ECON 3340 Chapter 9
Suppose T decreases. How must the central bank change the real policy interest rate to maintain the existing medium-run equilibrium? A. A decrease in T shifts the IS curve to the left, causing a decrease in output below Yn. To return to Yn, the central bank must decrease the real policy rate, causing LM to shift down. B. A decrease in T shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up. C. A decrease in T shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must decrease the real policy rate, causing LM to shift down. D. A decrease in T shifts the IS curve to the left, causing a decrease in output below Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up.
A decrease in T shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up.
Suppose the economy had initially been at potential output where IS crossed LM at . Which of the following events could have caused the output gap that you indicated on the graph? (Check all that apply.) A. A decrease in the tax rate B. A decrease in government spending C. An increase in tax rates D. A decrease in the risk premium, x
A decrease in government spending An increase in tax rates
Suppose G increases. How must the central bank change the real policy interest rate to maintain the existing medium-run equilibrium? A. An increase in G shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up. B. An increase in G shifts the IS curve to the left, causing a decrease in output below Yn. To return to Yn, the central bank must decrease the real policy rate, causing LM to shift down. C. An increase in G shifts the IS curve to the left, causing a decrease in output below Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up. D. An increase in G shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must decrease the real policy rate, causing LM to shift down.
An increase in G shifts the IS curve to the right, causing an increase in output above Yn. To return to Yn, the central bank must increase the real policy rate, causing LM to shift up.
Which of the following events could have caused the positive output gap that you indicated on the graph? (Check all that apply.) A. An increase in government spending B. A decrease in the tax rate C. A decrease in government spending D. An increase in the risk premium, x
An increase in government spending A decrease in tax rate A decrease in the risk premium, x
If (u − un) is greater than zero, then (Y − Yn) is greater than zero.
False
If (u − un) is less than zero, the output gap is negative.
False
Okun's law says that if output growth increases by one percentage point, the rate of unemployment drops by one percentage point.
False
The IS curve shifts right with an increase in G, right with an increase in T, and right with an increase in x.
False
The central bank can always act to keep output equal to potential output.
False
In the IS−LM−PC model, which of the following is assumed to be exogenous? A. G B. C C. I D. Y
G
When the policy rate increases, A. LM curve shifts upward. B. IS curve does not change. C. LM curve shifts downward. D. IS curve shifts to the right. E. IS curve shifts to the left.
IS curve does not change
When a government reduces its deficits by increasing taxes, in the short run, A. output returns to potential. B. IS curve shifts inward to the left. C. interest rate is higher. D. output increases.
IS curve shifts inward to the left
During the recent recession, several European countries proposed austerity measures that would help shrink the size of the national deficits within the countries. These proposed measures included tax hikes and cuts in government spending. When this happened in the United States in the 1990s, there was an accompanying decrease in the policy rate to help avoid slowing the economy down too much. Why was this same policy decision more difficult in Europe? A. There is no mechanism in Europe to change the policy rate like there is in the United States. B. Europeans protested against the austerity measures, which angered the government; it responded by intentionally not taking steps to limit the impact of these measures. C. In response to the recession, the policy rate in Europe had already been lowered close to the zero lower bound, so additional decreases were not viable. D. European governments had never implemented these types of austerity policies before so they were not aware of the need for monetary policy to limit the impacts.
In response to the recession, the policy rate in Europe had already been lowered close to the Zero Lower Bound, so additional decreases were not viable
Which of the following best characterizes the behavior of inflation in a medium-run equilibrium if the level of expected inflation is formed so πe equals π(−1)? A. Inflation is equal to some constant inflation rate irrespective of what it was the previous year. B. Inflation is decreasing. C. The inflation rate is equal to 0. D. Inflation is not changing.
Inflation is not changing
Which scenario—that inflation is anchored or that inflation is based on the previous year's rate—do you think is more realistic under a positive output gap? A. It is more realistic that the central bank will use an expected inflation anchor that is continuously incorrect rather than accept accelerating inflation. B. It is more realistic that the central bank will accept accelerating inflation rather than use an expected inflation anchor that is continuously incorrect. C. Neither are likely, as the central bank will not likely accept ever increasing inflation nor will it permanently use an incorrect anchor for inflation. D. Both are equally likely.
