EC102 Last Third Info
Which of the following statements is correct?
A. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment. B. In the long run, a higher or lower inflation rate has no effect on the unemployment rate. C. In the long run, a higher or lower price level has no effect on real GDP. D. All of the above.
b. Point D on the Phillips curve graph represents the same economic situation as point C on the aggregate demand and aggregate supply graph.
D
Workers generally form their expectations of future inflation based on the current conditions in the economy. Which one of the following does not reflect how they form their expectations?
During periods of high inflation, people do not take any particular action until the Fed has controlled the inflation rate.
a. Point ▼ D E neither D nor E on the Phillips curve LOADING... graph represents the same economic situation as point B on the aggregate demand and aggregate supply graph.
E
An article in the Economist magazine contains the following: "Robert Lucas . . . showed how incorporating expectations into macroeconomic models muddled the framework economists prior to the 'rational expectations revolution' thought they saw so clearly." Source: "How to Know What Causes What," Economist, October 10,2011. What economic framework did economists change as the result of Lucas's arguments?
Economists changed the theory of "adaptive expectations" where people assume that future rates of inflation will follow the past rates of inflation.
As of 1993, the Fed sets targets for which of the following in order to achieve price stability and high employment?
Federal funds rate
Why doesn't the Phillips curve represent a permanent trade-off between unemployment and inflation in the long run?
In the long run, aggregate supply is vertical.
General Juan Peron, the former dictator of Argentina, once said of the labor market in his country, "Prices have gone up the elevator, and wages have had to use the stairs." Source: Robert J. Shiller, "Why Do People Dislike Inflation?" in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and Strategy, Chicago: University of Chicago Press, 1997. In this situation, real wages in Argentina were
In this situation, real wages in Argentina were falling . Unemployment was likely to have been relatively low .
Why do most economists believe that it is important for a country's central bank to be independent of the rest of the country's central government?
Independent central banks are more effective at fighting inflation.
When SRAS 1 shifts to SRAS 2, the price level increases and the level of real GDP falls. What happens to the short-run Phillips curve when the short-run aggregate supply curve shifts (a supply shock)?
It shifts up such that a given level of unemployment occurs at a higher price level.It
Which of the following statements concerning the Phillips curve is correct?
Many economists and policymakers in the 1960s viewed the Phillips curve as a structural relationship.
Most economists in 1968 ▼ would would not have agreed with him because they ▼ believed in the stable trade-off relation manifested in the Phillips curve. knew about the long-run Phillips curve. distinguished between the short-run and the long-run Phillips curves.
Most economists in 1968 would not have agreed with him because they believed in the stable trade-off relation manifested in the Phillips curve.
How can the Fed fight a combination of rising unemployment and rising inflation?
Not easily; neither expansionary nor contractionary monetary policy can solve both problems simultaneously.
In the figure to the right, at what point is the inflation rate stable? That is, at what point can we refer to the inflation rate as the nonaccelerating inflation rate of unemployment LOADING...?
Point C
Which of the following statements is true about the Fed under the leadership of Chairman Alan Greenspan between 1987 and 2006?
The Fed attempted to enhance its credibility by announcing its monetary policy action at the conclusion of each FOMC meeting.
Which of the following decisions does the textbook discuss as an action by the Fed during Chairman Alan Greenspan's term that possibly contributed to the financial crisis of 2007-2009?
The Fed's decision to keep the target for the federal funds rate at 1 percent for more than 18 months after the end of the 2001 recession.
The short-run Phillips curve exhibits ▼ , whereas the long-run Phillips curve shows ▼ .
The short-run Phillips curve exhibits a trade-off between inflation and unemployment , whereas the long-run Phillips curve shows no trade-off between inflation and unemployment .
Suppose that the expected inflation rate increases from 4 percent to 6 percent. What will happen to the short-run Phillips curve?
The short-run trade-off between unemployment and inflation will be worse than before as the economy moves to a higher short-run Phillips curve.
Indicate the two main objections to the idea that the short-run Phillips curve is vertical.
Workers and firms might not have rational expectations. Contracts with workers keep wages sticky.
