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Štrade€introduces€a€number€of€potential€disturbances€on€both€the€demand€and€supply€sides€thatĻaffect€domestic€economic€performance€and€that€would€not€be€present€in€a€closed€economy.€€ToĻthe€extent€these€international€factors€represent€changing€events,€then€they€also€become€"news"€„„Ļ"Recession€in€Europe€spreads€to€U.S.€export€industries";€"Free€trade€with€Mexico€causesĻunemployment€in€Anchorage",€"End€of€Cold€War€ends€many€careers€in€the€defense€industry."€ĻBut€the€benefits€of€free€trade€across€national€boundaries€are€not€so€conspicuous€and€are€generallyĻdisregarded€by€most€of€us.€€Workers€displaced€by€foreign€competition€make€better€copy€than€theĻbenefits€that€consumers€receive€from€being€able€to€buy€from€efficient€producers€anywhere€in€theĻworld.€€The€discussion€of€the€effect€of€trade€restrictions€and€the€section€on€comparativeĻadvantage€tell€you€why€economists€are€virtually€unanimous€in€their€praise€for€efforts€to€expandĻtrade€and€eliminate€protectionist€policies€that€benefit€inefficient€producers€at€the€expense€of€theĻconsumer€or€taxpayer.Ō#†X$åXXX$åĆ#ŌŌ‡ X$åXXX$åŌņņŠ ŽO ŠóóĢ3.ņņ€Suppose€the€"Buy€American"€lobby€becomes€so€powerful€that€Congress€is€persuaded€to€addŠ `! Štariffs€and€quotas€to€a€large€number€of€imported€commodities.€€Use€the€AD/AS€framework€toĻforecast€the€short„€and€long„run€impact€of€this€action€on€our€real€output,€real€interest€rates,€theĻprice€level,€both€the€nominal€and€the€real€values€of€the€dollar€internationally,€the€balance€ofĻtrade,€and€the€government€deficit.óó€€Ō#†X$åXX X$å6#ŌŌ‡ X$åXXX$åŌA€"Buy€American"€policy€has€the€same€impact€as€tradeŠ Ē Šrestrictions€in€that€it€channels€resources€to€less€efficient€producers.€€If€we€understand€the€cost€„„Ļa€net€economic€loss€in€purchasing€power€in€order€to€strengthen€relatively€inefficient€domesticĻindustries€„„€and€are€still€willing€to€pay€it,€then€that€is€our€choice.€€But€the€effect€is€to€reduceĻour€overall€standard€of€living,€shifting€the€aggregate€supply€curve€to€the€left,€raising€the€priceĻlevel,€and€the€real€rate€of€interest.€€The€rising€real€rate€of€interest€means€an€increased€demandĻfor€dollars€and€causes€an€increase€in€both€the€nominal€and€real€exchange€rate.€€The€rise€in€theĻprice€level,€however,€tends€to€reduce€the€nominal€exchange€rate€leaving€its€net€changeĻindeterminate€without€further€information.€€We€also€need€more€information€to€be€sure€which€wayĻnet€exports€will€go,€since€the€drop€in€output€tends€to€increase€them,€while€the€rise€in€the€realĻexchange€rate€(via€the€increased€interest€rate)€tends€to€decrease€them.€€The€government€deficitĻwill€rise€because€of€the€drop€in€real€output.€€In€summary,€the€„ššASņņ*óó€š8š€„ššy,€+ššP,€&€+ššr.€€TheŠ  'Ģ $ Š+ššr€š8š€+ššDņņ$€óóš8š€+ššE€ņņandóó€+šše.€€The€+ššP€š8š€„ššE,€so,€without€further€information,€we€canŠ ō'µ!% Šonly€say€that€ššE€is€indeterminate.€€The€+ššr€and€„ššy€leave€x=xņņ0óó„xņņ1óóy„xņņ2óór€indeterminate€as€well.€Š ß( "& ŠThe€„ššyš8š€„ššt€š8š€+ššb,€a€cyclical€increase€in€the€government€deficit.Ō#†X$åXX X$åJ #ŌŌ‡ X$åXXX$åŌŠ Č)‰#' ŠĢ4.ņņ€Suppose€it€is€decided€that€economic€policy€should€be€directed€toward€a€significant€long„runŠ š+[%) Šreduction€in€our€balance„of„trade€deficit.€€The€following€policies€have€been€suggested;€evaluateĻeach€one,€and€explain€which€one€is€most€likely€to€achieve€the€goal€most€efficiently.Š n-/'+ Їa.€A€reduction€in€the€federal€deficit.€€óóŌ#†X$åXX X$å#ŌŌ‡ X$åXXX$åŌReducing€the€cash€flow€deficit€(by€„ššgņņ0óó€or€+šštņņ0€óó,€assumingŠ ? Šless€than€complete€tax„discounting)€has€the€familiar€contractionary€impact€on€IS€and€AD€and€theĻlong„run€result€is€a€lower€real€rate€of€interest€and€a€lower€price€level.€€The€lower€real€rate€ofĻinterest€means€a€reduced€demand€for€dollars€and€a€fall€in€the€real€exchange€rate.€€The€long„runĻresult,€other€things€unchanged,€would€be€a€reduced€balance„of„trade€deficit€as€the€declining€valueĻof€the€dollar€lowers€our€imports€and€stimulates€exports.ĢŌ#†X$åXX X$åQ#ŌŌ‡ X$åXXX$åŌņņĢb.€An€expansionary€monetary€policy.€€óóŌ#†X$åXX X$å²#ŌŌ‡ X$åXXX$åŌExpansionary€monetary€policy€would€have€no€long„runŠ   a Šimpact€on€the€trade€deficit€since€its€only€effect€is€on€the€price€level€and€the€nominal€interest€rate.Ģ€€Ō#†X$åXX X$å #ŌŌ‡ X$åXXX$åŌņņŠ t5  Šc.€Higher€tariffs€on€foreign€goods.€óóŌ#†X$åXX X$å#ŌŌ‡ X$åXXX$åŌ€In€terms€of€our€model,€this€would€show€up€as€a€net€increaseŠ ]  Šin€autonomous€net€exports€(+ššxņņ0óó),€and,€presuming€that€there€was€no€retaliation€from€our€tradingŠ H  Špartners,€this€would€tend€to€raise€net€exports€hence€lower€any€existing€trade€deficit.€€But€thisĻwill€bring€a€negative€supply„shock€(which€will€have€relatively€small€second„order€impacts€on€netĻexports€via€+ššr€and€„ššy),€and€so€the€drop€in€the€trade€deficit€has€been€purchased€at€the€costĻof€a€lower€standard€of€living.€€Retaliation€through€tariffs€on€our€exports€will€further€lower€ourĻstandard€of€living€and€will€also€cause€net€exports€to€fall€and€the€trade€deficit€to€rise.Ō#†X$åXX X$å”#ŌŌ‡ X$åXXX$åŌņņŠ Õ– ŠóóĢ5.ņņ€Suppose€it€is€a€policy€goal€to€increase€the€real€value€of€the€dollar€internationally.€€EvaluateŠ §h Šeach€of€the€following€in€terms€of€their€ability€to€achieve€that€goal€in€the€long€run.ĢĢa.€A€significant€and€lasting€reduction€in€the€Federal€deficit.€€óóŌ#†X$åXX X$å…#ŌŌ‡ X$åXXX$åŌLowering€the€deficit€causes€a€dropŠ d% Šin€the€real€rate€of€interest,€lowers€the€demand€for€dollars,€causing€a€drop€in€the€real€exchangeĻrate.Ō#†X$åXX X$å÷#ŌŌ‡ X$åXXX$åŌņņŠ 8ł ŠĢb.€A€rapid€increase€in€the€money€supply€and€consequent€inflation.