Neither are likely, as the central bank will not likely accept ever increasing inflation nor will it permanently use an incorrect anchor for inflation
How will the short-run equilibrium in period t+1 compare to the equilibrium in period t? A. Output will be above potential and inflation will be above expected inflation. B. Output will be unchanged and inflation will be above expected inflation. C. Output will be below potential and inflation will be above expected inflation. D. Both output and expected inflation will decrease.
Output will be above potential and inflation will be above expected inflation
Assume that the central bank does not change the real policy rate. How will the short-run equilibrium in period t+1 compare to the equilibrium in period t? A. Output will be below potential and inflation will increase. B. Output will be unchanged and inflation will decrease. C. Output will be above potential and inflation will increase. D. Both output and inflation will decrease.
Output will be above potential and inflation will increase.
The medium-run equilibrium is characterized by four conditions: 1. Output is equal to potential output Y = Yn. 2. The unemployment rate is equal to the natural rate u = un. 3. The real policy interest rate is equal to the natural rate of interest rn where aggregate demand equals Yn. 4. The expected rate of inflation πe is equal to the actual rate of inflation π. The IS relation is Y = C(Y − T) + I(Y, r + x) + G. Suppose rn is 2%. If x increases from 4 to 5%, how must the central bank change rn to maintain the existing medium-run equilibrium? A. The central bank should adjust the real policy rate until it also equals 5%. B. The central bank needs to increase the real policy interest rate by 1% in order to keep r + x unchanged. C. The central bank should adjust the real policy rate until it equals 4%. D. The central bank needs to decrease the real policy interest rate by 1% in order to keep r + x unchanged
The central bank needs to decrease the real policy interest rate by 1% in order to keep r + x unchanged
At the natural rate of unemployment, inflation is neither rising nor falling.
True
If (u − un) is equal to zero, the output is at potential.
True
If the output gap is positive, inflation is higher than expected inflation.
True
In a medium-run equilibrium, the rate of inflation is stable.
True
It is easier for the central bank to keep output at potential output if expectations of inflation are anchored.
True
A large increase in the price of oil increases the natural rate of unemployment.
Uncertain
Professor Blanchard discusses two key risks to the IMF's outlook that could slow growth in 2012 and in 2013. Which of the following is NOT one of these key risks? A. increase in oil prices B. another Euro crisis C. a monetary tightening D. all of the above
a monetary tightening
Under anchored expectations, there was _________, and under lagged expectations, there was _________. A. a permanently higher level of inflation; the same permanently higher level of inflation B. an acceleration of inflation; the same acceleration of inflation C. a permanently higher level of inflation; an acceleration of inflation D. an acceleration of inflation; a permanently higher level of inflation
a permanently higher level of inflation; an acceleration of inflation
For this question, assume that the economy is initially operating at the natural level of output. An increase in the price of oil will cause which of the following in the medium run? A. a reduction in output and an increase in the aggregate price level B. a reduction in the interest rate C. a reduction in unemployment, an increase in the nominal wage and an increase in the aggregate price level D. a reduction in the aggregate price level and no change in output E. a reduction in output and a reduction in the interest rate
a reduction in output and an increase in the aggregate price level
How does the zero lower bound on nominal interest rates make a fiscal consolidation more difficult? When facing a zero lower bound, fiscal consolidation can lead to __________ output and ___________, which will __________ tax revenue, making it harder to reduce the deficit.
decreasing; deflation; lower
The wage setting relation is A. horizontal. B. vertical. C. upward sloping. D. downward sloping.
downward sloping
Suppose in period t+4, the central bank decides to raise the real policy rate high enough to return the economy immediately to potential output and to the period t rate of inflation. Explain the difference between central bank policies using the two assumptions about expected inflation. Under anchored inflation expectations, the central bank would have to raise the policy rate __________. This __________ rate will cause ___________. Once the inflation goal has been achieved, the central bank ____________. Under lagged inflation expectations, the central bank would have to raise the policy rate ____________. This ___________ rate will cause ___________. Once the inflation goal has been achieved, the central bank ____________.
