its initial rate and real GDP will return to potential. (This is
shown in Figure 26.5.) In the interim, however, the economy may experience a recession. Thus
when there is an adverse supply shock, the Fed faces the "dilemma" of having to choose
between inflation and output stability.
4.
When people are confident that the Fed will maintain its original target inflation rate, their
inflationary expectations will not change even if actual inflation rises temporarily. When this is
the case we say that inflationary expectations are anchored. The importance of anchored
inflationary expectations is clear when there is an adverse supply shock. In this case, people
with anchored inflationary expectations believe that the Fed will act to ensure that inflation
quickly falls back to its initial level. Workers will then be less likely to ask for inflationary wage
increases and firms will be less likely to raise prices. (See Figure 25.7 for a review of this
process.) The second round of inflation will be eliminated, the AS curve will shift back to its
original position, and output will return to potential more quickly. Because any recession will be
shorter if inflationary expectations are anchored, the Fed will also be comfortable keeping its
target inflation rate unchanged.
Problems
1. Effects of a looser monetary policy:
a. The AD curve will shift to the right.
b. See Figure 26.2; note that in this case, loosening monetary policy shifts the AD curve to
the right. This causes output to increase from Y1 to Y2. This opens an expansionary gap
and causes the inflation rate to rise from π1 to π2. Inflation is now above its expected
rate, so inflationary expectations will rise and this will shift the AS curve to the left, from
AS1 to AS2. Output will return to potential (Y1) but inflation will be higher than it was
initially, i.e. inflation rises to π3.
2. Monetary policy and the effects of a favorable supply shock:
a. The AS curve shifts to the right in the short run. This is shown in both graphs below as
the shift from AS1 to AS2.
b. See the graph below. If the Fed accommodates the favorable supply shock, they will
tighten monetary policy, shifting the AD curve to the left (from AD1 to AD2). Output
returns to potential (Y1) and inflation is at the new, lower level of π3.
c. See the graph below. If the Fed does not accommodate the favorable supply shock,
then the AD curve will not shift; output will rise to Y2 and inflation will fall to π2 in the
short run. However, since the Fed has not changed its monetary policy rule, expected
inflation will remain at π1 and the AS curve will shift back from AS2 to AS1. Output will
return to potential and inflation will return to its original level, π1.
4. Dealing with simultaneous shocks to AD and AS:
a. The decline in consumer spending shifts the AD curve to the left.
b. See graph below. If the Fed does not change its monetary policy rule, the AD curve will
shift to the left, shown in the graphs below as the shift from AD1 to AD2.
c. Adding the AS shock:
i. The adverse inflation shock shifts the AS curve to the left, shown in the graphs below
as the leftward shift from AS1 to AS2.
ii. The Fed’s dilemma: let’s first suppose that the Fed does not change its monetary
policy rule. The result is shown in the figure below:
The economy
begins at
output level Y1
and inflation
rate π1. In the
short run, if the
Fed does not
change its
monetary
policy rule, the
economy will
end up with
output falling
to Y2 and
inflation
remaining at π1. (Notice that inflation could actually rise above π1, depending how
big are the relative shifts in AD and AS.) The economy goes into a deep recession as
the Fed does nothing in response to the decline in house prices and then raises
interest rates in response the inflation shock. In the long run, however, inflation
falls as inflationary expectations fall and shift the AS curve from AS2 to AS3. The
economy therefore experiences a deep recession, but returns to potential with a
lower long-run inflation rate (π2).
Now, suppose that the Fed loosens monetary policy in response to the decline in
house prices. Instead of remaining at AD2, as in the graph above, the AD curve will
shift to the right, back towards AD1. This will reduce the severity of the recession,
but the side effect will be to push up the inflation rate. As shown in the graph
below, if the Fed completely offsets the effects of the house price decline by shifting
the AD curve back to AD1, then inflation will rise to π2 in the short run but the fall in
output will be
smaller.
Eventually,
output will
return to
potential and
the inflation rate
will return to its
original rate.
The Fed is
clearly in a
difficult
position. If it
does not change
its monetary
policy rule, the decline in output will be larger than if it had loosened monetary
policy; however, if the recession is short, the economy will benefit in the long run by
having a lower inflation rate. On the other hand, if it accommodates the decline in
house prices, the recession may be milder at the cost of higher inflation in the short
run. Unfortunately, this was exactly the situation that the Federal Reserve faced in
2007 and 2008.
Chapter 19
Questions
1. Since 1870 real GDP per person has grown more than tenfold in the U.S. and many other
industrial countries; and by 25-fold in Japan. These large increases in output per person
have led to substantial increases in the material standard of living of the average person in
these countries. By contrast, growth has been much slower in countries such as Ghana,
which has led to a widening gap in standards of living between the high-income and lowincome countries.
2. Average labor productivity times the share of the population that is employed equals real
GDP per person. Real GDP per person is a basic determinant of long-run living standards.
The share of the population that is employed can only rise so far, given the fact that there
are always children, retired people, etc. Thus, large long-term gains in real GDP per person,
and hence living standards, must come from increases in average labor productivity.
3. Human capital is the talents, education, training, and skills of workers. Human capital is
important because workers with more human capital are more productive, implying higher
levels of output per worker and higher living standards. New human capital is created
through “investment in people”, as when individuals spend time and money acquiring an
education, or an employer devotes resources to training workers.
