© 2013 Pearson
The Short-Run
Policy Tradeoff
31
CHECKPOINTS
© 2013 Pearson
Click on the button to go to the problem
Checkpoint 31.1 Checkpoint 31.2
Checkpoint 31.3
Problem 1
Problem 1
Clicker
version
Problem 2
Problem 2
Problem 2
Clicker
version
Problem 3
Problem 3
Problem 3
Problem 4
Problem 4
In the news
Problem 5
In the news
Problem 1
In the news
© 2013 Pearson
CHECKPOINT 31.1
Practice Problem 1
The table describes 5 possible
outcomes for 2012 depending
on the level of aggregate
demand in that year.
Potential GDP is $10 trillion,
and the natural unemployment
rate is 5 percent.
Calculate the inflation rate for
each possible outcome.
© 2013 Pearson
CHECKPOINT 31.1
Solution
The inflation rate equals the
price level minus 100.
So for A, the inflation rate is
102.5 – 100 = 2.5 percent.
So for B, the inflation rate is
105.0 – 100 = 5 percent.
Calculate the other inflation
rates in the same way.
© 2013 Pearson
CHECKPOINT 31.1
Practice Problem 2
The table describes 5 possible
outcomes for 2012, depending
on the level of aggregate
demand in that year.
Potential GDP is $10 trillion,
and the natural unemployment
rate is 5 percent.
Use Okun’s Law to find real
GDP at each unemployment
rate in the table.
© 2013 Pearson
CHECKPOINT 31.1
Solution
Okun’s law is that
the output gap = –2 x (U – U*),
where U is the unemployment
rate and U* is the natural
unemployment rate.
For example, for A,
the output gap = –2 x (9 – 5) = –8,
which means that real GDP is 8
percent below potential GDP.
Real GDP is $9.2 trillion.
© 2013 Pearson
Potential GDP is $10 trillion,
and the natural unemployment rate is 5 percent.
CHECKPOINT 31.1
Okun’s law is that
the output gap = –2 x (U – U*),
where U is the unemployment
rate and U* is the natural
unemployment rate.
For example, for D,
the output gap = –2 x (4 – 5) = 2,
which means that real GDP is 2
percent above potential GDP.
Real GDP is $10.2 trillion.
© 2013 Pearson
Potential GDP is $10 trillion,
and the natural
unemployment rate is 5
percent.
CHECKPOINT 31.1
Practice Problem 3
The table describes 5 possible
outcomes for 2012, depending
on the level of aggregate
demand in that year.
Potential GDP is $10 trillion,
and the natural unemployment
rate is 5 percent.
What are the expected price
level and the expected inflation
rate in 2012?
© 2013 Pearson
CHECKPOINT 31.1
Solution
The expected price level is the
price level at full employment—
the economy is at full
employment.
The expected price level is 106
in row C.
The expected inflation rate is 6
percent a year.
© 2013 Pearson
Potential GDP is $10 trillion,
and the natural
unemployment rate is 5
percent.
CHECKPOINT 31.1
Practice Problem 4
The table describes 5 possible
outcomes for 2012, depending
on the level of aggregate
demand in that year.
Plot the short-run Phillips curve
for 2012 and mark the points A,
B, C, D, and E that correspond
to the data in the table.
© 2013 Pearson
Potential GDP is $10 trillion,
and the natural unemployment
rate is 5 percent.
CHECKPOINT 31.1
Solution
The short-run Phillips curve
plots the inflation rate against
the unemployment rate.
The figure shows the short-run
Phillips curve.
© 2013 Pearson
CHECKPOINT 31.1
Practice Problem 5
The table describes 5 possible
outcomes for 2012, depending
on the level of aggregate
demand in that year.
Plot the aggregate supply curve
for 2012 and mark the points A,
B, C, D, and E that correspond
to the data in the table.
© 2013 Pearson
Potential GDP is $10 trillion,
and the natural unemployment
rate is 5 percent.
CHECKPOINT 31.1
Solution
Plot the price level against real
GDP to draw the AS curve.
At A, the price level is 102.5 and
real GDP is $9.2 trillion (8 percent
below potential GDP of $10 trillion).
