Chapter 15

If households and firms expect higher rates of inflation, the ______ curve will shift _____.

- SRAS; upward Aggregate supply curves are built on inflationary expectations. When firms anticipate higher rates of inflation the SRAS curve shifts upward.

A large increase in oil prices is an example of:

- an adverse inflation shock Inflation shocks occur when some event disrupts the usual pattern of inflation. The large increase in world oil prices during the 1970's is an example of this type of shock. An inflation shock that increases inflation is called an adverse inflation shock.

To achieve long-run equilibrium in an economy with a recessionary gap, without the use of stabilization policy, the inflation rate must:

- decrease If the inflation rate falls on its own due to flexible wages and prices, stabilization policy may not be needed, so long as this decrease in inflation happens quickly.

If policymakers attempt to offset an adverse inflation shock with monetary _____, the resulting long-run equilibrium will be at _____ inflation rate compared to allowing the self-correcting mechanism return the economy to potential output.

- easing; a higher An adverse inflation shock is modeled as an upward shift of the SRAS curve, which in the short run results in higher inflation and lower output. The self-correcting mechanism of the economy means that inflation will gradually start to decrease until the economy is back in long-run equilibrium at the original level of inflation. If instead the central bank intervenes with monetary easing, aggregate demand will shift right and establish a long-run equilibrium where inflation remains at the higher level.

When the economy is in short-run equilibrium, there will be ______ output gap.

- either a recessionary or expansionary The economy is in short-run equilibrium at the output where the aggregate demand curve intersects the short-run aggregate supply line. If there is no output gap, then the economy is said to be in long-run equilibrium—not short-run equilibrium.

Compared to an initial long-run equilibrium, an aggregate supply shock that reduces potential output results in a(n) _____ gap in the short run and _____ output and _____ inflation in the long run.

- expansionary; lower; higher A decline in potential output, modeled as a leftward shift of the LRAS, creates an expansionary gap in the short run. As inflation rises, the short-run aggregate supply line shifts upward and a new long-run equilibrium is reached where actual output equals the new, lower level of potential output. The long run result of a fall in potential output is a permanent decline in output and a higher inflation rate.

Starting from long-run equilibrium, an adverse inflation shock results in a short-run equilibrium with ___ inflation and ____ output.

- higher; lower An adverse inflation shock is modeled as an upward shift in the SRAS curve. In the short run, this results in higher inflation and lower output.

Starting from long-run equilibrium, an increase in autonomous investment results in ____ output in the short run and _____ output in the long run.

- higher; potential An increase in autonomous investment is an example of an exogenous increase in spending, which shifts aggregate demand right and increases the short-run equilibrium. As a result of this expansionary gap, inflation will gradually increase, thereby shifting the SRAS line upward. When inflation has risen enough, the economy is back in long-run equilibrium at potential output.

An economy with an expansionary gap will, in the absence of stabilization policy, eventually experience a(n) ______ in the inflation rate, leading to a(n) ______ in output.

- increase; decrease An economy with an expansionary gap sees the bidding up of wages and production costs. This causes an upward shift in SRAS which results in higher inflation and decreased output.

When there is an expansionary gap, inflation will ______, in response to which the Federal Reserve will ____ real interest rates, and output will _____.

- increase; raise; decline Increasing inflation rates eliminate expansionary gaps because the SRAS curve shifts upward to bring the economy back to long-term equilibrium. The Fed accommodates this shift by raising interest rates as inflation climbs according to its existing reaction function, which means that output decline to the level of potential output

The self-correcting property of the economy means that output gaps are eventually eliminated by:

- increasing or decreasing inflation The mechanism by which output gaps are eliminated is changing prices. Note that inflation adjusts gradually to bring the economy into long-run equilibrium.

When actual output equals potential output and the inflation rate is equal to the expected rate of inflation, the economy is said to be in ______ equilibrium.

- long run Long-run equilibrium a situation in which actual output equals potential output and the inflation rate is stable. Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point.

A low rate of expected inflation tends to lead to a ___ rate of actual inflation and a high rate of expected inflation tends to lead to a ____ rate of actual inflation.

- low; high Households and businesses become accustomed to gradually rising prices so actual inflation seems to follow inflation expectations. Inflation expectations are built on recent past experiences.

Low expected inflation leads to ____ increases in wages and costs and to ____ actual inflation.

- small; low Inflation follows a "wage-price spiral." Small increases in prices are followed by small increases wages, which again only creates another round of minor price and wage increases.