€€óóŌ#†X$åXX X$åÖ#ŌŌ‡ X$åXXX$åŌMoney€supply€changes€haveŠ  Ė Šno€lasting€effects€on€the€real€variables€but€will€cause€an€increase€in€the€inflation€rate.€€This€riseĻin€the€price€level€will€cause€a€fall€in€the€nominal€exchange€rate€but,€in€the€long€run,€leave€theĻreal€exchange€rate€unchanged.Ō#†X$åXX X$åw#ŌŌ‡ X$åXXX$åŌņņŠ Ēˆ ŠĢc.€A€significant€tax€subsidy€for€those€who€save€rather€than€consume.€€óóŌ#†X$åXX X$åĢ#ŌŌ‡ X$åXXX$åŌThis€will€cause€a€drop€inŠ ™!Z Šautonomous€consumption€(„ššcņņ0óó€in€our€model)€and€the€long„run€impact€will€be€generally€the€sameŠ „"E Šas€in€5a.Ō#†X$åXX X$åp#ŌŌ‡ X$åXXX$åŌņņŠ m#.  ŠóóĢ6.ņņ€"We€ought€to€pass€a€law€that€would€make€it€illegal€for€foreigners€to€hold€U.S.€governmentŠ ?%" Šbonds.€€This€would€mean€that€our€debt€would€be€held€entirely€internally€and,€since€we€would€justĻowe€it€to€ourselves,€there€could€be€no€net€burden."€€Evaluate.óó€€Ō#†X$åXX X$åd#ŌŌ‡ X$åXXX$åŌOne€way€to€respond€to€this€is€toŠ 'Ō $ Šnote€that€what€is€crucial€to€the€outcome€is€how€the€borrowed€funds€are€used€and€what€rate€ofĻinterest€is€paid€for€them.€€The€ņņcitizenship€of€the€lenderóó€has€no€bearing€as€to€whether€the€actionŠ ē(Ø"& Šis€self„financing,€consumption„smoothing,€or€consumption„draining.€€Given€that€we€have€decidedĻto€use€deficit„financing€for€part€of€government€spending,€we€reduce€its€cost€by€borrowing€asĻcheaply€as€we€can,€regardless€of€the€identity€of€the€lender.€€By€not€allowing€foreigners€toĻpurchase€our€government€bonds,€we€not€only€prevent€ourselves€from€buying€from€the€low„costĻproducer€(in€this€case,€"borrowing€from€the€low€cost€lender"),€but€we€also€put€a€restriction€onŠ v-7'+ Šthe€inflow€of€capital€to€the€United€States.€€The€cost€of€such€a€policy€would€be€a€drop€in€ourĻstandard€of€living.Ō#†X$åXX X$åŚ #ŌŌ‡ X$åXXX$åŌŠ (é ŠĢ7.ņņ€"The€president€is€in€a€dilemma.€€His€desire€to€significantly€improve€the€balance€of€trade€(i.e.,Š ś» Šincrease€net€exports)€over€the€next€few€years€is€in€direct€opposition€to€his€stated€goals€ofĻbalancing€the€Federal€budget,€increasing€the€growth€of€the€capital€stock,€and€strengthening€theĻinternational€value€of€the€dollar".€€Do€you€agree€with€this€statement?óó€€Ō#†X$åXX X$å‚$#ŌŌ‡ X$åXXX$åŌThe€goal€of€increasingŠ · x Šnet€exports€(or€making€them€less€negative)€is€compatible€with€the€goals€of€reducing€the€FederalĻdeficit€and€increasing€the€growth€of€the€capital€stock,€because€those€would€both€involve€lowerĻlevels€of€the€real€interest€rate€which€would€lower€the€real€exchange€rate,€stimulate€exports€andĻchoke€off€imports.€€But€it€is€incompatible€with€the€last€goal€„„€strengthening€the€internationalĻvalue€of€the€dollar.€€If€this€means€an€increase€in€the€real€exchange€rate,€that€would€work€toĻdecrease€net€exports.€€If€it€means€an€increase€in€the€nominal€exchange€rate,€that€would€have€noĻimpact€on€the€trade€deficit€or€any€other€real€variable€in€the€long€run€(and€is,€therefore,€a€goalĻwithout€substance).€ĢĢŌ#†X$åXX X$å]&#ŌŌ‡ X$åXXX$åŌ8.ņņ€Suppose€the€large€balance€of€trade€deficit€in€the€U.S.€(x<0)€becomes€an€issue€in€the€electionŠ Ó” Šof€2000.€€All€the€presidential€candidates€are€proposing€ways€to€get€rid€of€the€"World's€LargestĻDebtor€Nation"€label.ĢĢa.€Candidate€A€argues€that€the€only€sensible€way€to€improve€the€balance€of€trade€is€throughĻmonetary€policy.€€He€argues€that€we€should€make€a€balanced€current€account€(x=0)€a€goal€forĻthe€Federal€Reserve€to€pursue.€€Would€this€work?€€óóŌ#†X$åXX X$å)#ŌŌ‡ X$åXXX$åŌSame€answer€as€for€question€4b.Ō#†X$åXX X$åŸ+#ŌŌ‡ X$åXXX$åŌņņŠ K  ŠĢb.€Candidate€B€argues€that€this€should€be€accomplished€by€fiscal€policy€instead.€€Would€herĻstrategy€work?€€óóŌ#†X$åXX X$å,#ŌŌ‡ X$åXXX$åŌSame€answer€as€question€4a.Ō#†X$åXX X$åŹ,#ŌŌ‡ X$åXXX$åŌņņŠ É ŠĢc.€Candidate€Z€shocks€everyone€by€arguing€that€there's€no€good€economic€reason€for€trying€toĻeliminate€a€balance„of„trade€deficit.€€Is€he€just€joking,€or€is€there€any€economic€rationale€behindĻthis€view?€€óóŌ#†X$åXX X$å'-#ŌŌ‡ X$åXXX$åŌThis€is€covered€in€Sections€7.6€and€7.7€of€the€chapter.€€It€is€important€to€understandŠ ® o Šthat€a€trade€deficit€is€also€a€capital„account€surplus€and€that€(as€with€the€government€deficit)€theĻissue€is€one€of€how€the€borrowed€funds€are€used.Ō#†X$åXX X$åR.#ŌŌ‡ X$åXXX$åŌņņŠ ‚"C ŠóóĢ9.€ņņ"It€is€as€natural€that€the€U.S.€should€import€savings€from€countries€that€are€good€at€savingŠ T$! Šas€that€we€should€import€coffee€from€countries€that€are€good€at€producing€coffee.€€Even€if€thisĻmeans€that€our€balance„of„trade€deficit€gets€worse€and€worse,€any€attempt€to€interfere€with€itĻwould€be€improper€and€unwise."€€Evaluate.óó€€Ō#†X$åXX X$å”/#ŌŌ‡ X$åXXX$åŌThe€answer€is€basically€the€same€as€for€questionŠ 'Ņ $ Š8c€above.Ō#†X$åXX X$åV1#ŌŌ‡ X$åXXX$åŌŠ ü'½!% ŠĢ10.€ņņ"The€great€thing€about€specialization€and€trade€is€that€it€expands€our€potential€standard€ofŠ Ī)#' Šliving.€€But€the€still€greater€problem€is€that€free€trade,€while€wonderful€for€the€winners,€leavesĻthe€losers€not€only€economically€weak€but€subservient€to€the€winners.€€In€reality,€we€need€toĻinclude€some€economic€protection€for€the€losers€if€we€want€to€reap€the€net€gains€promised€byĻinternational€trade."€€Do€you€agree€or€disagree?€€Give€a€full€evaluation€of€this€statement,€andŠ t-5'+ Šexplain€your€reasoning.€€óóŌ#†X$åXX X$åę1#ŌŌ‡ X$åXXX$åŌIn€order€to€take€advantage€of€the€opportunities€offered€by€world€tradeŠ ? Šwe€must€be€able€to€redirect€our€resources€in€response€to€changing€technologies€and€consumerĻpreferences€and€other€factors€that€dictate€comparative€advantage.€€With€only€a€small€handful€ofĻexceptions€(public€goods,€infant€industry,€etc.),€trade€restrictions€to€protect€a€particular€industryĻor€a€"way€of€life"€or€a€region,€we€will€end€up€imposing€a€net€loss€on€the€nation's€real€output.