© 2013 Pearson
CHECKPOINT 31.1
In the news
Canada’s inflation rises and unemployment falls
After two months of little change, inflation rose to 3.1
percent a year in September and pushed the
unemployment rate down to 7.1 percent.
Source: TradingEconomics.com, October 7, 2011
With expected inflation steady at 2.5 percent a year, did
the economy move along its short-run Phillips curve? Or
did the economy move off its short-run Phillips curve?
© 2013 Pearson
CHECKPOINT 31.1
Solution
With the expected inflation rate steady at 2.5 percent a
year, the increase in inflation was unexpected.
The Canadian economy remained on its short-run Phillips
curve and moved leftward up along it as the inflation rate
rose and the unemployment rate.
© 2013 Pearson
CHECKPOINT 31.2
Practice Problem 1
The figure shows a short-run
Phillips curve and a long-run
Phillips curve.
Identify the curves and label
them.
What is the expected inflation
rate and what is the natural
unemployment rate?
© 2013 Pearson
CHECKPOINT 31.2
Solution
The long-run Phillips curve is the
vertical curve, LPRC.
The short-run Phillips curve is the
downward-sloping curve SPRC0.
The expected inflation rate is the
inflation rate at which LPRC and
SPRC0 intersect—5 percent a a
year.
The LPRC is vertical at the natural
unemployment rate—6 percent.
© 2013 Pearson
CHECKPOINT 31.2
Practice Problem 2
The figure shows a short-run
Phillips curve and a long-run
Phillips curve.
If the expected inflation rate
increases to 7.5 percent a year,
show the new short-run and
long-run Phillips curves.
© 2013 Pearson
CHECKPOINT 31.2
Solution
If the expected inflation rate
increases to 7.5 percent a year,
the SRPC curve shifts upward to
intersect the LRPC curve at 7.5
percent a year,
but the long-run Phillips curve
does not change.
© 2013 Pearson
CHECKPOINT 31.2
Practice Problem 3
The figure shows a short-run
Phillips curve and a long-run
Phillips curve.
If the natural unemployment
rate increases to 8 percent,
show the new short-run and
long-run Phillips curves.
© 2013 Pearson
CHECKPOINT 31.2
Solution
An increase in the natural
unemployment rate shifts the
long-run Phillips curve rightward.
The short-run Phillips curve shifts
rightward so that it intersects the
LRPC curve at the expected
inflation rate and the higher
natural unemployment rate.
© 2013 Pearson
CHECKPOINT 31.2
Practice Problem 4
The figure shows a short-run
Phillips curve and a long-run
Phillips curve.
Aggregate demand starts to
grow more rapidly, and
eventually the inflation rate
rises to 10 percent a year.
How do unemployment and
inflation change?
© 2013 Pearson
CHECKPOINT 31.2
Solution
The figure shows that as inflation
expectations rise above 7.5
percent a year, the inflation rate
rises and unemployment
decreases.
As expectations rise closer to 10
percent a year, unemployment
starts to increase.
When the expected inflation is 10
percent a year, unemployment is
at the natural unemployment rate.
© 2013 Pearson
CHECKPOINT 31.2
In the news
From the Fed’s minutes
The Fed expects the unemployment rate will drop from
9.8 percent today to 9.25 percent by the end of 2010 and
to 8 percent by the end of 2011. Private economists
predict that the unemployment rate won’t drop to a more
normal 5 or 6 percent until 2013 or 2014. Inflation should
stay subdued, but the Fed needs to keep its eye on
inflation expectations.
Source: The New York Times, October 14, 2009
Is the Fed predicting that the U.S. economy will move
along a short-run Phillips curve or that the short-run
Phillips curve will shift through 2011?
© 2013 Pearson
CHECKPOINT 31.2
Solution
If inflation remains subdued and inflation expectations do
not change, the economy is on a short-run Phillips curve
at a point to the right of the LRPC.
The economy is predicted to move leftward up along the
SRPC toward the LRPC.
© 2013 Pearson
CHECKPOINT 31.3
Practice Problem 1
The current inflation rate is 5 percent
a year.
