Ch10

Suppose that in scenario A the Fed cares only about keeping the price level stable and in scenario B the Fed cares only about keeping output and employment at their natural levels. Explain how in each scenario the Fed would respond to the following. a. An exogenous decrease in the velocity of money. b. An exogenous increase in the price of oil.

A decrease in velocity means that people desire to hold more money per dollar of income so money demand increases. This increase in money demand reduces spending and so shifts the AD curve to the left. If the Fed wants to stabilize output, it increases the money supply so that AD shifts back to the right. If the Fed wants to stabilize prices, which if the Fed does nothing will fall as the economy moves to long-run equilibrium, it should increase the money supply so that AD shifts back to the right. So, whether the Fed wants to stabilize output or prices it should increase the money supply. An increase in the price of oil means that the SRAS curve shifts up as firms raise prices in response to the increase in the costs of production. In the short run output falls and the price level rises. To move the economy back to long-run equilibrium, the Fed should increase the money supply which shifts the AD curve to the right and returns the economy to its natural level of output but at a permanently higher price level. If the Fed wants to stabilize prices, it does nothing. Prices will remain higher for a while, but eventually firms will lower prices and the SRAS will shift down to the original long-run equilibrium. However, while the economy is adjusting, it will be in recession.

A. Suppose that M=1,200, V=4, and P=10, what is Y? Now suppose that P rises to 12, and that M and V are fixed. Now what is Y? B. Is this change shown as a movement along the aggregate demand curve or a shift of the aggregate demand curve? How do we know?

A. MV = PY, so Y = MV/P = 4800/10 = 480 if P = 10, Y = 400 if P = 12 B. Shown as a movement along the aggregate demand curve because the price leavel is on the vertical axis of the aggregate demand curve.

A. Suppose that M = 1,200, V = 4, and P=10, what is Y? Now suppose that V falls to 3.5, what is Y? B. Does the decline in V mean that people want to hold more or less money per dollar of income? C. Would the direction of the change in Y be the same if we started at a different price level say 8 or 12? D. Is the effect of a decrease in the velocity shown as a movement along the curve or a shift of the curve? E How do we know?

A. Y = 4800/10 = 480, Y = 4200/10 = 420 B. V goes down if people want to hold more money C. The decrease in velocity reduces the aggregate quantity of goods and services demanded at each price level, so the curve shifts left. D. Velocity is not a variable on the axes

A. Suppose that M = 1,200, V = 4, and P = 10, what is Y? Now suppose that M rises to 1,400, what is Y? B. Would the direction of the change in Y be the same if we started at a different price level say 8 or 12? C. Is the effect of a change in the money supply shown as a movement along the curve or a shift of the curve? D. How do we know?

A. Y = 4800/10 = 480, Y = 5600/10 = 560 B. Yes, because for a given price level and increase in the money supply raises Y C. The curve shifts right D. Because at each price level, which is on the vertical axis, output is higher when the money supply is higher.

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. a. What happens to the aggregate demand curve? b. What happens to the level of output and the price level in the short run and in the long run? Give a precise numerical answer. c. In light of your answer to part b, what happens to unemployment in the short run and in the long run according to Okun's law? Again, give a precise numerical answer. d. What happens to the real interest rate in the short run and in the long run? Here, your answer should just give the direction of changes.

If the Fed decreases the money supply AD shifts left. In the short run prices are unchanged and real output is lower. When output is below its natural level, firms are producing less than they desire and will reduce prices. As they reduce prices, the SRAS curve shifts down. The SRAS curve continues to shift down until output returns to its natural rate where firms are producing the desired quantity. So, in the long run the price level falls by 5%, but real output is unchanged. In the short run as output falls, unemployment rises. In the long run output returns to it natural rate which is higher than in the short run and unemployment falls back to its natural rate which is lower than in the short run. If the Fed increases the money supply AD shifts right. In the short run prices are unchanged and real output is higher. When output is above its natural level, firms are producing more than they desire and will raise prices. As they raise prices, the SRAS curve shifts up. The SRAS curve continues to shift up until output returns to its natural level where firms are producing the desired quantity. So, in the long run the price level is higher, but real output is unchanged. In the short run as output rises, unemployment falls. In the long run output returns to it natural rate which is lower than in the short run and unemployment rises back to its natural rate which is higher than in the short run.

Suppose that aggregate demand shifts left. In the long run what does it matter if the Fed responds to this shock or not?

If the Fed responds both the price level and real GDP return to their original level. If it does not respond firms will eventually reduce their prices, the SRAS curve will shift down, and real GDP will return to its original level, but the price level will be lower than if the Fed responds.

