8- Aggregate Supply and Business Cycles

Question 1

In our simple model of sticky prices, what is the probability of a firm changing their price?

Answer 1

There is a fixed probability of λ=0.5 of a firm being able to change its price so firms are identical apart from the fact that in any period 50% can change price and 50% can’t

Question 2

What is the notation for the log of the price level?

Answer 2

p

Question 3

What is the notation for the log of the price chosen by firms that are able to change price?

Answer 3

x

Question 4

What is the notation for the log of the price that firms would choose if they could change price in every period?

Answer 4

p*

Question 5

What happens to the probability of a firm changing their price if prices are flexible so not sticky?

Answer 5

It becomes certain, λ=1

Question 6

What is the notation for the constant elasticity of the demand for a firm’s output?

Answer 6

ϵ

Question 7

What is the notation for the log of real marginal cost?

Answer 7

mc_t

Question 8

What is the notation for the log of the mark-up of price over marginal cost?

Answer 8

μ or log(ϵ/ϵ-1)

Question 9

What is the notation for the sensitivity of marginal cost to the output gap?

Answer 9

ω

Question 10

When is there equilibrium in the aggregate supply model?

Answer 10

• All firms at their desired price (p_t = p_t*)
• Output at equilibrium so output gap is zero (ŷ=0)
• Expectations of inflation are correct (π_t+1=π^e)

Question 11

What does equilibrium in the aggregate supply model imply?

Answer 11

That inflation is constant

Question 12

How does being in or out of equilibrium affect the AS curve?

Answer 12

The AS curve slopes up when out of equilibrium but is completely vertical when in equilibrium

Question 13

What are the 3 main effects of a productivity shock (ε^s)?

Answer 13

• Increase in productivity
• Which reduces marginal cost
• Which reduces inflation

Question 14

Where does the AS curve intersect the y-axis?

Answer 14

Where π = π^e when there are no shocks

Question 15

How are inflation and the output gap determined?

Answer 15

By the intersection of the Aggregate demand and supply relationships

Question 16

What are the 3 main features of the Business cycle model?

Answer 16

• The economy is in equilibrium
• The economy is hit by a temporary shock, lasting 1 period
• In the period the shock hits, it moves output and inflation away from the equilibrium

Question 17

What happens in the case where expectations of inflation are anchored?

Answer 17

Expected inflation always equals the inflation target and the economy returns to equilibrium immediately after a shock ends

Question 18

What are the 2 main effects of a positive demand shock with anchored expectations?

Answer 18

• Higher output

- Higher inflation

Question 19

What are the 2 main effects of a productivity shock with anchored expectations?

Answer 19

• Higher output

- Lower inflation

Question 20

What are the 2 main characteristics of the AS curve when prices are flexible and not sticky?

Answer 20

• The AS curve is vertical

- The AS curve is shifted by productivity shocks

Question 21

What are the 3 main outcomes of supply and demand shocks when prices are flexible?

Answer 21

• Demand shocks do not affect output
• Demand shocks have a larger impact on inflation
• Supply shocks have a larger impact on both inflation and the output gap

Question 22

Explain why the assumption of expected inflation equalling inflation target in anchored expectations may be wrong

Answer 22

In anchored expectations, expectations are only correct in equilibrium. If citizens know how the economy works, then they know that shocks will change inflation