14.2 Shocks and Policy Responses

Question 1

In this section, what is the central assumption we make in our macro model and what is its purpose?

Answer 1

In this analysis, we make a central assumption in our macro model—that AD and AS shocks do not influence the level of potential output, .

With this assumption in place, a central prediction of our model is that the long-run effect of AD and AS shocks involves no change in real GDP because the economy’s adjustment process brings real GDP back to (the unchanged) .

Question 2

What is Demand inflation?

Answer 2

Demand inflation

Inflation arising from an inflationary output gap caused, in turn, by a positive AD shock.

Question 3

What are some potential reasons fora positive AD shock?

Answer 3

The shift in the AD curve could have been caused by a reduction in tax rates; by an increase in such autonomous expenditure items as investment, government, and net exports; or by an expansionary monetary policy.

Question 4

When does demand inflation often occur?

Answer 4

Demand inflation often occurs at the end of a strong business-cycle upswing, when real GDP exceeds Y* , causing excess demand to develop in the markets for labour, intermediate goods, and final output.

Question 5

What are some simplifying assumptions that we make in our study of demand inflation?

Answer 5

First, we continue to assume that Y* is constant.

Second, we assume that initially there is no inflation at all.

These two assumptions imply that our starting point is a stable long-run equilibrium, with constant real GDP and price level, rather than the long-run equilibrium with constant inflation.

We then suppose that this long-run equilibrium is disturbed by a rightward shift in the AD curve. This shift causes the price level and output to rise.

Question 6

What two cases is it important to distuinguish between when studying positive AD shocks.

Answer 6

It is important next to distinguish between the case in which the Bank of Canada validates the demand shock and the case in which it does not.

Question 7

In the case where the BoC holds money supply constant, what happens to inflation and the inflationary gap provided by a positive AD shock?

Answer 7

**A demand shock that is not validated produces temporary inflation, but the economy’s adjustment process eventually restores potential GDP and stable prices. **

As long as the Bank of Canada holds the money supply constant, the rise in the price level moves the economy upward and to the left along the new AD curve, reducing the inflationary gap.

Eventually, the gap is eliminated, and equilibrium is established at a higher but stable price level, with output at Y* .

In this case, the initial period of inflation is followed by further inflation that lasts only until the new long-run equilibrium is reached.

Question 8

Graph of a demand shock with no validation

Answer 8

Question 9

What happens when a positive demand shock is validated by the central bank?

Answer 9

Monetary validation of a positive demand shock causes the AD curve to shift further to the right, offsetting the upward shift in the AS curve and thereby leaving an inflationary gap despite the ever-rising price level.

Question 10

What two forces are at play when a positive demand shock is validated by Central Bank monitary policy?

Answer 10

Two forces are now brought into play. Spurred by the inflationary gap, the increase in nominal wages causes the AS curve to shift upward. Fuelled by the expansionary monetary policy, however, the AD curve shifts further to the right.

As a result of both of these shifts, the price level rises, but real GDP remains above . Indeed, if the shift in the AD curve exactly offsets the shift in the AS curve, real GDP and the inflationary gap will remain constant.

Question 11

What type of inflation is the result of continued validation of a demand shock?

Answer 11

Continued validation of a demand shock turns what would have been transitory inflation into sustained inflation fuelled by monetary expansion.

Question 12

What is Supply Inflation?

Answer 12

Supply inflation

Inflation arising from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production.

Question 13

What are some examples of supply shocks?

Answer 13

An example of a supply shock is a rise in the costs of raw materials, such as oil.

Another is a rise in domestic wages not due to excess demand in the labour market. The rise in wages might occur, as we saw earlier, because of generally held expectations of future inflation. These shocks cause the AS curve to shift upward.

Question 14

What are the initial effects of any negative supply shock?

Answer 14

The initial effects of any negative supply shock are that the price level rises while output falls

Question 15

A Supply Shock With and Without Validation (Graph)

Answer 15

Adverse supply shocks initially raise prices while lowering output.

If there is no monetary validation, the reduction in wages and other factor prices makes the AS curve shift slowly back down to AS0 .