[Related to Solved Problem #4] Suppose the inflation rate has been 15 percent for the past four years. The unemployment rate is currently at the natural rate of unemployment of 5 percent. The Federal Reserve decides that it wants to permanently reduce the inflation rate to 5 percent. To do this, the Fed would use ▼ a contractionary an expansionary policy.
a contractionary
In an opinion column in the Wall Street Journal, Stanford University economist John Taylor, originator of the Taylor rule, argued, "As I see it, the broader evidence in the United States and in many other countries ... is that a rules-based policy has worked and that discretionlong dashconstrained or otherwiselong dashhas not." Source: John B. Taylor, "Taylor on Bernanke: Monetary Rules Work Better Than 'Constrained Discretion'," Wall Street Journal, May 2, 2015. When Taylor refers to a "rules-based policy," he means
a formulaic strategy for targeting the money supply and the federal funds rate.a
Economists who believed that the Phillips curve represented a structural relationship LOADING... believed that the curve represented
a permanent trade-off between unemployment and inflation.
In a real business cycle model, which of the following best explains an increase in real GDP above the full-employment level?
a positive technology shocka
The "Volcker disinflation" was
a significant reduction in the inflation rate between 1979 and 1989, under the leadership of Fed Chairman Paul Volcker.
Above are four graphs, and below are four economic scenarios, each of which would cause either a movement along the short-run or long-run Phillips curve or a shift in the short-run or long-run Phillips curve. Match each scenario with the appropriate graph.
a. The proportion of younger and less skilled workers in the labor force decreases. 3 b. The Fed carries out an expansionary monetary policy 4 c. Congress enacts significant new legal barriers to firing workers 1 d. Workers and firms lower the inflation rate they expect 2
If General Motors and the United Auto Workers (UAW) union fail to accurately forecast the inflation rate, the real wage will be different than the company and the union had expected. The company and the union sign long-term contracts rather than negotiate a new contract each year because each party believes that the
actual inflation rate will be equal to their expected inflation rate in the long term.
If actual inflation is higher than expected inflation, the
actual real wage is less than the expected real wage: unemployment falls.
Alan Greenspan
agreed with Paul Volcker about the importance of keeping inflation low.
If Lucas and Sargent were right,
an expansionary monetary policy would not work if people had rationalan expectations, since they will use all available information including knowledge of the effects of the Fed's monetary policy.
If the Federal Reserve keeps monetary policy unchanged, eventually the unemployment rate will be:
back to the 5% natural rate of unemployment.
When Burns refers to "the current environment," he means the 1970s, a period in which
both inflation and unemployment worsened.
During the 1980s and 1990s, the relationship between growth in M2 and inflation
brokebr down, and the Fed announced that it would no longer set targets for M2.
The concept of a nonaccelerating inflation rate of unemployment (NAIRU) helps us to understand why in the long run, the Federal Reserve
can affect the inflation rate but not the unemployment rate.
If the long-run aggregate supply curve is vertical, then the Phillips curve
cannot be downward sloping in the long run.
When Robert Shiller asked a sample of the general public what they thought caused inflation, the most frequent answer he received was "greed." Most economists would argue that inflation is caused by
changes in both aggregate demand and aggregate supply.ch
While many economists and policymakers supported the Fed's decision to maintain the federal funds rate at a near-zero level for over six years, Charles Schwab, the founder and chairman of a discount brokerage firm that bears his name, argued that the economy was harmed by keeping interest rates low for an extended period of time: U.S. households lost billions in interest income during the Fed's near-zero interest rate experiment. ... Because they are often reliant on income from savings, seniors were hit the hardest. ... Seniors make up 13% of the U.S. population and spend about $1.2 trillion annually. ... This makes for a potent multiplier effect. Source: Charles R. Schwab, "Raise Interest Rates, Make Grandma Smile," Wall Street Journal, November 19, 2014. If the Fed had raised interest rates earlier than it did, Schwab would have expected
consumer spending to have increased.
If the board had kept its estimate fixed at 5.5 percent during a period when the actual NAIRU was lower, monetary policy would have been too
contractionary in an effort to increase the unemployment rate.
