B1 - SRAS and the Tradeoff between Inflation and Unemployment

Question 1

What happens to output in the short-run when there is a shift in aggregate demand (AD)?

Answer 1

Shifts in AD affect output only in the short-run.

Question 2

What is the long-run effect of shifts in aggregate demand on the economy?

Answer 2

In the long-run, shifts in aggregate demand only affect the price level.

Question 3

Why is it assumed that prices cannot change in the short-run in the context of AD shifts?

Answer 3

This assumption is made to simplify analysis, although it is not particularly realistic except possibly during a deep recession or depression (according to Keynes).

Question 4

According to Keynesian economics, under what condition might prices be less flexible in the short-run?

Answer 4

Prices might be less flexible in the short-run during a deep recession or depression.

Question 5

How do we currently understand the impact of shocks or policy changes on the economy in the long-run?

Answer 5

We accept that shocks or policy changes affect only the price level in the long-run.

Question 6

What needs to be reconsidered about the short-run effects of shocks or policy changes in our current understanding?

Answer 6

We need to rethink the short-run effects, acknowledging that shocks or policy changes can impact both output and prices from point A to B.

Question 7

What are the key points regarding the short-run and long-run impacts of aggregate demand shifts?

Answer 7

Shifts in AD only affect output in the short-run and only the price level in the long-run. This is based on the assumption that prices are inflexible in the short-run, which is not always realistic.

Question 8

How do we currently view the short-run (A to B) and long-run (A to C) impacts of economic shocks or policy changes?

Answer 8

We accept that in the long-run (A to C), shocks or policy changes affect only the price level, but we need to rethink their short-run (A to B) impacts on output and prices.

Question 9

What characterizes the short-run aggregate supply (SRAS) curve in the ‘new Keynesian’ approach?

Answer 9

The SRAS curve is upward sloping.

Question 10

How is the ‘new Keynesian’ SRAS curve different from the classical SRAS curve?

Answer 10

The classical SRAS curve is vertical, indicating no short-run tradeoff between output and price levels, while the ‘new Keynesian’ SRAS curve is upward sloping, indicating a short-run tradeoff.

Question 11

How is the Phillips curve derived from the ‘new Keynesian’ SRAS curve?

Answer 11

The Phillips curve is derived by observing the inverse relationship between inflation and unemployment as depicted by movements along the upward sloping SRAS curve in the short-run.

Question 12

What does the Phillips curve represent in economic terms?

Answer 12

The Phillips curve shows the short-run tradeoff between inflation and unemployment.

Question 13

Why is the tradeoff between inflation and unemployment shown by the Phillips curve considered temporary?

Answer 13

Because it only applies in the short-run; in the long-run, this tradeoff does not hold as expectations adjust.

Question 14

What are the policy implications of the temporary nature of the Phillips curve tradeoff?

Answer 14

Policymakers must recognize that attempts to reduce unemployment through inflationary policies will only be effective in the short-run and can lead to higher inflation without reducing unemployment in the long-run.

Question 15

What happens to the tradeoff between inflation and unemployment in the long-run?

Answer 15

In the long-run, the tradeoff disappears as expectations adjust, leading to the natural rate of unemployment where inflation does not reduce unemployment.

Question 16

How does the ‘new Keynesian’ SRAS curve affect the formulation of economic policy?

Answer 16

It suggests that while short-term policies can exploit the tradeoff between inflation and unemployment, such policies must be managed carefully to avoid long-term inflation without reducing unemployment.

Question 17

What is the relationship between expected inflation and the Phillips curve in the long-run?

Answer 17

In the long-run, as expected inflation adjusts, the Phillips curve becomes vertical at the natural rate of unemployment, indicating no tradeoff between inflation and unemployment.

Question 18

What are the two types of frictions considered in modeling the temporary tradeoff?

Answer 18

Sticky prices: Some fractions of prices are fixed, while the remainder are flexible.

Imperfect information: The general price level is not perfectly observed.

Question 19

How do we model the temporary trade-off between inflation and unemployment?

Answer 19

Uses frictions such as sticky prices or imperfect information which is less extreme than completely fixed prices.

Question 20

What is the concept of ‘sticky prices’ in economic modeling?

Answer 20

Sticky prices refer to a situation where some fraction of prices in the economy are fixed in the short-run, while others are flexible.

Question 21

What is meant by ‘imperfect information’ in the context of modeling the temporary tradeoff?

Answer 21

Imperfect information means that economic agents do not perfectly observe the general price level, leading to discrepancies in their expectations and actual prices.

Question 22

What common equation for the short-run aggregate supply (SRAS) can be derived from both sticky prices and imperfect information?

Answer 22

The equation for SRAS is derived by recognizing that output differs from its ‘natural level’ if the general price level (P) does not equal the expected price level (EP).

Question 23

What role does the parameter α play in the SRAS equation?

Answer 23

The parameter α (where α > 0) determines the sensitivity of output to deviations between the actual and expected price levels.

Question 24

How do sticky prices contribute to the temporary tradeoff in the SRAS model?

Answer 24

Sticky prices create a temporary tradeoff because some prices are slow to adjust, causing short-term deviations in output when actual prices differ from expected prices.

Question 25

How does imperfect information lead to a temporary tradeoff in the SRAS model?

Answer 25

Imperfect information causes a temporary tradeoff because economic agents make decisions based on inaccurate perceptions of the general price level, leading to short-term output fluctuations when actual prices deviate from expectations.

Question 26

What is the Sticky-Price Model widely used for?

Answer 26

The sticky-price model is widely used in macroeconomic models, including those used by central banks.