2. See Text Figure 25.2 and discussion in the text.

Transcription

1 Chapter 25: Using the Economic Fluctuations Model Solutions to End-of-Chapter Problems 1. In Figure 25-1, the AD line shifts from AD 0 to AD 1 by the amount of the increase in G; C increases as real GDP rises in the short run, while X falls and I is unaffected. The IA line remains fixed at IA (SR) due to sticky prices arising from limited information and implicit contracts. Staggered wage contracts also contribute to price inertia. In the medium run, price adjustment begins to occur as indicated by IA (MR). This means that the central bank will raise the interest rate, consistent with the policy rule for the medium run. C continues to rise due to the multiplier effect, and I falls, due to the higher interest rate. X remains above the baseline value since Y exceeds its initial value. The spending line shifts down, reflecting these changes. In the long run, the original baseline values are reobtained at IA (LR) and at LR in the spending diagram. The interest rate is higher at LR on the policy rule line. Figure See Text Figure 25.2 and discussion in the text. 3. The central bank would have to anticipate the increase in G spending by shifting to a more inflation-aggressive policy rule a shift to the left so that at the original inflation rate, IA (SR), the interest rate would be higher. See Figure 25.5 of the text as an example of this. This would be done by lowering the growth of the money supply. The change in the policy rule would shift the AD line to the left so that real GDP is below potential before the increase in G spending. In the short run, I spending would decline because of the increase in the interest rate. X would decline as the dollar appreciates. C spending would decline in the short run because of the decline in real GDP via the multiplier. In the medium run the IA line shifts down to IA (MR) in Figure 25.5 because inflation has declined and the central bank lowers the interest rate under the new policy rule. Real GDP is still below potential, and C, I, and X are below the baseline values. In the long run, the baseline values are reobtained. The process just described assumes that the central bank in effect shifts the AD Copyright Houghton Mifflin Company. All rights reserved. 1

2 Chapter 25 line far enough to the left by the change in monetary policy to allow G spending to take effect well below potential at IA (SR). Thereafter the central bank would have to carry out coordinative monetary policy so that the AD line ends up at its original location in the long run. 4. Reinflation occurs when there is a change in the monetary policy rule. At each inflation rate the interest rate is lower in Figure 25-2 because the central bank adopts a less aggressive stance toward inflation. If the target rate increases from 2 to 5 percent, the central bank increases the growth of the money supply and the interest rate is lower in the short run, SR on the policy rule. I spending increases and Y rises above potential as C spending rises (AD 0 to AD 1 ). A lower interest rate leads to dollar depreciation and exports are more competitive so that net exports rise in the short run. In the medium run IA (MR) rises as the increase in real GDP beyond potential reinflates the economy and the central bank increases the interest rate. I spending is diminished but above the baseline value, along with the C and X components. The central bank further increases the interest rate to LR on the policy rule and I declines along with C. The spending line shifts down to LR, the original real GDP value. The IA line shifts to IA (LR) at potential GDP. The only permanent effect is the higher rate of inflation, since all the spending components return to their baseline values. Figure a. In Figure 25-3, the current deviation from potential is 2 percent. b. Inflation will be 3 percent at potential GDP of $5,000 billion. The adjustment occurs because the GDP deviation from potential is 2 percent. This puts upward pressure on wages and prices that increases the rate of inflation. This will occur because as contracts are renewed, they will reflect altered expectations about inflation so that gradually the inflation rate will increase until it reaches 3 percent. 2 Copyright Houghton Mifflin Company. All rights reserved.

3 Using the Economic Fluctuations Model Potential GDP Inflation IA 1 AD line Real GDP (billions of dollars) Figure a. The Fed policy rule shifts to the left; it slows the growth of money to a rate compatible with 2 rather than 3 percent inflation. This goal is accomplished by the open market sale of government securities, which reduces liquidity in the financial system. b. The scenario starts from potential GDP of $5,000 billion and inflation at 3 percent. The decrease in the growth of money shifts the AD line from AD0 to AD1 in Figure In the short run the shift in the AD line results in a negative deviation of real GDP from potential of 2 percent, since AD 1 has real GDP equal to $4,900 billion at inflation of 3 percent Inflation IA 0 AD 0 IA 1 AD 1 Figure Real GDP (billions of dollars) Copyright Houghton Mifflin Company. All rights reserved. 3

4 Chapter 25 c. The negative deviation from potential in part (b) reduces income through the multiplier. In the short run, C spending falls, X spending rises, and I spending remains the same. The lower inflation target takes effect in the medium run as real interest rates decline so that I spending increases. In the long run the decline in inflation and real interest rate increases C, X, and I spending until potential GDP is reached. 7. a. In the short run GDP is below potential at SR. The Fed is assumed to raise interest rates, consistent with the description in the text. b. This is portrayed in Text Figure Real GDP falls and inflation increases but only temporarily. See discussion of temporary shifts in the IA line. 8. a. The GDP deflator is 100 in 2001 and 105 in 2002 so that the rate of inflation is 5 percent. Because the economy is at potential GDP in 2002, the inflation rate will remain what it was in percent. b. If real GDP is below potential, there is not pressure for wage growth since the natural adjustment is for the IA line to shift down until IA intersects the AD line at potential GDP. 9. Figure 25-5 shows the two countries with the same AD at identical potential GDP, Y* 1 = Y* 2 for country 1 (low money growth) and country 2 (high money growth). In the case of country 1, the policy rule targets INF 1 with interest rate R 1 and so the price adjustment line is IA 1 = INF 1. For country 2, INF 2 is higher than INF 1 and so the price adjustment line is IA 2 = INF 2. It is also likely that country 2 s policy rule is flatter than that of country 1. Figure In Figure 25-6 the share of GDP going to government decreases, increasing the share of nongovernment spending to the NG, NG 1, and lowering the real rate of interest to R 0. This 4 Copyright Houghton Mifflin Company. All rights reserved.

5 Using the Economic Fluctuations Model in turn increases the share of GDP going to I, X, and C so that spending on these components must rise relative to their previous values. Similarly, the decrease in G spending shifts the AD line from AD 0 to AD 1. In the short run, real GDP is below potential, returning to potential in the long run as inflation falls from IA 0 to IA 1. Corresponding to this decline is a decrease in the interest rate along the policy rule from R 0 to R 1 at LR. The usual sequence of adjustments in the spending components would apply. Figure 25-6 Copyright Houghton Mifflin Company. All rights reserved. 5