An opinion column in the Wall Street Journal notes, "In a democracy, the tradeoff for a central bank's independence is accountability to the nation's elected leadership." Source: David Wessel, "Explaining 'Audit the Fed'," Wall Street Journal, February 17, 2015. A country would want to grant its central bank more independence than it grants, say, its department of agriculture or department of education, because the central bank
controls the money supply, and the more independent the central bank, the lower is the likelihood of inflation.
In 1968, Herbert Stein, who would later serve on President Nixon's Council of Economic Advisors, wrote, "Some who would opt for avoiding inflation would say that in the long run such a policy would cost little, if any, additional unemployment." Source: Herbert Stein, The Fiscal Revolution in America, Chicago: University of Chicago Press, 1969, p. 382. Stein's statement was ▼ correct incorrect .
correct
Higher interest rates would have
decreased investment spending by firms and home purchases.de
Look again at the chart on prices during the early 1930s: Year Consumer Price Index %-Change in Prices 1929 17.1 minus 1930 16.7 minus2.3% 1931 15.2 minus9.0 1932 13.7 minus9.9 1933 13.0 minus5.1 Which of the following terms best describes the situation during 1933?
deflation
In a speech in September 1975, then Fed chairman Arthur Burns said the following: "There is no longer a meaningful trade-off between unemployment and inflation. In the current environment, a rapidly rising level of consumer prices will not lead to the creation of new jobs...Highly expansionary monetary and fiscal policies might, for a short time, provide some additional thrust to economic activity. But inflation would inevitably accelerate- a development that would create even more difficult economic problems than we have encountered over the past year." Source: Arthur F. Burns, "The Real Issues of Inflation and Unemployment," in Federal Reserve Bank of New York, Federal Reserve Readings on Inflation, February 1979. Burns's views in this speech are ▼ similar to different than the views at the Fed in the late 1960s.
different than
A significant reduction in the inflation rate is called
disinflation.
If the board had kept its estimate fixed at 5.5 percent during a period when the actual NAIRU was higher, monetary policy would have been too
expansionary in an effort to decrease the unemployment rate
Robert Shiller asked a sample of the general public and a sample of economists the following question: "Do you agree that preventing high inflation is an important national priority, as important as preventing drug abuse or preventing the deterioration in the quality of our schools?" Fifty-two percent of the general public, but only 18 percent of economists, fully agreed. The general public believes that inflation is a bigger problem than economists do because the general public believes that real wages fall until a full inflation correction takes place .
fall until a full inflation correction takes place .
The Fed's "target policy rate" refers to the
federal funds rate.
In this case,
firms will hire fewer workers than they had planned to hire and employment will fall.
[Related to the Making the Connection] In an opinion column in the New York Times, economist Justin Wolfers of the University of Michigan noted, "Over recent years, policy makers have also worked to lower long-term interest rates by shaping expectations about future monetary policy decisions." Source: Justin Wolfers, "The Fed Has Not Stopped Trying to Stimulate the Economy," New York Times, October 29, 2015. An attempt to shape expectations about future policy decisions is what the Fed refers to as
forward guidance.
As a result of this policy, the unemployment rate will be greater than the natural rate of 5 percent and the inflation rate will be edging down slowly.
greater than down
An article in the Wall Street Journal has the headline "Don't Look Now, but Market Inflation Expectations Are Falling." Source: Jon Hilsenrath, "Don't Look Now, but Market Inflation Expectations Are Falling," Wall Street Journal, August 10, 2015. If inflation turns out to be lower than households and firms had previously expected, the actual real wage will end up being
higher than the expected real wage.
Slow growth in aggregate demand leads to
higher unemployment and lower inflation.
Workers, firms, banks, and investors in financial markets care about the future rate of inflation because
if actual inflation turns out to be different from the expected inflation, real wages, profits, and interest will be different from their expected values.
Such views are rare today because
in the long run there is no tradeoff between inflation and unemployment.in
If the unemployment rate is below the natural rate, the inflation rate tends to ___________, and eventually, the short-run Phillips curve will shift _______.
increase; up
As a result of the supply shock, the rate of inflation has increased .
increased
If this evaluation of the economic situation is correct, the Fed should consider
increasing its federal funds rate target.