enough to eliminate the output gap higher; inflation to return to the anchored rate; will not need to make any further changes significantly higher than if expectations were anchored significantly higher; a recession, causing large reductions in inflation; can return the policy rate to its original level
Suppose in period t+4, the central bank decides to raise the real policy rate high enough to return the economy immediately to potential output and to the period t rate of inflation. Explain the difference between central bank policies using the two assumptions about expected inflation. Under anchored inflation expectations, the central bank would have to raise the policy rate __________. This __________ rate will cause _______________. Once the inflation goal has been achieved, the central bank ____________. Under lagged inflation expectations, the central bank would have to raise the policy rate _____________. This _________ rate will cause _________. Once the inflation goal has been achieved, the central bank ___________.
enough to eliminate the output gap higher; inflation to return to the anchored rate; will not need to make any further changes significantly higher than if expectations were anchored significantly higher; a recession, causing large reductions in inflation; can return the policy rate to its original level
The government policy to reduce the deficit has caused output from period t to period t + 1 to ________ and the change in inflation rate over this period has ________.
fall; become negative
Consider the period t+2 equilibrium under the assumption that πet+2 = πt+1. If the central bank leaves the real policy rate unchanged, how does actual inflation in period t+2 compare to inflation in period t+1? Similarly, how does actual inflation in period t+3 compare to inflation in period t+2? Actual inflation in period t+2 will be __________ inflation in period t+1, and actual inflation in period t+3 will be __________ inflation in period t+2.
greater than; greater than
If the central bank leaves the real policy rate unchanged, how does actual inflation in period t+2 compare to inflation in period t+1? Similarly, how does actual inflation in period t+3 compare to inflation in period t+2? Actual inflation in period t+2 will be _____________ inflation in period t+1, and actual inflation in period t+3 will be _____________ inflation in period t+2.
greater than; similar to
Consider the period t+2 equilibrium under the assumption that πet+2 = πt+1. If the central bank leaves the real policy rate unchanged, how does actual inflation in period t+2 compare to inflation in period t+1? To keep the real policy rate unchanged, the central bank would need to __________ the nominal policy rate. Actual inflation in period t+2 will be _________ than inflation in period t+1.
increase greater than
Continue to period t+3. Making the same assumption about the level of expected inflation and the real policy rate, how does actual inflation in period t+3 compare to inflation in period t+2? To keep the real policy rate unchanged in period t+3, the central bank would need to _________ change the nominal policy rate. Actual inflation in period t+3 will be _______ than inflation in period t+2.
increase greater than
If expected inflation depends on past inflation, then in period t + 2, the real policy rate will _________. This will cause output in period t + 3 to _________. A. decrease; fall further B. increase; rise back to potential C. increase; fall further D. decrease; rise back to potential
increase; fall further
From 1970 to the mid−1990s, the relative price of crude petroleum A. increased dramatically, then decreased dramatically. B. decreased dramatically, then increased dramatically. C. steadily decreased. D. remained more or less the same. E. steadily increased.
increased dramatically, then decreased dramatically
If the output is too high, to achieve the medium run equilibrium, the central bank will A. increase money supply. B. increases inflation rate. C. increases policy rate. D. reduces policy rate.
increases policy rate
The Phillips curve shows that when the unemployment rate is lower than the natural rate, A. policy rate is higher than expected. B. policy rate is lower than expected. C. inflation is lower than expected. D. inflation is higher than expected.
inflation is higher than expected
For this question, assume that the economy is initially operating at the natural level of output. An increase in consumer confidence will cause A. an increase in the real wage in the medium run. B. no change in the real wage in the medium run. C. ambiguous effects on the real wage in the medium run. D. a reduction in the real wage in the medium run.