The Fed announces that it will slow
the money growth rate so that
inflation will fall to 2.5 percent a year.
If no one believes the Fed and
expected inflation remains at 5
percent a year, explain the effect of
the Fed’s action on inflation and
unemployment next year.
© 2013 Pearson
CHECKPOINT 31.3
Solution
As the actual inflation rate falls
with no change in the expected
inflation rate, the
unemployment rate increases
as the economy moves down
along its short-run Phillips
curve.
The long-run Phillips curve
does not change.
© 2013 Pearson
CHECKPOINT 31.3
Study Plan Problem
The inflation rate is 5 percent a year. The Fed
announces that it will slow the money growth rate so
that inflation will fall to 2.5 percent a year. If no one
believes the Fed and expected inflation remains at 5
percent a year, then next year _________.
A. the inflation rate will fall, but the unemployment rate will not
change as the economy moves down the long-run Phillips curve
B. the inflation rate will fall, and the unemployment rate will increase
as the economy moves down the short-run Phillips curve
C. nothing will happen. It takes more than a year for unemployment
and inflation to begin to respond to a slowdown in money growth
D. the unemployment rate will increase, but inflation will not change
© 2013 Pearson
CHECKPOINT 31.3
Practice Problem 2
The current inflation rate is 5
percent a year.
The Fed announces that it will
slow the money growth rate so
that inflation will fall to 2.5 percent
a year.
If everyone believes the Fed,
explain the effect of the Fed’s
action on inflation and
unemployment next year.
© 2013 Pearson
CHECKPOINT 31.3
Solution
Because people believe the Fed
the expected inflation falls to 2.5
percent a year.
The short-run Phillips curve shifts
downward to SPRC1.
The inflation rate falls to 2.5
percent a year, and unemployment
remains at 6 percent.
© 2013 Pearson
CHECKPOINT 31.3
Study Plan Problem
The inflation rate is 5 percent a year. The Fed announces
that it will slow the money growth rate so that inflation will
fall to 2.5 percent a year. If everyone believes the Fed,
then next year ___________.
A. the inflation rate will fall and the unemployment rate will increase in
a movement down the short-run Phillips curve
B. the unemployment rate will increase, but inflation will not change
C. the inflation rate will fall to 2.5 percent a year, but unemployment
will not change as the economy moves down the long-run Phillips
curve. The short-run Phillips curve shifts downward
D. nothing will happen. It takes more than a year for unemployment
and inflation to begin to respond to a slowdown in money growth
© 2013 Pearson
CHECKPOINT 31.3
Practice Problem 3
The current inflation rate is 5
percent a year.
The Fed announces that it will slow
the money growth rate so that
inflation will fall to 2.5 percent a year.
If no one believes the Fed, but the
Fed keeps inflation at 2.5 percent for
many years, explain the effect of the
Fed’s action on inflation and
unemployment.
© 2013 Pearson
CHECKPOINT 31.3
Solution
Initially, inflation falls below
5 percent a year and
unemployment rises above
6 percent.
The longer the Fed maintains
the slower money growth rate,
the more people will start to
expect lower inflation and the
short-run Phillips curve will start
to shift downward.
© 2013 Pearson
CHECKPOINT 31.3
The unemployment rate will
start to decrease.
Eventually, inflation is 2.5
percent a year and the
unemployment rate returns
to 6 percent.
© 2013 Pearson
CHECKPOINT 31.3
Practice Problem 4
FOMC Press Release, September 21, 2011
The FOMC anticipates a slow growth in the context of
price stability and substantial resource slack will keep
inflation subdued for some time.
Source: Board of Governors of the Federal Reserve System
Where on the short-run Phillips curve does the Fed
believe the economy to be?
What is the Fed anticipating will happen to the short-run
Phillips curve?
© 2013 Pearson
CHECKPOINT 31.3
Solution
With substantial resource slack, the Fed believes that the
economy is at a point on the short-run Phillips curve where
the unemployment rate is above the natural
unemployment rate and the inflation rate is below the
expected inflation rate.
That is, on the SRPC to the right of the LRPC.
The Fed anticipates that the SRPC will shift downward
and inflation rate will fall.
© 2013 Pearson