If aggregate demand shift left what happens that moves the economy back to the long run? Do you think this happens because firms want to move the economy back to the long run, or because firms are each following their own self-interest?

In response to lower demand firms initially reduce production, but the decrease in marginal cost eventually results in firms reducing their prices. This is shown by shifting the SRAS curve down. Firms are pursuing self-interest. They are trying to maximize profits.

Explain the impact of an increase in the money supply in the short run and in the long run.

In the short run an increase in the money supply shifts the AD curve to the right. Since prices are sticky in the short run, producers increase production to meet increased demand. As output is above the natural rate, firms are producing more than they desire and so will raise their prices. The increase in prices is shown by shifting the SRAS curve up and so moving along the AD curve to the left. As prices rise the aggregate quantity of output demanded falls. The SRAS curve continues shifting up until the economy has reached long-run equilibrium. So, output returns to its natural rate and the price level is higher.

List two leading economic indicators given in the text but not the notes. (for Ch 10)

Index of supplier deliveries, money supply M2, difference between the interest rate on a 10 year Treasury note and a 3 month Treasury bill

Which declines by a larger percentage during recessions, consumption or investment?

Investment

Why is it easier for the Fed to deal with demand shocks than with supply shocks?

It is easier for the Fed to deal with demand shocks than with supply shocks, because monetary policy affects the AD curve. So, monetary policy can shift the AD curve back towards long-run equilibrium which moves both prices and output back to their original level. Supply shocks, created by changes in the cost of production, move the SRAS curve along the AD curve and so move price and output in the opposite directions. So there is no way for the Fed to return both output and the price level to their original values. If, for example, the Fed wishes to stabilize output in response to an adverse supply shock it would increase the money supply to shift AD right. This accommodative policy moves output back toward its natural rate, but keeps the price level permanently higher. If the Fed does nothing, the economy is below the natural rate which creates downward pressures on prices. As prices fall the SRAS curve shifts down and the economy returns to the natural rate of output at its original price level.

In this chapter what do we assume about firms' response to changes in demand in the short run? What does this imply about the slope of the short-run aggregate supply curve?

No firm changes their price in the short run The SRAS is horizontal

Which if either is consistent with monetary neutrality, the short-run aggregate supply curve or the long-run aggregate supply curve?

Only the long-run aggregate supply curve

What is the advantage and what is the disadvantage of accommodative monetary policy in response to an adverse supply shock?

The advantage is that output and unemployment move back more quickly to their natural rates. The disadvantage is that the price level rises. While it is rising, there is inflation.

What determines the position of the long-run aggregate supply curve? Is the position of the LRAS curve determined by the money supply? If the price level rises what happens to the quantity of goods and services supplied in the long run?

The amounts of available capital, labor, and technology, and institutions No There is no change

When real GDP declines during a recession, what typically happens to consumption, investment, and the unemployment rate?

When real GDP falls consumption and investment fall and unemployment rises. The percentage decrease in consumption is smaller than the percentage decrease in real GDP while the percentage decline in investment is much larger than the percentage decrease in real GDP. Unemployment rises when real GDP falls. The rule of thumb provided by Okun's Law says that real GDP growth = 3% - 2 x (annualized change in the unemployment rate).

If the money supply rises, then in the short run a. aggregate demand shifts right and output rises. b. aggregate demand shifts left and output falls. c. short-run aggregate supply shifts up and output rises. d. short-run aggregate supply shifts down and output falls.

a. aggregate demand shifts right and output rises

In the long run the rate of output is determined by a country's a. capital, labor, available technology, and its institutions. b. everything in a plus the money supply. c. everything in b plus taxes net of transfers. d. everything in c plus the price level.

a. capital, labor, available technology, and its institutions.

If all firms fix their prices, then the short-run aggregate supply curve is a. horizontal. b. vertical. c. upward sloping. d. horizontal until it reaches the natural rate of output and vertical at higher levels of output.

a. horizontal.

If short-run aggregate supply shifts down, then firms with fixed prices initially a. increase production but eventually raise their prices. b. increase production but eventually reduce their prices. c. decrease production but eventually raise their prices. d. decrease production but eventually reduce their prices.

a. increase production but eventually raise their prices.

When deriving the aggregate demand curve, which variable(s) is(are) held constant? a. the money supply and the amount of money people want to hold per dollar of income. b. the money supply but not the amount of money people want to hold per dollar of income. c. the amount of income people want to hold per dollar of income, but not the money supply d. the price level.

a. the money supply and the amount of money people want to hold per dollar of income.