€ĻThe€converse€of€this€is€that€the€gains€from€unrestricted€trade€will€more€than€offset€the€lossesĻexperienced€by€those€hurt€by€the€reallocation€of€resources.€€There€is€an€enormous€practicalĻproblem€of€how€to€identify€and€then€compensate,€out€of€the€net€gains€from€the€expanded€trade,Ļthose€who€are€hurt€by€tradeŌ#†X$åXX X$åd4#ŌŌ‡ X$åXXX$åŌ.€€In€practice,€such€attempts€to€ease€the€costs€imposed€by€losersŠ ‰ J Šthrough€public€policy€are€clearly€imperfect€and€incomplete.€€The€more€we€attempt€to€expandĻsuch€programs,€the€more€likely€we€are€to€weaken€the€incentives€for€people€to€transfer€their€workĻand€capital€out€of€areas€in€which€we€are€relatively€inefficient€and€into€areas€in€which€we€nowĻhave€a€comparative€advantage.€€But€there€are€ways€that€we€can€protect€ourselves€by€the€kindsĻof€education€and€skills€we€develop€„„€not€too€specialized,€emphasizing€general€skills€that€can€beĻtransferred€from€area€to€area€and€so€on.€€In€any€event,€the€statement€in€the€question€that€saysĻ"we€need€to€include€some€economic€protection€for€the€losers€if€we€want€to€reap€the€ņņnetóó€gainsŠ č©  Špromised€by€international€trade"€is€not€true€economically,€but€it€may€be€true€politically.€€If€tooĻmany€people€are€harmed€by€international€trade€and€not€compensated€through€retraining€or€otherĻmeans,€then€the€political€process€may€generate€trade€restrictions€even€though€these€impose€a€netĻloss€on€the€economy.Ō#†X$åXX X$å¹7#ŌŌ‡ X$åXXX$åŌŠ ŽO ŠĢ11.ņņ€Your€rich€uncle€is€convinced€that€the€trend€toward€less€restrictions€on€international€trade€isŠ `! Šabout€to€end€and€that€the€rest€of€the€nineties€will€see€round€after€round€of€tariffs€and€subsidiesĻdesigned€to€increase€one€nation's€advantage€at€the€expense€of€the€others.€€Knowing€of€yourĻinterest€and€training€in€economics,€he€has€set€up€a€fund€of€$1,000,000€for€you€to€manage€in€aĻway€that€would€take€advantage€of€his€virtual€certainty€of€a€coming€round€of€trade€wars€and€aĻreduction€in€the€volume€of€world€trade.€€Use€your€understanding€of€the€macroeconomy€to€deviseĻa€strategy€for€maximizing€his€return€by€appropriate€investments€„„€both€stocks€and€bonds€„„€inĻthe€U.S.€economy.€€Assume€his€forecast,€which€differs€completely€from€current€conventionalĻpredictions,€nevertheless€comes€true.€€Explain€your€reasoning.Ō#†X$åXX X$å8<#ŌŌ‡XƒčXXX$åŌóó€€Ō#†X$åXXXƒčŁ?#ŌŌ‡ X$åXXX$åŌThe€key€event€here€is€thatŠ Ŗ k Šincreased€protectionist€policies€will€result€in€negative€supply„shocks€and,€hence,€higher€real€ratesĻof€interest€and€falling€bond€prices.€€He€should€sell€bonds€now€and€buy€them€back€after€theirĻprice€decline.€€In€terms€of€stocks,€he€should€sell€holdings€in€industries€that€are€particularlyĻsensitive€to€rising€real€interest€rates€or€are€especially€dependent€on€open€foreign€markets.Š  P$! ŠŌ#†X$åXX X$å @#ŌŌ‡XƒčXXX$åŌßi€7N3#h 0  `€€E°@xĆee®łč? Œißā °±°±°(#°(#āā āā āā āā ā°ā āā °±°±°±°±ā°ā āā °±°±°±°±ā°ā āā °±°±°±°±ā°ā āā °(#°(#°±°±āŌ#†X$åXXXƒč$B#ŌŌ‡ X$åXXX$åŌ2.ņņ€It€is€widely€believed€that€private€saving€in€the€U.S.€has€diminished€over€recent€decades€andŠ _  Šthat€this€is€responsible€for€a€number€of€our€economic€problems.€€But€suppose€there€is€a€suddenĻand€substantial€increase€in€saving€as€it€returns€to€earlier€levels,€with€a€resulting€decline€inĻautonomous€consumption€(„ššcņņ0óó).€€In€terms€of€our€new€expectations„augmented€model€(AD/ASņņeóó)Š  Ż Štrace€the€impact€of€this€event€from€short€run€through€long€run,€explaining€the€process€linkingĻshort„€and€long„run€outcomes.€€Specifically,€use€the€model€to€explain€how€this€drop€inĻautonomous€consumption€will€affect€y,€P,€r,€i,€x,€b,€and€e.óóŌ#†X$åXX X$åŖC#ŌŌ‡ X$åXXX$åŌ€€The€drop€in€autonomous€spendingŠ ×˜  Šcauses€a€leftward€shift€of€the€IS€curve€and€the€usual€contraction€of€aggregate€demand.€€TheĻdifference€from€earlier€chapters€is€that€we€now€have€a€more€realistic€model€that€allows€the€priceĻlevel€to€adjust€partially€in€the€short€run,€and€so€this€means€that€the€LM€curve€will€also€shiftĻ(partially)€in€the€short€run.€€Compared€to€the€more€simplistic€rigid€short€run€price€model€we€getĻa€somewhat€different€pattern€of€short„run€changes.€€The€long„run€outcome€is€the€same,€thoughĻit€now€has€a€bińńńńńńŌ% €K Ōńńńńńńt€more€substance,€since€it€is€tied€to€how€quickly€information€flows€andĻexpectations€adjust.€€The€short„run€impact€is€„ššy,€„ššP,€„ššr€and€also€+šši€(due€to€„ššr),€+ššxĻ(due€to€„ššy€ņņandó󀄹šr),€+ššbņņ(cyc)óó€and€„šše€(due€to€„ššr).€€In€the€long€run,€we€move€back€to€fullŠ !ā Šemployment€with€complete€market€clearing,€and€so€ššy=0,€„„ššP,€„„ššr,€++šši,€+ššx,€ššb=0,Ļand€„šše.Ģ⠰°°(#°(#āŌ#†X$åXX X$å“F#ŌŌ‡ X$åXXX$åŌĢÖ€ĒÖß…€&+O?;h|Ŗ3T`Ų0uhfę3³Ģ ¤š’’€EĀŒT(ĀŒT…ß3.ņņ€According€to€the€AD/ASņņeóó€framework,Š Ēˆ Šprice€level€expectations€can€play€aĻsignificant€role€in€determining€real€output,Ļreal€interest€rates,€and€so€on.€€ĢĢa.€Use€this€model€to€show€the€likely€impactĻof€a€sudden€doubling€of€the€expected€priceĻlevel,€assuming€no€other€changes€in€eventsĻor€policies.€€In€particular,€explain€whetherĻthere€is€good€reason€to€fear€that€such€anĻeconomy€would€be€highly€susceptible€to€theĻproblem€of€"self„fulfilling€prophecies."€€óóŌ#†X$åXX X$åļJ#ŌŌ‡ X$åXXX$åŌIfŠ Ģ#! Šprice€level€expectations€suddenly€doubleĻfrom€Pņņeóó=Pņņ0óó€to€Pņņeóó=2Pņņ0óó,€the€short„runŠ  %a# Šaggregate€supply€curve€will€shift€up,€asĻshown€in€the€bottom€graph€on€the€right,Ļmoving€the€economy€from€A€to€B€in€theĻshort€run.€€The€rise€in€the€ņņactualóó€price€levelŠ D)#' Š(from€Pņņ0óó€to€Pņņ1óó)€causes€LM€to€shift€to€theŠ /*š#( Šleft.€€The€net€result€of€this€increasedĻexpectation€of€+ššP€is€an€actual€+ššP€asĻwell€as€a€drop€in€real€output€and€an€increaseĻin€the€real€interest€rate.