no change in the real wage in the medium run
For this question, assume that the economy is initially operating at the natural level of output. An increase in unemployment benefits will cause: A. an increase in the real wage in the medium run B. ambiguous effects on the real wage in the medium run C. a reduction in the real wage in the medium run D. no change in the real wage in the medium run
no change in the real wage in the medium run
Now consider the period t+2 equilibrium making the assumption that πet+2 = π. If the central bank leaves the real policy rate unchanged, how does actual inflation in period t+2 compare to inflation in period t+1? To keep the real policy rate unchanged, the central bank would need to ________ the nominal policy rate. Actual inflation in period t+2 will be ________ than inflation in period t+1.
not change equal to
Okun's law shows that when the unemployment rate is above the natural rate, A. output is below potential. B. output is above potential. C. inflation is higher than expected. D. inflation is lower than expected.
output is below potential
In this chapter we discussed the policy decisions that central banks can make to return an economy back to a stable equilibrium whenever there is an outside shock. The policy choices are straightforward and can be decided on directly by the central bank. Why then do central banks not do a better job of keeping economies near a stable equilibrium all the time? One issue that arises is that in real life it is very hard to know the true level of ____________. Since this is hard to observe, we need to rely on inflation to get an idea of where the economy is. When doing this, we focus on the change in ______________ as our guide.
potential output change in inflation
How did the inflation and output outcomes differ when expected inflation was anchored (πet+2 = π) relative to when it was lagged (πet+2 = πt+1)? Under anchored expectations, output _________ and there was ________ of inflation, and under lagged expectations, output __________ and there was _________ of inflation.
remained the same; a permanently higher level; remained the same; an acceleration
Continue to period t + 3. Making the same assumption about the level of expected inflation and the real policy rate, how does actual inflation in period t + 3 compare to inflation in period t + 2? Actual inflation in period t+3 will be ________ than inflation in period t+2.
similar to
The change in the unemployment rate is approximately equal to A. the negative policy rate. B. the negative inflation rate. C. the negative of the growth rate of money supply. D. the negative of the growth rate of output.
the negative of the growth rate of output
The central bank can have a hard time adjusting the economy appropriately because ________. A. even though central banks can determine the state of the economy easily, they usually do not have the long-run health of the economy as their main goal. B. the economy usually responds too quickly to policy decisions and there is a lot of "noise" in the economy, making it hard to know precise relationships between variables. C. even though central banks can determine the state of the economy easily, and the economy responds to policy decisions quickly, the policy decisions made by central banks are consistently incorrect. D. there is a lag in how long it takes the economy to respond to policy decisions and there is a lot of "noise" in the economy, making it hard to know precise relationships between variables.
there is a lag in how long it takes the economy to respond to policy decisions and there is a lot of "noise" in the economy, making it hard to know precise relationships between variables
The IMF examined a scenario in which uncertainty in the Middle East would cause oil prices to increase by 50%. The IMF predicted that this increase in oil prices would cause the level of output over the next two years: A. to decrease by 2% in the United States and Europe and by 2.5% in Japan. B. to decrease by 1% in the United States and Europe and by 1.5% in Japan. C. to decrease by 3% in the United States, Europe and in Japan. D. to decrease by 3% in the United States and Europe and by 0.5% in Japan.
to decrease by 1% in the United States and Europe and by 1.5% in Japan
If instead, the level of expected inflation is π, what is the level of actual inflation in the medium-run equilibrium? A. The same as rn. B. π. (pi with the line above it) C. 0 D. It cannot be determined
π. (pie with the line above it)
Is it true that in the medium run, a fiscal expansion leads to an increase in the natural rate of interest? A. No, when the central bank increases the real policy rate to address a fiscal expansion, the natural rate reacts by moving in the opposite direction, resulting in a decrease in rn. B. No, the central bank will decrease the real policy rate to address a fiscal expansion, so the new lower rate results in stable inflation and a return to Yn, thus lowering rn. C. Yes, when the central bank decreases the real policy rate to address a fiscal expansion, the natural rate reacts by moving in the opposite direction, resulting in an increase in rn. D. Yes, when the central bank increases the real policy rate to address a fiscal expansion, the new rate results in stable inflation and a return to Yn, thus making the new rate, rn.
Yes, when the central bank increases the real policy rate to address a fiscal expansion, the new rate results in stable inflation and a return to Yn, thus making the new rate, rn.