6. Short-run economic fluctuations

Question 1

What is potential output?

Answer 1

It is the normal level of output that an economy is able to produce.

Depends on resources: workforce, technology,

It is the output when resources are utilized at normal intensity.

Question 2

What is the natural rate of unemployment?

Answer 2

It is the average/normal level of unemployment

Question 3

What are economic booms?

Answer 3

Periods where actual output exceed potential output

Question 4

What does Okun’s law say?

Answer 4

((Y - Y) / Y) = -2(U - U*)

The equation says that the output gap falls by 2 percentage points when unemployment rises 1 percentage point over the natural rate.

Question 5

What is aggregate expenditure?

Answer 5

AE is the total spending on an economy’s goods and services by people, firms, and governments.

Question 6

What is an expenditure shock?

Answer 6

Any event that changes aggregate expenditure for a given interest rate. Causes AE curve to shift

Question 7

What are some examples of an expenditure shock?

Answer 7

Taxes, government spending, consumer confidence, new technologies, changes in bank lending, foreign business cycle

Question 8

What is countercyclical monetary policy?

Answer 8

A change in interest rates to offset an expenditure shock in order to keep output unchanged

Question 9

What are rational expectations? (Inflation)

Answer 9

Says that people’s expectations of future variables are the best possible forecasts based on all available information

Question 10

What are adaptive expectations? (Inflation)

Answer 10

Also known as backward-looking expectations

Says that expectations are not based on all available information. Instead, it is determined by past inflation

Question 11

Why are adaptive expectations reasonable? (Inflation)

Answer 11

1. Convienient way to forecast inflation

2. Do not lose much because they are fairly good forecasts as inflation rates move very slowly. 1-2% at most

Question 12

What is the key idea of the Phillips curve?

Answer 12

An economic boom raises inflation and a recession reduces inflation.

Question 13

What is a supply shock, and give examples.

Answer 13

A supply shock, v, is an event that causes a major change in firm’s production costs

Examples: Oil price change, new labor contracts, change in exchange rate

Question 14

What trade-offs do central banks face?

Answer 14

Policymakers can reduce inflation by raising the real interest rate, but at the cost of reducing output in the short run

Question 15

What is accomodative monetary policy?

Answer 15

Central bank responds passively to supply shocks and lets inflation go wherever the shock pushes it

Question 16

What is nonaccomodative monetary policy?

Answer 16

Central bank responds to supply shocks by raising/lowering output with interest rate changes in order to keep inflation stable.

Question 17

What is disinflation?

Answer 17

Monetary policy where central bank raises interest rates temporarily to reduce inflation. The cost of disinflation is lower output.

Question 18

What is long-run neutrality of money?

Answer 18

In long-run, monetary policy does not affect real variables, those that are adjusted for inflation, such as real GDP and real interest rates.

In long-run, policy only affects nominal GDP, nominal interest rates, and inflation (all not adjusted for inflation)

Question 19

On what does potential output depend?

Answer 19

Labor force, capital stock, technology

NOT MONETARY POLICY

Question 20

What does Okun’s law imply?

Answer 20

Unemployment is at its natural rate if output is equals potential output.