€€So,€in€this€sense,ŠÓ-”',°Ā°Ā Šwe€could€say€that€expectations€have€been€partially€self„fulfilling,€since€the€price€level€has€risenĻless€than€was€expected.€€But€note€that€if€the€ņņonlyóó€thing€that€changed€was€expectations,€the€long„Š (é Šrun€equilibrium€will€return€to€point€A,€where€the€actual€and€expected€price€level€are€equal.€€InĻother€words,€if€there€are€no€objective,€tangible€reasons€for€expectations€to€have€changed,€weĻwould€expect€that€they€will€return€to€their€original€level€even€though€unstable€expectations€canĻcause€short„run€deviations€from€full€employment.€ņņŌ#†X$åXX X$å“M#ŌŌ‡ X$åXXX$åԀРЏ ŠĢb.€How€does€the€extent€to€which€changing€price€expectations€affect€real€output€depend€onĻwhether€expectations€adjust€"adaptively"€or€"rationally?"€€Explain.€€óóŌ#†X$åXX X$å”R#ŌŌ‡ X$åXXX$åŌIf€expectations€were€formedŠ ‹ L Š"rationally"€we€would€expect€that€they€would€adjust€less€sluggishly,€and€the€recovery€from€BĻto€A€would€be€relatively€quick.€€"Adaptive"€expectations€„„€based€solely€on€the€actual€price€levelĻin€the€preceding€periods€„„€would€take€longer€to€work€their€way€down,€since€they€will€be€underĻthe€influence€of€the€short„run€price€level€at€Pņņ1óó€for€a€longer€time.Š 1ņ  ŠŌ#†X$åXX X$åŽS#ŌŌ‡ X$åXXX$åŌĢ4.€ņņAccording€to€the€AD/ASņņeóó€model,€why€do€price€level€misperceptions€have€such€a€potentiallyŠ Ä  Špowerful€impact€on€the€overall€economy?€€Explain€fully.€€óóŌ#†X$åXX X$å}U#ŌŌ‡ X$åXXX$åŌStudents€should€be€encouraged€to€putŠ īÆ  Šthis€in€their€own€words,€in€a€way€that€makes€sense€to€them.€€The€answer€should€revolve€aroundĻthe€point€that€we€make€our€current€choices€based€on€our€perceptions€and€that€these€willĻsometimes€by€wrong.€€These€initial€misperceptions€have€an€impact€on€labor€supply€andĻproduction€decisions€that€can€be€thought€of€as€the€"first€round"€impact€of€unexpected€events€orĻpolicies€on€real€output€and€employment.€€How€long€the€resulting€divergence€from€fullĻemployment€lasts€will€depend€upon€a€combination€of€how€rapidly€expectations€adjust€to€the€newĻinformation€and€the€extent€to€which€various€market€frictions€slow€down€the€rate€at€whichĻmarket„clearing€wage€and€price€changes€actually€occur.ĢĢŌ#†X$åXX X$åuV#ŌŌ‡ X$åXXX$åŌ5.ņņ€Evaluate€the€statements€below,€noting€how€they€depend€on€the€presence€of€specific€conditions.Š  Ė ŠĢa.€"The€'policy€ineffectiveness€proposition'€is€non„activist€propaganda€masquerading€as€scientificĻanalysis.€€It€has€no€logical€foundation€and€obviously€doesn't€apply€to€the€world€in€which€weĻlive."€€óóŌ#†X$åXX X$åŸY#ŌŌ‡ X$åXXX$åŌThe€"policy€ineffectiveness€proposition"€is€a€serious€scientific€hypothesis€that€says€thatŠ ° q Šthe€primary€reason€that€real€output€diverges€from€its€full€employment€level€is€because€ofĻmisperceptions,€and€that€there€are€good€economic€reasons€to€think€that€we€make€considerableĻeffort€to€correct€our€perceptions€and€adjust€our€decisions€should€they€be€based€on€incorrectĻinformation.€€Once€you€accept€the€fact€that€ņņonlyóó€misperceptions€can€cause€deviations€from€fullŠ V$! Šemployment,€it€is€hard€to€find€a€very€convincing€rejection€of€this€theorem€of€policyĻineffectiveness.€€But€the€New€Keynesian€inclusion€of€market€frictions€says€that€even€with€rationalĻexpectations€there€will€be€a€slower€return€to€full€employment€and€hence€an€opportunity€forĻstabilization€policy€to€make€its€contribution.€€These€are€alternative€hypotheses,€and€if€the€newĻKeynesian€frictions€turn€out€to€be€relatively€small€in€practice,€then€the€hypothesis€of€"policyĻineffectiveness"€and€its€non„activist€implications€cannot€be€dismissed€even€if€we€may€not€likeĻtheir€policy€implications.€€ĢĢb.ņņŌ#†X$åXX X$å%[#ŌŌ‡ X$åXXX$åŌ€"Fine€tuning€is€likely€to€do€more€harm€than€good€because€it€treats€the€symptoms€of€instabilityŠ ‰,J&* Šrather€than€their€underlying€cause."óóŌ#†X$åXX X$åø_#ŌŌ‡ X$åXXX$åŌ€€Whether€or€not€"fine€tuning"€is€a€useful€metaphor€andŠ t-5'+ Šstrategy€for€stabilization€policy€is€again€a€scientific€question,€not€an€issue€to€be€decided€by€anĻappeal€to€ideological€criteria.€€It€could€be€the€case€that€as€our€economic€knowledge€„„€theory€andĻmeasurement€„„€continues€to€improve€that€we€will€have€the€capability€of€intervening€much€moreĻeffectively,€keeping€the€economy€much€closer€to€full€employment€than€we€have€in€the€past.€ĻThose€whose€value€judgments€tell€them€the€less€government€involvement€the€better€could€stillĻtake€a€non„activist€position.€€But€they€could€no€longer€contend€that€such€a€policy€is€a€failure,Ļonly€that€they€think€it€is€unwise€to€give€such€powers€to€the€government,€even€though€they€areĻlikely€to€reduce€economic€fluctuations€and€lower€the€average€unemployment€rate.Ō#†X$åXX X$å•`#ŌŌ‡ X$åXXX$åŌņņŠ ž _ ŠóóĢ6.ņņ€The€call€for€an€end€to€continuing€government€budget€deficits€is€not€only€politically€bipartisanŠ p1  Šbut€also€has€advocates€from€all€the€schools€of€thought€on€macroeconomic€fluctuations.€€SupposeĻa€substantial€cut€in€government€spending€is€made€to€try€to€end€the€large€cash„flow€deficits.€€How€Ļwould€the€predictions€of€its€macroeconomic€consequences€differ€across€the€following€groups:ĻKeynesian,€new€Keynesian,€new€classical,€real€business€cycle,€and€monetarist?€€Explain.€óóŌ#†X$åXX X$å d#ŌŌ‡ X$åXXX$åŌ€ThisŠ ×  Šis€a€good€question€to€test€students'€understanding€of€these€alternative€models€in€a€fairlyĻstraightforward€setting€„„€a€cut€in€government€spending.€€The€answers€will€differ€according€toĻthe€underlying€views€of€how€fast€expectations€adjust,€the€extent€of€tax€discounting€behavior,€€andĻthe€degree€to€which€there€are€other€frictions€beyond€misperceptions.€€The€€"In€Summary€.€.€.ĻA€Guide€to€Business€Cycle€Theories"€at€the€end€of€section€8.8€provides€a€simple€framework€forĻanswering€this.