If there is monetary validation, the AD curve shifts from AD0 to AD1, as shown by arrow ②.

Equilibrium is re-established at E2 with output equal to potential output but with a higher price level, P2.

Question 16

What happens after an AS shock in the case of no validation?

Answer 16

Question 17

What is a major concern about the adjustment process of the AS curve in the face of an AS shock?

Answer 17

A major concern in this case is the speed of wage adjustment.

If wages do not fall rapidly in the face of excess supply in the labour market, the adjustment back to potential output can take a long time.

For example, suppose the original AS shock raised firms’ costs by 6 percent. To reverse this shock and return real GDP to , firms’ costs must fall by 6 percent. If nominal wages fell by only 1 percent per year, it would take several years to complete the adjustment.

Question 18

In conclusion, what is a major problem that can arrise from an AS shock that is not validated by the central bank?

Answer 18

Whenever wages and other factor prices fall only slowly in the face of excess supply, the recovery to potential output after a non-validated negative supply shock will take a long time.

Question 19

What does Monetary validation ofa negative supply shock cause?

Answer 19

Monetary validation of a negative supply shock causes the initial rise in the price level to be followed by a further rise, resulting in a higher price level but a much faster return to potential output than would occur if the recessionary gap were relied on to reduce wages and other factor prices.

Question 20

What is the most Dramatic example of a negative supply shock?

Answer 20

The most dramatic example of a supply-shock inflation came in the wake of the first OPEC oil-price shock.

In 1974, the member countries of the Organization of the Petroleum Exporting Countries (OPEC) agreed to restrict output. Their action caused a threefold increase in the price of oil and dramatic increases in the prices of many petroleum-related products, such as fertilizer and chemicals.

The resulting increase in industrial costs shifted AS curves upward in all industrial countries. At this time, the Bank of Canada validated the supply shock with large increases in the money supply, whereas the Federal Reserve (the U.S. central bank) did not.

As the theory predicts, Canada experienced a large increase in its price level but almost no recession, while the United States experienced a much smaller increase in its price level but a deeper recession.

Question 21

Is Monetary Validation of Supply Shocks Desirable?

Answer 21

Suppose the Bank of Canada were to validate a large negative supply shock and thus prevent what could otherwise be a protracted recession. Expressed in this way, monetary validation sounds like a good policy. Unfortunately, however, the cost of monetary validation in this situation is the possibility of extending the period of inflation. If this inflation leads firms and workers to expect further inflation, then point in Figure 14-5 will not be the end of the story.

Question 22

What is a potential consiquence of monetary validation of a negative supply shock?

Answer 22

As expectations for further inflation develop, and wages continue to rise, the AS curve will continue to shift upward. But if the Bank continues its policy of validation, then the AD curve will also continue to shift upward.

It may not take long before the economy is in a constant inflation, as first shown in Figure 14-2. In this situation, real GDP equals Y* and there is no output gap, but there are ongoing costs to households and firms coming from the constant inflation.

Question 23

How can costant inflation be halted? What is the name for the situation that occurs in this case?

Answer 23

Once begun, a constant inflation can be halted only if the Bank of Canada stops validating the expectational inflation initially caused by the supply shock.

The longer it waits to do so, the more firmly held will be the expectations that it will continue validating the shocks. Such a situation of a constant inflation is sometimes referred to as a wage-price spiral.

Question 24

What can be lost when reducing a constant inflation?

Answer 24

As we will see later in the chapter, reducing a constant inflation, especially one with firmly entrenched inflationary expectations, can be very costly in terms of lost output and employment.

Question 25

What would be the result if the Bank acted to maintain output above Y*

Answer 25

What would happen to the rate of inflation is predicted by the acceleration hypothesis, which says that when the central bank conducts its policy to hold the inflationary gap constant, the actual inflation rate will accelerate.

Question 26

What is the acceleration hypothesis?

Answer 26

Acceleration hypothesis

The hypothesis that when real GDP is held above potential, the persistent inflationary gap will cause inflation to accelerate.

Question 27

What is an example of the domino effect resulted from a situation outlined in the acceleration hypothesis?