An article in the New York Times in 2015 quoted Minneapolis Fed President Narayana Kocherlakota as stating that "disinflation is worrisome." However, most economists applaud the "Volcker disinflation" of the 1980s. Source: Reuters, "Fed's Kocherlakota Sees Risk of U.S. Disinflation," New York Times, April 14, 2015. Disinflation might have been a good thing in the 1980s, but worrisome in 2015, because
inflation was persistently high and the Fed was not credible in thein 1980s, but inflation was persistently low and the Fed was more credible in 2015.
The Fed appears to believe that the more "potent multiplier effect" is associated with
investment spending because it is more sensitive to lower interest rates.in
In referring to an "unfavorable foreign currency translation," the company meant that
it was more expensive for businesses around the world to purchase U.S. goods because of changes in the exchange rate.it
Many Fed officials have been opposed to adopting a rules-based policy because
it would reduce the ability of the Fed to respond rapidly to a financial crisis.
Further, the aggregate demand and aggregate supply model explicitly shows changes in the ▼ level of real GDP unemployment rate , while the Phillips curve explicitly shows the ▼ level of real GDP unemployment rate .
level of real GDP unemployment rate
A movement from point A to point C could be caused by
long run effects of contractionary monetary policy.lo
Prior to the U.S. dollar strengthening, Fed policy had been attempting to reach a point on the short-run Phillips curve representing
lower unemployment and higher inflation because the inflation rate had been below the Fed's target of 2 percent for more than three years.
In 2010, Congress passed the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) which
made it much more difficult for the Fed to use a too-big-to-fail policy.
The effect is
more likely if inflation is unanticipated because workers would not seek higher nominal wages.
In early 2015, an article in the Economist noted that it was possible that in the United States, "the NAIRU may already have been reached and inflation will start accelerating; the Fed should act soon." Source: "Jobs Matter, Not the Dollar," Economist, March 25, 2015. NAIRU is the
nonaccelerating inflation rate of unemployment.no
This approach works by
offering information about the policy outlook and expectations for the future path of the federal funds rate.of
A lower estimate of the natural rate of unemployment would lead the Fed to lower its target policy rate because the
output gap would increase.
An article in the Economist observes that "a sudden unanticipated spurt of inflation could lead to rapid economic growth." Source: "How We Got Here," Economist, January 21, 2013. This statement implies that there is a ▼ negative positive relationship between inflation and economic growth.
positive
Given that the Phillips curve is derived from the aggregate demand and aggregate supply model, why use the Phillips curve? The answer is that while the aggregate demand and aggregate supply model shows the ▼ price level inflation rate , the Phillips curve explicitly shows the ▼ price level inflation rate .
price level inflation rate
This statement in Goodyear's annual report illustrates the concern that many businesses had regarding the Federal Reserve's policy to
raise interest rates because the inflation rate was below the target rate.
In an article in Forbes, Paul Roderick Gregory, an economist at the University of Houston, commented on the use of monetary policy to fight a recession: "Those who devise stimulus programs must know in advance the extent to which households and businesses will correctly anticipate the policy. A policy that has been used x times in the past is unlikely to have a stimulative effect because it will be easily anticipated." Source: Paul Roderick Gregory, "Thomas Sargent, Rational Expectations And The Keynesian Consensus," Forbes, October 11, 2011. When Gregory says that the "policy ... is unlikely to have a stimulative effect because it will be easily anticipated," he indicates his belief that households and businesses have
rational expectations of inflation in which all available information is used in forming expectations.