€€The€basic€Keynesian€framework€would€predict€the€largest€drop€in€real€outputĻwhen€government€spending€is€reduced.€€The€real€business€cycle€and€new€classical€views€wouldĻpredict€little€or€none,€since€the€surprise€element€will€dissipate€quickly.€€The€new€Keynesian€viewĻwould€see€market€frictions€causing€reduced€output€to€persist€even€after€expectations€haveĻadjusted.€€The€monetarist€view,€though€non„activist€like€the€new€classical€and€real€businessĻcycle,€sees€less€rapid€return€to€full€employment.€€Its€prediction€of€the€short„run€contractionaryĻimpact€of€this€spending€cut€would€be€more€like€the€Keynesian€and€new€Keynesian€than€theĻothers.Ō#†X$åXX X$å^f#ŌŌ‡ X$åXXX$åŌŠ ķ® ŠĢ7.ņņ€Recent€studies€have€shown€that€for€every€$100€loss€of€income/output€in€the€economy€(„ššy),Š æ€ Šthe€government€absorbs€approximately€$33€of€it.€€About€$25€of€the€$100€drop€in€before„taxĻincome€comes€out€of€taxes.€€Another€$8€comes€from€increased€transfer€payments€(e.g.,Ļunemployment€compensation€and€welfare€payments)€and€increased€interest€payments€(on€theĻrising€Federal€deficit).€€The€net€result€is€that€household€income€falls€only€about€$67€instead€ofĻthe€full€$100.€€Many€believe€that€this€"automatic€stabilizer"€mechanism€has€been€responsible€forĻmuch€of€the€apparent€reduction€in€output€and€employment€fluctuations€in€the€U.S.€in€the€post„¼World€War€II€period.Ģ€€Ģa.€Explain€how€the€declining€tax€payments€and€increasing€transfer€payments€work€as€anĻ"automatic€stabilizer."€óó€By€preventing€after„tax€income€(y„t)€from€falling€as€much€as€it€otherwiseŠ Ū(œ"& Šwould,€such€programs€reduce€the€size€of€the€multiplier€and,€hence,€the€distance€of€the€leftwardĻshift€in€IS€and€AD.€€But€alert€students€will€remember€that€this€cushion€is€no€free€lunch.€€SinceĻthere€is€a€drop€in€tax€collections€and€a€slight€increase€in€government€spending,€this€tells€us€thatĻthe€cushion€is€merely€a€tax€postponement€that€shows€up€as€a€higher€deficit€now€and€higher€taxesĻ(deficit€plus€interest)€later.€€To€the€extent€that€we€are€tax„discounters,€this€"cushion€ofŠ j-+'+ Špostponement"€will€have€a€reduced€impact.€€The€nature€and€implications€of€tax„discountingĻbehavior€is€discussed€in€Chapter€12.ņņŠ (é ŠĢb.€In€what€ways€is€that€preferable€to€using€discretionary€policy€changes€to€deal€with€theĻproblem?€€In€what€ways€is€it€inferior?€€Explain.€€óóOne€of€the€main€advantages€of€such€stabilizersŠ ć ¤ Šis€that€they€have€been€set€up€in€advance€and€kick€in€as€soon€as€the€downturn€begins.€€ThisĻavoids€the€inevitable€and€sometimes€very€long€delays€when€a€discretionary€fiscal€response€mustĻgo€through€the€legislative€process.ņņŠ   a ŠĢc.€Suppose€we€extend€the€scope€of€this€program€by€increasing€transfer€payments€so€that€the€entireĻloss€in€income€is€cushioned.€€Evaluate€the€likely€costs€and€benefits€of€such€an€aggressiveĻautomatic€stabilization€program.€€Explain.€€óóPushing€it€to€such€an€extreme€makes€it€sound€tooŠ D  Šgood€to€be€true€and€should€trigger€a€skeptical€response€in€all€of€us.€€We€can't€get€something€forĻnothing€and,€hence,€this€entire€cushion€must€be€paid€by€someone,€sometime.€€The€longer€it€isĻpostponed,€the€higher€the€interest€payments€will€be.€€The€issue€of€tax„discounting€behaviorĻcomes€into€play€and€seems€more€likely€as€we€push€the€program€to€such€an€extreme.ĢĢ8.ņņ€To€which€explanation€of€cyclical€fluctuations€„„€classical,€Keynesian,€monetarist,€newŠ ¼} Šclassical/real€business€cycle,€or€new€Keynesian€„„€do€you€think€each€of€the€following€statementsĻapplies?€€(Note:€they€may€fit€more€than€one€or€they€may€fit€none.)€€Briefly€defend€your€answer.ĢĢa.€"Economic€fluctuations€associated€with€the€ups€and€downs€of€the€business€cycle€are€not€aĻmajor€economic€problem.€€In€fact,€they€are€the€inevitable€side€effects€of€the€workings€of€a€marketĻsystem."€€óóŌ#†X$åXX X$å&k#ŌŌ‡ X$åXXX$åŌClassical€and€new€classical/real€business€cycle€would€share€this€view.Ō#†X$åXX X$åöw#ŌŌ‡ X$åXXX$åŌņņŠ 4õ ŠĢb.€"The€primary€justification€for€having€policy€rules€is€the€presence€of€long€and€variable€lags€inĻthe€policy„making€process."€óóŌ#†X$åXX X$å~x#ŌŌ‡ X$åXXX$åŌ€Ō#†X$åXX X$å[y#ŌŌ‡ X$åXXX$åŌMonetarists€emphasize€the€possibility€of€such€lags€as€being€a€reasonŠ ń² Što€avoid€an€activist€policy€of€"fine€tuning."€€But€even€with€a€policy€rule€there€can€beĻunpredictable€lags€between€the€time€the€policy€change€is€made€and€its€impact€on€the€economy.€ĻSupport€for€rules€has€more€to€do€with€predictability€and€the€issue€of€inflationary€bias€(to€beĻdiscussed€in€the€next€chapter).€€€€ņņ€€Š —!X ŠĢc.€"The€major€reason€that€unemployment€persists€so€long€is€the€failure€of€price€expectations€toĻadjust€rapidly€enough."€€óóŌ#†X$åXX X$åžy#ŌŌ‡ X$åXXX$åŌThe€basic€Keynesian€and€monetarist€views,€so€different€in€theirŠ T$! Šconclusions€about€stabilization€policy,€share€a€theoretical€framework€with€relatively€sluggishĻadaptive€expectations.Ģ€€Ō#†X$åXX X$å|#ŌŌ‡ X$åXXX$åŌņņŠ 'Ņ $ Šd.€"The€credibility€of€the€government€(our€confidence€that€they€will€carry€through€on€theirĻannounced€policies)€determines,€in€part,€the€size€of€the€business€cycle."€óóŌ#†X$åXX X$å}#ŌŌ‡ X$åXXX$åŌ€New€classical/realŠ ć(¤"& Šbusiness€cycle€and€new€Keynesian€would€both€stress€this,€because€it€would€reduceĻmisperceptions€as€a€source€of€deviations€from€full€employment.ĢŌ#†X$åXX X$å~#ŌŌ‡ X$åXXX$åŌņņĢe.€"As€sincere€as€policy„makers'€intentions€may€be,€the€unfortunate€result€is€that€their€attemptsĻto€smooth€the€business€cycle€actually€make€it€worse."€€óóŌ#†X$åXX X$å#ŌŌ‡ X$åXXX$åŌMonetarists€are€generally€alone€on€this.€Š r-3'+ ŠThe€other€non„activists€stress€rapid€market„clearing€and€rational€expectations€and,€thereby,€endĻup€with€a€framework€in€which€shifts€in€aggregate€demand€have€relatively€little€impact€on€realĻoutput€and€employment.