Most economists believe that prices are sticky a. in the short and long run. b. In the short run only. c. in the long run only. d. in neither the short nor the long run.

b. In the short run only.

There is an adverse supply shock. If the Federal Reserve uses policy to move output back to its natural rate how does the long-run equilibrium compare to where it would be if the Federal Reserve took no action? a. Both the price level and output are higher if the Fed reacts. b. The price level is higher but output is the same if the Fed reacts. c. Output is higher but the price level is the same if the Fed reacts. d. Output and the price level will be the same in the long-run whether the Fed reacts or not e. None of the above are correct.

b. The price level is higher but output is the same if the Fed reacts.

The position of the long run aggregate supply curve is a. consistent with the classical dichotomy because it depends on the money supply. b. consistent with the classical dichotomy because it does not depend on the money supply. c. inconsistent with the classical dichotomy because it depends on the money supply. d. inconsistent with the classical dichotomy because it does on depend on the money supply.

b. consistent with the classical dichotomy because it does not depend on the money supply.

If velocity decreases, then in the short run, a. output is below its natural rate creating upward pressures on prices. b. output is below its natural rate creating downward pressures on prices. c. output is above its natural rate creating upward pressures on prices. d. output is above its natural rate creating downward pressures on prices.

b. output is below its natural rate creating downward pressures on prices.

Assuming the economy self corrects which curves shift as the economy moves back to the natural rate of output? a. the aggregate demand curve, but not the short-run aggregate supply curve b. the short-run aggregate supply curve, but not the aggregate demand curve c. the aggregate demand curve and the short-run aggregate supply curve d. the long-run aggregate supply curve.

b. the short-run aggregate supply curve, but not the aggregate demand curve

The long run aggregate supply curve is a. horizontal b. vertical c. an upward sloping 450 line. d. horizontal until it reaches the natural rate of output and then vertical.

b. vertical

A survey of firms found that about what percentage of firms adjust their prices once a year or less than once a year? a. 0% b. 25% c. 50% d. 75%

c. 50%

Which of the following shifts aggregate demand to the right? a. a decrease in the price level b. an increase in the price of oil c. a decrease in money demanded per unit of income d. a decrease in the money supply e. All of the above are correct.

c. a decrease in money demanded per unit of income

The price level falls and output rises. Assuming this is the short run effect of a shock, which of the following could have caused this? a. aggregate demand shifted right b. aggregate demand shifted left c. aggregate supply shifted down d. aggregate supply shifted up

c. aggregate supply shifted down

During recessions the percentage decline in consumption a. is larger than the percentage decline in investment spending. b. Is about the same as the percentage decline in investment spending. c. is smaller than the percentage decline in investment spending. d. is larger than the decline in investment spending about as often as it is smaller.

c. is smaller than the percentage decline in investment spending.

If aggregate demand shifts to the right, then in the short run a. output is below its natural rate and there are upward pressures on prices. b. output is below its natural rate and there are downward pressures on prices. c. output is above its natural rate and there are upward pressures on prices. d. output is above its natural rate and there are downward pressures on prices.

c. output is above its natural rate and there are upward pressures on prices.

Most economists would agree that a 1% increase in the money supply will a. have no impact on the price level in either the short or the long run. b. increase the price level by 1% in the short run and 1% in the long run. c. increase prices by 1% in the short run, but leave them unchanged in the long run. d. increase prices by less than 1% in the short run and increase prices by 1% in the long run.

d. increase prices by less than 1% in the short run and increase prices by 1% in the long run.

If for some reason aggregate demand shifted left, a. the Fed could return output to its natural rate by decreasing the money supply. If it does nothing prices will eventually rise. b. the Fed could return output to its natural rate by decreasing the money supply. If it does nothing prices will eventually fall. c. the Fed could return output to its natural rate by increasing the money supply. If it does nothing prices will eventually rise. d. the Fed could return output to its natural rate by increasing the money supply. If it does nothing prices will eventually fall.

d. the Fed could return output to its natural rate by increasing the money supply. If it does nothing prices will eventually fall.

A drought would shift the short-run aggregate supply curve a. down and so raise output. b. down and so reduce output. c. up and so raise output. d. up and so reduce output.

d. up and so reduce output.

During 2014 the unemployment rate fell by about 1% point. According to Okun's law, output growth in 2014 should have been about a. 1% b. 2% c. 3% d. 4% e. 5%

e. 5%