Answer 27

The Bank of Canada may start by validating 2 percent inflation, but soon 2 percent will become expected, and given the demand pressure the inflation rate will rise to 3 percent and, if the Bank insists on validating 3 percent, the rate will become 4 percent, and so on, without limit.

The process will end only when the Bank ends its policy of validation.

Question 28

What is the reason for the name NAIRU?

Answer 28

Question 29

According to the acceleration hypothesis, what is the relationship between inflationary output gaps, expectations of inflation and actual rate of inflation?

Answer 29

According to the acceleration hypothesis, as long as an inflationary output gap persists, expectations of inflation will be rising, which will lead to increases in the actual rate of inflation.

Question 30

3 various causes of inflation in our macro model…

Answer 30

The first two points tell us that a temporary burst of inflation need not be a monetary phenomenon. It need not have monetary causes, and it need not be accompanied by monetary expansion.

The third point tells us that sustained inflation must be a monetary phenomenon. If a rise in prices is to continue indefinitely, it must be accompanied by a monetary policy that allows the money supply to continually increase.

Question 31

(3 points ) Summarize the macroeconomic changes that accompany inflation, assuming that real GDP was initially at its potential level:

Answer 31

The first two points tell us that inflation is not, in the short run, a purely monetary phenomenon because there are real consequences.

The third point tells us that inflation is a monetary phenomenon from the point of view of long-run equilibrium.

Question 32

Without monetary calidation, what does a positive demand shock cause?

Answer 32

Without monetary validation, positive demand shocks cause inflationary output gaps and a temporary burst of inflation.

The gaps are removed as rising factor prices push the AS curve upward, returning real GDP to its potential level but at a higher price level.

Question 33

Without monetary validation, what do negative supply shocks cause?

Answer 33

Without monetary validation, negative supply shocks cause recessionary output gaps and a temporary burst of inflation.

The gaps are eventually removed when factor prices fall sufficiently to restore real GDP to its potential and the price level to its initial level.

Question 34

What is required in order for inflation initiated by either a supply or demand shock to to continue indefinitely?

Answer 34

Only with continuing monetary validation can inflation initiated by either supply or demand shocks continue indefinitely.

Question 35

What is sustained inflation caused by?

Answer 35

Sustained inflation is always and everywhere caused by sustained monetary expansion.

Question 36

How may the BoC potentially validate during an inflation gap?

Answer 36

Question 37

Explain why higher U.S. interest rates would lead to lower prices of U.S. stocks

Answer 37

Question 38

Assume that people trust the central​ bank’s announcement that it will implement an expansionary monetary policy that will shift the AD curve up by 5 percent. Show the likely effect of this announcement on the AS curve.

Answer 38

Question 39

A constant inflation rate is shown with aggregate demand shifting rightward…

Answer 39

To have a sustained and constant level of​ inflation, the AD curve has to shift to the right at the same rate as the AS curve shifts to the left. If both curves are not shifting at the same​ rate, then the level of inflation will not be constant.

Question 40

What is the most common danger that economists see in validating negative supply shocks?

Answer 40

The most common danger that many economists see in validating negative supply shocks is that it may lead to increased inflation​ expectations, which will cause the AS curve to shift upward. If validation​ continues, then the AD curve will also shift​ upward, resulting in a​ wage-price spiral, which can only be stopped if the Bank stops​ validation, which can cause a prolonged recession with high unemployment. The alternative is for the Bank to refuse to validate any supply shock and accept a deeper recession with less expected inflation.

Question 41

What would an anticipated rise in U.S. interest rates do to the Canadian economy?

Answer 41

The anticipated rise in U.S. interest rates would make United States bonds more attractive to investors relative to Canadian​ bonds, which would lead to an increase in demand for U.S. money and a decrease in demand for Canadian​ money, which would cause depreciation of the Canadian dollar. Since Canadian goods would become relatively cheaper to foreign​ consumers, this would cause a rise in Canadian net​ exports, resulting in an upward shift in the Canadian AE​ curve, and,​ therefore, a rightward shift of the Canadian AD curve.