€Ō#†X$åXX X$åõ#ŌŌ‡ X$åXXX$åŌņņŠ Ņ ŠĢf.€"As€sincere€as€policy„makers'€intentions€may€be,€their€attempts€to€smooth€the€business€cycleĻare€futile.€€They€have€no€impact€whatsoever€on€output€and€employment,€and€they€only€end€upĻdiverting€our€attention€away€from€those€areas€in€which€government€policy€can€make€aĻdifference."€€óóŌ#†X$åXX X$åK#ŌŌ‡ X$åXXX$åŌThis€would€be€the€position€of€the€new€classical€and€real€business€cycle€schools.Ō#†X$åXX X$åʂ#ŌŌ‡ X$åXXX$åŌņņŠ ž _ ŠĢg.€"Changes€in€government€spending€cause€equal€and€opposite€changes€in€private€spending,Ļleaving€total€demand€unchanged."óó€€Ō#†X$åXX X$åXƒ#ŌŌ‡ X$åXXX$åŌThis€would€only€be€true€under€the€classical€assumption€ofŠ [  Šconstant€velocity€of€money.€€The€resulting€vertical€LM€curve€means€that€any€shift€in€IS€(privateĻor€public)€would€have€no€impact€on€aggregate€demand.€€In€a€less€strict€sense,€however,€it€is€trueĻof€all€schools€of€thought€that€a€change€in€government€spending€will€be€exactly€offset€by€privateĻspending€in€the€long€run€in€a€zero„growth,€fully„employed€economy.€€That€is,€although€theĻchange€in€government€spending€will€shift€IS€and€AD,€in€the€long€run€the€economy€will€just€slideĻup€or€down€its€vertical€long„run€AS€curve.ĢŌ#†X$åXX X$å1„#ŌŌ‡ X$åXXX$åŌĢ9.ņņ€The€new€Keynesian€view€of€macroeconomic€fluctuations€is€obviously€a€descendent€of€earlierŠ „f Šviews€in€the€Keynesian,€activist€tradition.€€Compare€these€two€views€in€terms€of€both€their€basicĻassumptions€and€their€implications.€€Evaluate€the€statement€that€"the€new€Keynesian€view€isĻcloser€to€the€new€classical€approach€than€to€the€old€Keynesian€model."óó€€The€similarities€amongŠ b# ŠKeynesian€views€have€to€do€with€the€presence€of€significant€sources€of€market€friction€thatĻprolong€deviations€from€full€employment€following€demand€side€shifts.€€But€over€the€decadesĻthe€early€Keynesian€assertions€of€wage€and€price€rigidity€have€become€increasingly€unconvincingĻfor€both€theoretical€and€empirical€reasons.€€The€market€frictions€of€the€new€Keynesians€are€muchĻmore€limited€and€specific,€too€small€to€justify€the€kind€of€large„scale,€confident,€fine„tuningĻapproach€associated€with€activist€views€of€the€1960s.€€They€can,€under€certain€conditions,Ļsupport€more€cautious€and€restricted€monetary€and€fiscal€responses€to€signs€of€recession€orĻaccelerating€inflation.€€The€new€Keynesian€view€is€more€sensitive€to€the€quickness€at€whichĻmisperceptions€are€corrected€and€often€more€conscious€of€problems€with€policy€lags.€€In€thisĻsense,€it€is€much€closer€to€the€classical,€non„activist€tradition€than€to€the€activist€views€of€theĻearly€Keynesian€model.€€ĢĢ10.€ņņ"It€is€the€responsibility€of€the€government€to€take€such€steps€as€are€necessary€to€minimize€theŠ 9%ś" Šrecessionary€phase€of€the€business€cycle.€€The€cost€in€terms€of€lost€output€and€jobs€is€simply€oneĻthat€cannot€and€need€not€be€tolerated."€€It€seems€almost€impossible€to€disagree€with€such€a€nobleĻstatement,€the€kind€that€any€successful€politician€can€unleash€at€a€moment's€notice.€€Yet€a€carefulĻeconomic€analysis€would€reveal€a€number€of€substantive€issues€that€would€put€this€into€theĻ"easier€said€than€done"€category.€€Evaluate€this€statement€from€the€perspective€of€the€followingĻviews€of€economic€fluctuations:€€monetarist,€new€classical,€real€business€cycle,€Keynesian,€andĻnew€Keynesian.€€Explain€your€reasoning€carefully.€€óóThis€is€just€another€variation€on€the€questionsŠ š+[%) Šanswered€in€8€and€9€above.ĢŠ n-/'+ ЇŌ#†X$åXX X$åŹ†#ŌŌ‡XƒčXXX$åŌßi€7J3 #h 0  `€€E°@xĆee®łč? Œißā °±°±°(#°(#āā āā āā āā ā°ā āā °±°±°±°±ā°ā āā °±°±°±°±ā°ā āā °±°±°±°±ā°ā āā °(#°(#°±°±āŌ#†X$åXXXƒčē#ŌŌ‡ X$åXXX$åŌÖ€4ĒÖ2.ņņ€With€the€coming€of€national€elections,€particularly€presidential,€comes€renewed€awareness€ofŠ _  Šthe€so„called€"political€business€cycle"€„„€that€is,€fluctuations€in€real€output€and€employmentĻattributable€to€political€incentives€and€electoral€politics.€€In€addition€to€the€possibility€of€four„¼year€cycles€in€output,€there€is€the€related€issue€of€a€long„term€trend€in€inflation€which€also€seemsĻto€have€its€roots€in€policy€choices€rather€than€in€the€private€sector€of€the€economy.€€Which,€ifĻany,€of€the€modern€theories€of€economic€fluctuations€„„€new€classical,€new€Keynesian,Ļmonetarist,€and€real€business€cycle€„„€are€consistent€with€the€existence€of€"political€businessĻcycles"€and€"inflationary€bias"?€€Explain€your€reasoning.óó€€Ō#†X$åXX X$åm‘#ŌŌ‡ X$åXXX$åŌThe€inflationary€bias€issue€is€aboutŠ Ą  Ša€potential€inconsistency€in€our€policy€choices.€€To€the€extent€that€the€political€process€ranks€lowĻunemployment€ahead€of€low€inflation,€the€short„run€tradeoff€between€them€tends€to€become€aĻpolicy€trap€that€a€short„sighted€electorate€will€force€politicians€to€lead€us€into.€€The€situation€isĻone€of€self„fulfilling€expectations€and€any€theory€of€the€business€cycle€that€includes€rationalĻexpectations€can€show€a€situation€in€which€discretionary€stabilization€policy€can€be€forced€intoĻan€inflationary€stance.€€This€happens€because€expectations€of€more€inflation€shift€the€short„runĻPhillips€curve€upwards,€and€if€the€government€doesn't€respond€€by€"accommodating"€theseĻhigher€expectations€(+ššš šņņeóó)€with€higher€actual€inflation€(+ššš š)€it€will€create€an€information€gapŠ  Ė Š[(š š„š šņņeóó)<0]€that€will€cause€unemployment€to€rise€[U=Uņņ*óó„ššņņ1óó(š š„š šņņeóó)+ššņņ2óó(U„Uņņ*óó)ņņ„1óó].€€Of€theŠ ó“ Šalternative€theories€of€fluctuations,€the€new€Keynesian€picture€of€the€economy€with€significantĻmarket€frictions€would€make€this€policy€trap€appear€more€irresistible€than€the€other€models.