Final Review

. Explain how a higher rate of return on saving could, at least in theory, lead to lower saving

A higher rate of return on saving means that savers obtain higher income. The associated income effect means that individuals have an incentive to consume more today, as well as in the future. If this is strong enough to outweigh the substitution effect (a higher rate of return on saving encourages more saving and less consumption), then the saving rate could go down. (Another way to say this is that, with a higher return on saving, you can enjoy the same level of consumption tomorrow even if you save less today.)

Make a list of things that would shift the long-run aggregate supply curve to the right?

Examples in the text (or variations) include increased immigration, a decrease in the minimum wage, less generous unemployment insurance, an increase in the capital stock, an increase in the average level of education, a discovery of new mineral deposits, advances in technology, and removal of barriers to international trade.

Some economists argue suddenly reducing money supply growth is a costly way to reduce inflation and that it may not work. For example, If a government cuts money growth but makes no real fiscal reforms, people will expect the government will eventually need to expand the money supply to pay for its expenditures. Thus, the promise to fight inflation will not be credible. Explain why credibility is important to a reduction in the inflation rate.

If people believe that the government really will honor its promise to reduce inflation, than inflation expectations fall. This change in expectations shifts the short-run Phillips curve left so that at any actual inflation rate the unemployment rate will be lower. If the government reduces money supply growth and at the same time people reduce their inflation expectations, unemployment will rise by less than if people maintain their inflation expectations. The same argument can be made using the following equation. Unemployment rate = natural rate of unemployment - a(actual inflation - expected inflation) Suppose the government reduces actual inflation. If expected inflation is unchanged, then the unemployment rate rises by more than if people revise their expectations of inflation downward.

Describe the process in the money market by which the interest rate reaches its equilibrium value if it starts above equilibrium.

If the interest rate is above equilibrium, there is an excess supply of money. People with more money than they want to hold given the current interest rate deposit the money in banks and buy bonds. The increase in funds to lend out causes the interest rate to fall. As the interest rate falls, the quantity of money demanded increases, which tends to diminish the excess supply of money

In the long run what primarily determines the natural rate of unemployment? In the long run what primarily determines the inflation rate? How does this relate to the classical dichotomy?

In the long run the natural rate of unemployment is primarily determined by labor market factors including government policy concerning minimum wages and unemployment benefits. In the long run inflation is primarily determined by money supply growth. These determinants are consistent with the classical dichotomy which states that real and nominal variables are determined independently

What do most economists believe concerning the relation between the price level and real output?

Most economists believe that in the long run, real variables are not affected by nominal variables. So, for example, changes in the money supply do not change real variables in the long run. However, most economists believe that nominal variables do change real variables in the short run. In the short-run prices and wages may be fixed based on the expected price level. If the actual price level differs from the expected price level, real variables are affected.

Suppose that the government goes into deficit in order to help local school districts build better schools. Does this burden future generations?

The benefits of the project accrue not just to the current generation, but also to future generations. By running a deficit, the government spreads some of the cost to future generations as well.

How does a reduction in the money supply by the Fed make owning stocks less attractive?

The reduction in the money supply raises the interest rate. So the return on bonds increases relative to the return on stocks. The increase in the interest rate also causes spending to fall, so that revenues and profits fall, making shares of ownership in corporations less valuable.

The long-run trend in real GDP is upward. How is this possible given the business cycles? What explains the upward trend?

There are occasional short-lived periods of negative real GDP growth. However, in most years real GDP increases. The years of increase are more frequent and the increases large enough that over long periods of time real GDP increases despite the occasional declines. The long-run upward trend in real GDP is due to increases in the labor force and capital stock and advances in technological knowledge.

Some countries have had relatively high inflation and relatively high unemployment for long periods of time. Is this consistent with the Phillips curve? Defend your answer.

They are consistent with the long-run Phillips curve. In the long run the natural rate of unemployment is determined by factors other than inflation. For example, the natural rate of unemployment will be higher in a country with a higher minimum wage and more generous unemployment compensation. In the long run, inflation depends on the growth rate of the money supply. So, it is possible for a country with a Phillips curve that is farther to the right to also have greater money supply growth and higher inflation

Explain the logic according to liquidity preference theory by which an increase in the money supply changes the aggregate demand curve.

When the money supply increases, the interest rate falls. As the interest rate falls people will want to spend more and firms will want to build more factories and other capital goods. This increase in aggregate demand happens for any given price level, so aggregate demand shifts right.

Suppose that the Prime Minister and Parliament of Veridian are disappointed with the high inflation rates under the current system where the Veridian Ministry of Finance is in charge of the money supply. They make reforms to lower inflation from its current rate of 8%. Suppose further that the public is confident that with the reforms in place that inflation will fall to 2%. Also suppose that those in control of the money supply actually conduct monetary policy so that the actual inflation rate is 4%. Using long-run and short-run Phillips curves and assuming the natural rate of unemployment is 6%, show the initial long run equilibrium of Veridian and label it "A". Assuming that the government had actually set inflation at 2% and that the public believed this, label the long-run equilibrium "B". Now, suppose that inflation expectations fell to 2% and that the government unexpectedly created inflation of 4%. Show the short-run equilibrium and label it "C". If the money supply continues to grow at a rate consistent with 4% inflation, show where the economy ends up and label that point "D".

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