Robert Lucas said: "In practice, it is much more painful to put a modern economy through a deflation than the monetary theory we have would lead us to expect. I take this to mean that we have 'price stickiness."' Source: Paul A. Samuelson and William A. Barnett, eds., Inside the Economist's Mind: Conversations with Eminent Economists, Malden, MA: Blackwell Publishing, 2007, p. 63. When Lucas made the comment about "the monetary theory we have," he meant the
rational expectations theory.ra
Models that use factors, such as technology shocks, to explain fluctuations in real GDP instead of changes in the money supply are called
real business cycle models.re
Economists during the early 1960s thought of the Phillips curve as a "policy menu" because they thought that the Phillips curve
represented a structural relationship in the economy that would not change as a result of policy changes.re
According to Milton Friedman, differences between the actual and expected inflation rates could lead the actual unemployment rate to
rise above or fall below the natural rate.
The unemployment rate
rose from 6% to 10% during the period of the Volcker disinflation.
As the public starts expecting a higher inflation rate, the short-run Phillips curve will ▼ not shift at all shift up and to the right shift down and to the left .
shift up and to the right
Consider the long-run Phillips curve and the short-run Phillips curve in the graph at right. A movement from point A to point B could be caused by
short run effects of contractionary monetary policy.
In macroeconomics courses in the 1960s and early 1970s, some economists argued that one of the U.S. political parties was willing to have higher unemployment in order to achieve lower inflation and that the other major political party was willing to have higher inflation in order to achieve lower unemployment. Such views of the trade-off between inflation and unemployment might have existed in the 1960s because the Phillips curve was widely viewed as
stable
Do all economists agree with Lucas's main conclusions about the effectiveness of monetary policy? Briefly explain. Many economists have remained skeptical of all the following, except
that there is ath short-run trade-off between unemployment and inflation.
In Congressional testimony, Federal Reserve Chairman Ben Bernanke said: "Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation." Source: "Testimony of Chairman Ben S. Bernanke before the Joint Economic Committee,U.S.Congress," March 28, 2007. When Federal Reserve Chairman Ben Bernanke said that the public's expectations of inflation could "become embedded in wage and price decisions," he meant
that workers, firms, consumers, and the government will all take the inflation rate into account when making decisions.
If, in the long run, real GDP returns to its potential level, then in the long run,
the Phillips curve is vertical.
The event that may have led him to conclude that it is more painful to reduce the inflation rate than theory would predict was
the Volcker disinflation.
If workers and firms have rational expectations and wages and prices adjust quickly, then if the Fed announces a credible expansionary monetary policy,
the inflation rate will increase, but the unemployment rate will be unchanged.
Milton Friedman argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation, since
the long-run Phillips curve is vertical, there is no trade-off between unemployment and inflation in the long run.
Cross-country evidence supports that the more independent a country's central bank,
the lower its inflation rate.th
Over time, the Federal Reserve Board of Governors has changed its estimate of the nonaccelerating inflation rate of unemployment (NAIRU). The following are the board's NAIRU estimates for selected years. Year NAIRU (percent) 1970 6.0 1980 6.4 1990 5.6 2000 5.1 2008 4.8 2011 6.0 2017 4.7 Source: Board of Governors of the Federal Reserve System. The board would change its estimate of the NAIRU over time when
the natural rate of unemployment changes as a result of demographic changes or changes in labor market institutions.th
In the United States, the Fed is held accountable to the nation's elected leadership through
the nomination and confirmationth process, and the requirement to submit semiannual reports on monetary policy and the economy to Congress.
Suppose that the inflation rate is increasing each year for a number of years, then
the rational expectations hypothesis is likely to give more accurate forecasts because if workers or firms have rationalth expectations, then they will use all the available information to forecast future inflation.
The Phillips curve exhibits
the relationship between the unemployment and the inflation rates.th
We can tell whether a monetary policy has worked by
the state of the economy.
Robert Lucas and Thomas Sargent argued that
there might not be a trade-off between unemployment and inflation in the short run, and the short-run Phillips curve would be vertical.
[Related to the Chapter Opener] In its 2014 Annual Report, Goodyear noted, "The increasing strength of the U.S. dollar created unfavorable foreign currency translation for many of our businesses around the world." Source: Goodyear Tire & Rubber Company, 2014 Annual Report, p. 3. In referring to the "increasing strength of the U.S. dollar," the company meant that
the dollar/foreign currency exchange rate had risen.
Friedman defined the "natural rate of unemployment" as the
unemployment rate that exists when the economy produces potential GDP.