€€TheĻreason€is€that€the€drop€in€unemployment€following€an€unexpected€increase€in€aggregate€demandĻwill€be€longer„lasting€in€the€new€Keynesian€view€than€in€the€others.€€For€the€new€classicalsĻ(AD/ASņņeóó+REH),€the€resulting€„ššU€would€be€so€short„lived€that€it€would€offer€relatively€littleŠ €A Štemptation.€€For€the€real€business€cyclists€(AD/ASņņeóó+REHššššASņņ*óó),€the€situation€would€beŠ i* Šsimilar€because€they€see€demand„side€fluctuations€causing€a€relatively€small€part€of€the€ups€andĻdowns€in€real€output€and€unemployment,€and€standard€macro€policy€manipulation€can't€causeĻor€cure€supply„side€fluctuations.€€Ō#†X$åXX X$廔#ŌŌ‡ X$åXXX$åŌŠ $ å ŠĢ3.ņņ€Suppose€that€the€trend€toward€a€rising€natural€rate€of€unemployment€finally€turns€around€andŠ ö!· Šwe€experience€„ššUņņ*€óófor€the€remainder€of€the€90s.€€Assuming€that€there€are€no€other€major€eventsŠ į"¢  Šor€policy€changes,€what€impact€would€you€predict€this€would€have€on€š š,€y,€r,€R,€c,€i,€x,€b,€e,Ļand€E?€€Explain.€€óóŌ#†X$åXX X$åQœ#ŌŌ‡ X$åXXX$åŌA€reduction€in€the€natural€rate€of€unemployment€(„ššUņņ*óó)€falls€in€our€earlierŠ ³$t" Šcategory€of€an€improvement€in€"institutional€efficiency"€(+ššiņņnstóó)€and€shows€up€in€the€AD/ASņņeóóŠ ž%_# Šframework€as€a€positive€supply€shock.€€That's€the€key€to€the€impact€on€real€output,€real€interestĻrates,€consumption,€investment,€and€so€on.€€But,€as€will€be€made€clearer€in€the€next€chapter,€theĻimpact€on€the€rate€of€inflation€(hence,€R€and€E)€will€last€only€for€the€duration€of€these€shifts.€ĻOnce€the€natural€rate€stabilizes€at€a€new€level,€however€much€lower€it€may€be,€the€inflation€rateĻwill€return€to€its€initial€level€(assuming,€of€course,€nothing€else€but€Uņņ*óó€has€changed).€€It€isŠ +*ģ#( Štempting€to€think€that€the€lower€natural€rate€of€unemployment€will€bring€lower€inflation.€€ThatĻwill€happen€only€during€the€adjustment€while€ASņņ*óó€is€shifting€out.€€But€once€the€change€isŠ ż+¾%* Šcomplete,€we€will€see€the€LRPC€having€shifted€left€and€the€economy€at€the€same€rate€of€inflationĻas€when€the€falling€Uņņ*óó€began.€€It's€just€another€way€of€coming€upon€the€important€truth€thatŠ Ļ-', Šthere's€no€long„run€relationship€between€inflation€and€unemployment.Ō#†X$åXX X$åž#ŌŌ‡ X$åXXX$åŌņņŠ ? ŠóóĢ4.ņņ€In€terms€of€the€basic€equation€and€graph€of€the€Phillips€curve€„„€U=Uņņ*óó„ššņņ1óó(š š„š šņņeóó)+ššņņ2óó(U„Uņņ*óó)ņņ„1óóŠ Ņ Š„„€suppose€that€ššš šņņeóó=0€always.€€Graph€the€Phillips€curve€and€discuss€its€policy€implications.€€Š ü½ ŠĢa.€Why€does€constant€expectations€make€such€a€difference?€€óóSince€inflation€expectations€is€theŠ Ī  Škey€shift€variable€in€the€short„run€Phillips€curve,€its€constancy€means€that€movements€up€orĻdown€the€short„run€Phillips€curve€will€no€longer€generate€the€pressure€for€a€ššš šņņeóó€that€will€shiftŠ ¢ c Šthe€short„run€curve.ņņŠ ‹ L ŠĢb.€How€might€this€relate€to€the€observed€long„run€tradeoff€originally€identified€by€A.€W.€Phillips?€ĻExplain.óó€€Ō#†X$åXX X$å2£#ŌŌ‡ X$åXXX$åŌThis€is€an€obvious€explanation€of€periods€in€which€the€tradeoff€apparently€remainedŠ F  Šstable€over€time.€€It€points€up€the€important€result€that€the€original€Phillips€curve€has€essentiallyĻbecome€a€special€case€of€the€modern€Phillips„curve€model.Ō#†X$åXX X$娦#ŌŌ‡ X$åXXX$åŌŠ Ū  ŠĢ5.ņņ€Suppose€an€empirical€study€finds€that€the€Phillips€curve€for€the€U.S.€can€be€represented€byŠ ģ­  Šthe€following€relationship€„„€U=.06„.5(š š„š šņņeóó).€Š ט ŠĢa.€€Graph€it€and€discuss€the€specifics€of€the€tradeoff.€€óóŌ#†X$åXX X$åń§#ŌŌ‡ X$åXXX$åŌGraphing€U=.06„.5(š š„š šņņeóó)€yields€a€LRPCŠ ©j Š(š šņņeóó=„š š)€that€is€vertical€at€the€natural€rate€of€6%.€€Multiplying€out€gives€us€U=[.06+.5š šņņeóó]„.5š š,Š ”U Šwhere€the€horizontal€intercept€is€the€term€in€brackets€and,€therefore,€increases€and€decreasesĻwith€changes€in€inflation€expectations.€€The€slope€of€the€short„run€Phillips€Curve€is€dš š/dUĻ=1/(dU/dš š)€which,€in€this€equation,€comes€out€as€1/(„.5)€or€„2.€€A€2%€drop€in€unemploymentĻaccompanies€a€1%€increase€in€inflation,€other€things€the€same.€(A€more€realistic€slope€of€theĻSRPC€would€be€something€like€„.5,€implying€an€ššņņ1óó€parameter€of€„2.0€rather€than€„0.5.)Ō#†X$åXX X$åK©#ŌŌ‡ X$åXXX$åŌņņŠ !ā ŠĢb.€Now€suppose€that€a€second€study€identifies€a€significant€omission€and€finds€that€the€U.S.€isĻbest€described€by€U=.06„.5(š š„š šņņeóó)+.5(U„.06)ņņ„1óó.€Graph€it,€and€discuss€the€tradeoff.€€How€wouldŠ Ü Šthe€implications€of€this€relationship€differ€from€those€of€the€first?€€Explain.óó€Ō#†X$åXX X$å7¬#ŌŌ‡ X$åXXX$åŌThe€second€studyРņ Šyields€an€equation€that€can€be€written€as:€U=[.06+.5š šņņeóó+.5Uņņ„1óó„.5(.06)]„.5š š€orŠ ° q ŠU=[.03+.5š šņņeóó+.5Uņņ„1óó]€„€.5š š.€€Assuming€ššUņņ*óó=0,€this€still€yields€a€vertical€LRPC€(since€(.5)Uņņ„Š ™!Z Š1óó=3%€in€the€long€run).€€The€difference€between€this€equation€and€the€one€from€the€initial€studyŠ ‚"C Šis€that€the€intercept€now€contains€the€lagged€unemployment€term€(.5Uņņ„1óó).€€This€slows€down€theŠ k#,  Šreturn€to€full€employment€by€adding€a€presumed€"friction"€in€addition€to€the€inflationĻmisperceptions.€€It's€in€the€spirit€of€the€new€Keynesian€model€of€business€fluctuations.Ō#†X$åXX X$åČ­#ŌŌ‡ X$åXXX$åŌŠ =%ž" ŠĢ6.ņņ€Occasionally€the€economy€finds€itself€in€a€situation€of€"inflationary€recession,"€which€meansŠ 'Š $ Šhigh€inflation€but€output€below€the€full€employment€level.€€In€terms€of€the€Phillips€curve,€it€showsĻup€as€š š>0€and€U>Uņņ*óó€simultaneously.€€Š ć(¤"& ŠĢa.€How€would€this€situation€show€up€in€the€Phillips€curve€graph€and,€according€to€the€modernĻview€of€the€Phillips€curve,€how€could€misinformation€contribute€to€the€situation?€€Be€specific.