4. To get the most output (in terms of ditches dug), you should give the first shovel to the
strongest worker, the next shovel to the second strongest worker, and so on until you run
out of shovels. Because a stronger worker can make better use of a shovel than a worker
who weaker, this strategy is consistent with the Low-Hanging Fruit Principle: limited
resources should be devoted first to their most productive uses. Since workers without
shovels produce nothing, the more shovels you have, the more total output and output per
worker will be produced; thus extra capital (shovels) enhances average labor productivity.
However, because an extra shovel will be used by a worker who is weaker than those who
already have shovels, the extra output made possible by each additional shovel is declining,
which is what is meant by the term “diminishing returns to capital.”
5. Economists generally agree that the resurgence in productivity growth since 1995 was the
product of rapid technological progress, driven primarily by increased investment in new
information and communication technologies (ICT). Economists base this hypothesis on
evidence that growth in industries that either produce or use ICT experienced acceleration
in productivity while there was no acceleration in those industries that neither produce nor
use much ICT.
6. Entrepreneurs are people who create new business enterprises. By combining workers with
new and more productive technologies or by having the same workers produce more highly
valued products and services, entrepreneurs increase the productivity of any given set of
workers. Effective managers (who oversee the day-to-day operations of businesses) also
increase productivity, through activities such as improving the organization of production,
finding the best matches of workers and jobs, obtaining necessary financing, and
coordinating the firm’s activities and needs with those of its suppliers and customers.
7. Policies that governments can use to promote growth include the following:
• encouraging the development of human capital (for example, by support of
education);
• encouraging high rates of saving and investment (for example, through tax breaks);
• making public investments in infrastructure (such as highways, bridges, and
communications networks);
• supporting basic research.
• Providing a political and legal environment conducive to growth, including a stable
political system, well-defined property rights, free and open exchange of ideas, and
a tax and regulatory system favorable to entrepreneurship and other economically
productive activities.
8. Environmental fragility and limited resources may impose limits on the expansion of current
types of economic activities (e.g. more and more cars, more and more coal-fired power
plants.) Global environmental problems, such as global climate change, are not handled
very well by the market or by individual national governments and are definitely cause for
concern. However, there are reasons to believe that that the “limits to growth” thesis may
be overstated. These include, but are not limited to, the following:
• Economic growth includes the development of better and more efficient products
and services, which may be less taxing on the environment than current products;
• economic growth provides additional resources that can be used to help protect the
environment;
• market mechanisms will tend to alleviate shortages of resources by dampening
demand and encouraging supply, as happened in the 1970s energy crisis and seems
to be happening today (2008) as oil prices rise..
Problems
1. After one year, Richland’s real GDP per person equal $10,000*(1.01), after two years it
equals $10,000*(1.01)*(1.01) = $10,000*(1.01)2, and so on. After ten years, Richland’s GDP
per person equal $10,000*(1.01)10 = $11,046, and after twenty years it equals
$10,000*(1.01)20 = $12,202.
Poorland’s GDP per person after ten years is $5,000*(1.03)10 = $6,720, and after twenty
years it equals $5,000*(1.03)20 =$9,031. Thus, Poorland has gone from half the level of
income of Richland to about three-quarters the level in Richland in twenty years.
Suppose that GDP per person in Richland and Poorland are equal after t years; our
objective is to find t. After t years Poorland’s GDP per person is $5,000*(1.03)t, and
Richland’s GDP per person is $10,000*(1.01)t. Setting these two expressions equal, and
dividing both sides by $5,000, we get
(1.03)t = 2*(1.01)t
By solving the above equation for t (algebraically, graphically, or by trial and error), we find
that Poorland catches up in between 35 and 36 years.
6. Productivity in check-out lines:
a. With four employees and two lanes, both lanes have a checker and a bagger. Total
80 customers per hour
output is 80 customers per hour. Average labor productivity is
=
4 workers
20 customers per hour per worker.
b. A bagger increases output by 15 customers per hour (the difference between the 40
customers serviced by a checker and a bagger and the 25 customers served by a checker
alone.) If there is an empty lane available, a checker working alone increases output by
25 customers. So the best strategy is to take one of the baggers and make him or her a
checker in the new lane. Total output is then 90 customers per hour (40 for the checker
and bagger plus 25 for each checker working alone) and average labor productivity is
22.5 customers per hour. Note that adding capital (the extra lane) increases both total
output and average labor productivity.
c. With four lanes, all four employees become checkers. Total output is 100 customers
and average labor productivity is 25 customers per hour. Because there are only four
employees, a fifth lane adds no output (average labor productivity remains 25
customers per hour). We therefore do observe diminishing returns to capital, at least
for the fifth lane: Adding a third lane increased output by 10 customers per hour, as did
adding a fourth lane. However, adding a fifth lane does not increase output further.
8. Productivity in fishing:
a. Zero, as that will allow her stock of fish to double by next year.
b. Maximizing the growth of her stock of fish has the disadvantage that it allows Hester no
current income to spend. In other words, Hester can have the benefit of a very high
income and consumption next year only at the cost of starving herself this year.
Analogously, the more a country is willing to “starve itself” this year, by saving and
investing its resources in new capital goods rather than consuming, the faster it will
grow.
c. To maximize her current income Hester should sell all her fish this year, realizing $5000.
The problem with this strategy is that it leaves no source of income for the future.
d. If Hester harvests none of her fish this year, she has no income this year; and if she
harvests all of her fish this year, she has no income next year. Having very low or zero
income in either year is very unpleasant for Hester. A better choice is to sell some fish
this year, allowing for a reasonable level of current income and consumption, while
leaving enough fish in the hatchery to provide for reasonable income in the future as
well. In the same way, a country should choose a rate of economic growth that
balances the cost of sacrificing consumption today against the benefits of higher income
and consumption in the future.