If the Fed fails to act, it is likely that the short-run Phillips curve will shift
up over time as inflation up occurs, and workers and firms adjust to the higher inflation rate.
If workers and firms have rational expectations, they will
use all available information when forming their expectations of future inflation; thus, the actual inflation rate will be equal to the expected inflation rate.
If the Fed wants to move from a point on the short-run Phillips curve representing high unemployment and low inflation to a point representing lower unemployment and higher inflation, then it should
use expansionary monetary policy.
He concluded that the U.S. economy apparently had "price stickiness," because
wages and prices declined very slowly during the disinflation process. wa
Therefore, during the 1970s, there ▼ was was not a trade-off between unemployment and inflation.
was not
They were not correct to think of the Phillips curve as a "policy menu."
were not correct
A serious inconsistency exists between a vertical long-run aggregate supply curve and a downward-sloping long-run Phillips curve because
when the long-run aggregate supply curve is vertical at potential real GDP, the long-run Phillips curve is vertical at the natural rate of unemployment.
[Related to the Making the Connection] In 2015, an article in a publication of the Federal Reserve Bank of San Francisco noted, "FOMC participants have steadily lowered their estimates of the natural rate of unemployment ... over the past several years." The article also noted that "a lower natural rate of unemployment also implies a lower target policy rate." Source: Mary C. Daly, Fernanda Nechio, and Benjamin Pyle, "Finding Normal: Natural Rates and Policy Prescriptions," FRBSF Economic Letter, July 6, 2015. Members of the Federal Open Market Committee might have believed that the natural rate of unemployment was lower in 2015 than it had been several years earlier because
while unemployment had persisted for more than four years after the end of thewh 2007-2009 recession, it then began to decline.
Consider the graph on the right, where both the short-run and long-run Phillips curves are vertical. An expansionary monetary policy will increase the inflation rate continuously but will have no effect on the unemployment rate because of all the following except
workers and firms who have adaptive expectations will not consider the Fed's policy before forming their expectations about inflation.
There is a different short-run Phillips curve for every level of the ___________ inflation rate. The inflation rate at which the short-run Phillips curve intersects the long-run Phillips curve equals the ___________ inflation rate.
expected; expected
If expected inflation is higher than actual inflation, actual real wages in the economy will turn out to be _________ than expected real wages; consequently, firms will hire _________ workers than they had planned.
higher; fewer
A negative supply shock, such as the OPEC oil price increases of the early 1970s, can be illustrated by a shift to the ______________ of the short-run aggregate supply curve and a shift _________________ of the short-run Phillips curve.
left; up
After Fed Chairman Paul Volcker began fighting inflation in 1979, workers and firms eventually ____________ their expectations of future inflation, and the short-run Phillips curve shifted ___________.
lowered; down
The Phillips curve was developed by A.W. Phillips in 1957 and shows the relationship between unemployment and inflation. The curve, shown at the right, indicates what type of relationship between the two variables?
. Inverse relationship
If workers ignore inflation in forming their expectations of the real wage rate, what is the effect of an expansionary monetary policy?
A move up along the short-run Phillips curve.
What effect does expansionary monetary policy have on equilibrium if consumers have rational expectations LOADING...?
A movement from point A to point C.
What is the Fed doing to increase the credibility of its policies?
A. Announcing the federal funds target rate. B. Whenever a change in policy is announced, the change actually takes place. D. A and B only.
In the figure to the right, expected inflation is initially at 1.5%. When expected inflation increases to 4.5%, which of the following will occur?
A. At the natural rate of unemployment, inflation is 4.5%. B. Unemployment reaches the natural rate of 5%. C. To have 3.5% unemployment rate, inflation would be 7.5%. D. All of the above.
Paul Volcker is credited largely with which of the following?
A. Fighting inflation by reducing the growth of the money supply. B. The "Volcker disinflation." D. A and B only.
According to many economists and policymakers, what other options does the Fed have to improve its credibility with workers, firms, and investors?
A. Following the Taylor rule. B. Following a discretion strategy. C. Following a rules strategy. D. All of the above