ĻóóŌ#†X$åXX X$åͰ#ŌŌ‡ X$åXXX$åŌThis€requires€some€combination€of€misperceptions€(specifically,€š šņņeóó>š š)€and/or€market€frictionsŠ ‡,H&* Š[mimicked€by€(U„Uņņ*óó)ņņ„1óó>0]€that€leave€U>Uņņ*óó,€because€one€or€both€of€last€two€terms€in€theŠ p-1'+ ŠPhillips€curve€equation€€(Ō#†X$åXX X$å³#ŌŌ‡ X$åXXX$åŌU=Uņņ*ņ ņóó„ššņņ1óó(š š„š šņņeóó)ó ó+ņ ņššņņ2óó(U„Uņņ*óó)ņņ„1ó óóóŌ#†X$åXX X$å\“#ŌŌ‡ X$åXXX$åŌ)€have€positive€values.€Ō#†X$åXX X$åņ“#ŌŌ‡ X$åXXX$åŌŠ ? ŠĢb.€ņņ"The€solution€to€inflationary€recession€requires€a€combination€of€contractionary€monetaryŠ Ó Špolicy€(to€reduce€inflation)€and€expansionary€fiscal€policy€(to€stimulate€output)."€€Evaluate.óó€Ō#†X$åXX X$åLµ#ŌŌ‡ X$åXXX$åŌThisŠ ż¾ Šseemingly€wise€statement€is€quite€wrong€in€the€context€of€the€modern€AD/ASņņeóó€and€Phillips€curveŠ č © Šmodel.€€The€simplest€way€to€see€this€is€to€note€that€it€calls€for€a€policy€that€expands€aggregateĻdemand€to€be€combined€with€another€policy€that€contracts€aggregate€demand.€€They're€workingĻin€opposite€directions€and€they€will€either€just€cancel€each€other€out,€leaving€aggregate€demandĻunchanged,€or€one€will€predominate,€worsening€one€thing€but€improving€the€other.€€There€is€anĻimplicit€solution€to€a€situation€of€inflationary€recession€in€the€Phillips€curve€framework,€but€itĻis€certainly€not€this€one.Ō#†X$åXX X$åz¶#ŌŌ‡ X$åXXX$åԀР^  ŠĢ7.ņņ€Evaluate€the€statements€below€in€terms€of€the€AD/ASņņeóó€model€and€modern€views€of€the€PhillipsŠ 0ń  Šcurve.€€ĢĢa.€"Long„run€equilibrium€means€full€employment,€but€it€can€occur€at€any€rate€of€inflation.€€OnlyĻby€accident€would€inflation€happen€to€be€zero."€€Do€you€agree?€€€óóŌ#†X$åXX X$åH¹#ŌŌ‡ X$åXXX$åŌIt's€true€that€full€employmentŠ Ö— Šis€invariant€with€respect€to€the€inflation€rate€in€this€model.€€€(Of€course€ņņextremelyóó€high€rates€ofŠ Į‚ Šinflation€will€cause€demonetization€and,€thereby,€falling€output€and€rising€unemployment.€€ThisĻPhillips€curve€model€would€need€to€be€amended€for€the€triple„digit€and€higher€inflationĻsituations.)€€But€to€say€that€only€by€accident€would€inflation€be€zero€suggests€that€inflation€hasĻnothing€to€do€with€our€actions€and€policies.€€The€next€chapter€will€focus€on€how€and€whyĻinflation€is€our€policy€choice.Ō#†X$åXX X$åĢŗ#ŌŌ‡ X$åXXX$åŌņņŠ P ŠĢb.€"Reducing€inflation€without€causing€a€rise€in€unemployment€can€be€achieved€only€with€aĻcareful€and€intelligent€blend€of€monetary€and€fiscal€policies."€€Do€you€agree?€€óóŌ#†X$åXX X$åR½#ŌŌ‡ X$åXXX$åŌThis€is€the€sameŠ  Ģ Škind€of€nonsense€statement€as€in€the€second€part€of€question€6.€€The€most€important€lesson€aboutĻdisinflation€is€the€crucial€role€that€credibility€and€expectations€play€in€determining€how€muchĻunemployment€results.€€Ō#†X$åXX X$åZ¾#ŌŌ‡ X$åXXX$åŌņņРȉ ŠĢ8.€Evaluate€the€statements€below.ĢĢa.€"The€basic€message€of€the€modern€Phillips€curve€is€that€once€high€inflation€is€built€into€anĻeconomy,€reducing€it€is€very€difficult€and€costly.€€The€strong€implication€is€that€it€is€not€worthĻthe€recession€it€would€take€to€reduce€it."€€óóŌ#†X$åXX X$噿#ŌŌ‡ X$åXXX$åŌThis€statement€overstates€the€case.€€How€deep€theŠ >%’" Šresulting€recession€would€be€depends€on€how€rapidly€expectations€adjust€(hence€the€credibilityĻof€the€policy€change)€and€the€degree€of€market€frictions.€€It€also€makes€the€implicit€presumptionĻthat€the€cost€of€continued€inflation€is€small€relative€to€the€cost€of€temporary€unemployment.€ĻThere's€something€to€this,€and€it€is€examined€in€the€next€chapter.Ō#†X$åXX X$å Į#ŌŌ‡ X$åXXX$åŌņņŠ ä(„"& Šā āŠ Ķ)Ž#' Šß€&.I 95h p«’{`Ų0uoĢĢĢĢĆõ’’(€E—ŗ <q;q—ŗ <qßb.€"The€Employment€Act€of€1946€and€ā āsubsequent€Acts€commit€the€government€to€policies€that€willĻbring€about€full€employment€and€price€stability.€€Not€only€is€this€beyond€the€government's€power,Ļbut€it€is€dangerous€in€failing€to€recognize€that€the€costs€of€unemployment€are€far€greater€thanĻthe€costs€of€inflation.€€We€need€to€strike€a€realistic€balance€between€these€two€evils€that€reflectsĻtheir€importance€in€our€lives."€€óóŌ#†X$åXX X$åóĀ#ŌŌ‡ X$åXXX$åŌA€puzzling€statement,€to€say€the€least.€€The€last€sentence€shouldŠ ć ¤ Šbe€a€red€flag€to€students€by€now.€€The€message€of€the€modern€Phillips€curve€is€that€the€notionĻof€a€š šrealistic€balancešš€between€inflation€and€unemployment€is€an€erroneous€and€perniciousĻconcept.€€Ō#†X$åXX X$åŸÅ#ŌŌ‡ X$åXXX$åŌŠ   a Šā °—°—°(#°(#āĢ9.ņņ€€Suppose€there€are€three€very€similarŠ r3  Šeconomies,€initially€at€full€employment€with€noĻinflation.€€All€three€suddenly€increase€moneyĻsupply€growth€by€10%.€€In€Country€A,€theĻunemployment€rate€declines;€in€B,€it€doesn'tĻchange€at€all;€while€in€C,€it€actually€rises.€ĻHow€could€such€different€outcomes€beĻexplained€in€terms€of€the€Phillips€curve€model?óóŠ Ó” ŠŌ#†X$åXX X$åĒ#ŌŌ‡ X$åXXX$åŌĢĢĢA:€The€increase€in€the€money€supply€increasesĻinflation,€and€if€this€was€not€anticipated,€theĻunemployment€rate€will€fall€to€UņņAóó.Š I  ŠĢB:€If€the€increase€in€the€money€supply€wasĻā °(#°(#°—°—ācorrectly€anticipated,€then€the€+ššš š€will€be€matched€by€+ššš šņņeóó,€leaving€unemployment€at€Uņņ*óó.Š Å ŠŌ#†X$åXX X$åÉ#ŌŌ‡ X$åXXX$åŌĢC:€If€the€10%€increase€in€the€money€supply€was€less€than€anticipated,€the€resulting€+ššš š€willĻbe€less€than€the€+ššš šņņeóó,€and€unemployment€rises€to€UņņCóó.Š æ€ ŠĢ10.€ņņAssuming€that€both€the€data€and€the€statistical€testing€are€reliable,€how€would€you€explainŠ ‘!R Šthe€apparent€fact€that€there€was€a€long„run€tradeoff€between€inflation€and€unemployment€in€theĻU.S.€until€sometime€in€the€1960s,€at€which€time€it€seems€to€have€simply€vanished?€€Ō#†X$åXX X$åÆŹ#ŌóóŌ‡ X$åXXX$åŌThe€answerŠ e#&  Šis€a€combination€of€the€answers€to€questions€4€and€9€above.Ō#†X$åXX X$åŻĢ#ŌŌ‡»SŖ»XX$åŌŠ P$! 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