econ ch 17 study guide

new keynesian inflation dynamics

= initial sluggish adjustment of the price level in response to aggregate demand increases followed by higher inflation later on. if a significant portion of all prices do not adjust rapidly, then in the short run, the supply curves are horizontal. as an example, a leftward shift in AD will induce the largest possible decline in equilibrium real GDP. in the long run, the price level will "unstick" due to profit gains over time and change to where the equilibrium real GDP is back to normal.

New Classical approach: unexpected money supply increase from the Fed versus anticipated money increase from the Fed

AD curve shift outward, causing price level and real GDP to rise, short-run equilibrium goes from A to B, then it reaches C on the LRAS curve after SRAS shifts upward. if this increase is ANTICIPATED, a new SRAS curve will result and shift upward simultaneously with rise in AD. in this situation, economy moves from point A to point C without passing point B.

impact of contractionary policy

AD curve shifts to the left; price level decreases; real GDP decreases. SRAS curve shifts to the right as input prices lower to meet new AD curve position. The new equilibrium point goes back on LRAS curve as unemployment rate returns to its natural level. Real GDP returns to long-run real GDP level but at a lower price level.

impact of expansionary policy

AD curve shifts to the right; price level increases; real GDP increases. SRAS curve shifts to the left as input prices rise to meet new AD curve position. The new equilibrium point goes back on LRAS curve as unemployment rate returns to its natural level. Real GDP returns to long-run real GDP level but at a higher price level.

If we further assume that there is pure competition in all markets and that all prices and wages are flexible, we obtain what many call the _____ _________ approach to evaluating the effects of macroeconomic policies.

New Classical

stagflation

a situation characterized by lower real GDP, lower employment, and a higher unemployment rate during the same period that the rate of inflation increases; most recent period of minor stagflation in US occurred between 2008 and 2016, where sharp increases in global oil prices, increases in marginal tax rates, and new federal regulations on firms were contributors to the stagflation

rational expectations hypothesis

a theory stating that people combine the effects of past policy changes on important economic variables with their own judgement about the future effects of current and future policy changes. two key elements: (1) individuals base their forecasts (expectations) about the future values of economic variables on all readily available past and current info; (2) these expectations incorporate individuals' understanding about how the economy operates, including the operation of monetary and fiscal policy.

economists supporting passive policymaking argue that if activist policymakers attempt to exploit the apparent trade-off in the Phillips curve, ______ ______ will no longer move up and down in a/an ________ way.

aggregate demand; unpredictable

active (discretionary) policymaking

all actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy

habit formation

an inclination for household choices, such as decisions to purchase goods and services, to become automatic, or habitual, through frequent repetition. behavioral economists argue that once people get into the habit of spending more of their real disposable income on goods and services, they tend to continue to do so in the present. habit formation, therefore, strengthens the argument that policy changes can exert significant longer-term effects on AD.

during booms, the overall unemployment rate can go _____ the natural rate, so cyclical unemployment is _____.

below; negative

structural unemployment

caused by a variety of "rigidities" throughout economy, results from factors including: (1) government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work; (2) union activity that sets wages above equilibrium level and also restricts mobility of labor

rational inattention

choosing to acquire information infrequently and to make decisions based on incomplete knowledge of the state of the economy during intervals between updates; a consequence of the bounded rationality

policy irrelevance proposition

concludes that policy actions have no real effects in the short run if policy actions are anticipated and none in the long run even if policy actions are unanticipated. under the assumption of rational expectations on the part of decision-makers, anticipated policy cannot alter the rate of unemployment or level of real GDP. regardless of the nature of anticipated policy, unemployment rate = natural rate, and real GDP will be determined solely by LRAS.

small menu costs

costs that deter firms form changing prices in response to demand changes--for example, the costs of renegotiating contracts or printing new list prices. menu costs contribute to short-run sticky prices, argue new Keynesians. they say sticky prices strengthen the argument favoring active policymaking as a means of preventing substantial short-run swings in real GDP.

deviations of the actual unemployment rate from the natural rate are called ______ because they are observed over the course of nationwide business fluctuations

cyclical unemployment

the phillips curve seems to suggest that it was possible for _______ to fine-tune the economy by selecting the policies that would produce the exact mix of _________ that suited current government objectives, but matters are not so simple.

discretionary policymakers; unemployment and inflation

during recessions, the overall unemployment rate _____ the natural rate, so cyclical unemployment is _______.

exceeds; positive

people who favor passive policymaking also argue that if the Fed grows the money supply to achieve a certain inflation rate, workers and job seekers (and other economic participants) will _____________________________.

expect that inflation rate to continue, thus changing their expectations about wages

during periods between updates to people's base of knowledge about economic conditions, expectations about inflation will

fail to reflect fully actual changes in the inflation rate. the result will be a downward-sloping Phillips curve along which policymakers might seek to generate movements--at least during short-run intervals between the public's informational updates.

shifting the phillips curve

figure 17-5 in section 17.2.3: increases in AD by authorities causes A (5,0) to shift up to B. if they continue this stimulus, workers' expectations will adjust, causing unemployment rate to rise and the phillips curve to shift outward to the right. later, unemployment rate returns to the natural rate (Un), but inflation rate is at a higher point than it was in point A - a change from (5,0) to (5,3).

natural rate of unemployment

frictional and structural unemployment are the components; defined as the rate of unemployment that would exist in the long run after everyone in the economy fully adjusted to any changes that have occurred

the greater the unanticipated decrease in aggregate demand, the ____ the amount of deflation that results in the short run, and the _____ the unemployment rate.

greater; higher

the greater the unanticipated increase in aggregate demand, the ____ the amount of inflation that results in the short run, and the _____ the unemployment rate.

greater; lower

reduction in unemployment occurs because wage offers encountered by unemployed workers are unexpectedly ____. As far as workers are concerned, these _______ ______ wages appear initially to be _____ in ______ wages. It is this perception that induces them to ____ the duration of their job search.

high; higher nominal; increases; real; reduce

active policymaking pays off when prices are sticky because

if a policymaker acts rapidly enough, the period of contraction experienced by the economy when AD shifts left may be brief. active policymaking can thereby moderate or even eliminate recessions.

If the Fed attempts to reduce the unemployment rate, it must _____ the rate of growth of the money supply enough to produce a corresponding inflation rate (check fig 17-5 section 17.2.3). proponents of passive policymaking argue that after the money supply stops _____, the inflation rate will soon return to _____ and unemployment rate will go back to its natural rate.

increase; growing; zero

passive (nondiscretionary) policymaking

policymaking that is carried out in response to a rule, therefore not in response to an actual or potential change in overall economic activity

bounded rationality

the hypothesis that people are limited in their ability to consider every conceivable choice available to them

economists viewed the negative relationship between inflation rate and unemployment rate as a

trade-off between the two.

The Phillips Curve

y-axis is the inflation rate, x-axis is the unemployment rate. Un is the unemployment rate at a natural rate, a vertical line on the graph that crosses the phillips curve at a point A. at A, the actual inflation rate and the expected inflation rate each equal 0%. an unanticipated increase in AD makes price level rise and inflation rate rise, causing unemployment rate to fall. A to B is an upward movement here. an unanticipated decrease in AD makes price level fall and unemployment rise. A to C is a downward movement here.