Chapter 14

Question 1

What happens to wages when there is excess demand for labour that is associated with an inflationary gap (Y>Y*)?

Answer 1

There is upwards pressure on nominal wages meaning that they increase

Question 2

What happens to wages when there is excess supply of labour that is associated with a recessionary gap (Y<Y*)?

Answer 2

It puts downward pressure on nominal wages through, meaning that wages decrease

Question 3

What happens to wages when there is the absence of either an inflationary or a recessionary gap (Y=Y*)?

Answer 3

This means that demand forces are not exerting any pressure on nominal wages meaning that they do not change

Question 4

When real GDP is equal to Y*, what is the unemployment rate equal to?

Answer 4

It is equal to NAIRU

Question 5

What does NAIRU stand for?

Answer 5

It stands for the non-accelerating inflation rate of unemployment

Question 6

When real GDP exceeds potential GDP (Y>Y*), the unemployment rate will be less than what?

Answer 6

It will be less than NAIRU (U<U*). This is because there is an inflationary gap characterized by excess demand for labour, and nominal wages tend to rise

Question 7

When real GDP is less than potential GDP (Y<Y*), the unemployment rate will exceed what?

Answer 7

It will exceed NAIRU (U>U*). This is because there is a recessionary gap characterized by excess supply of labour, and nominal wages tend to fall

Question 8

What does the expectation of some specific inflation rate create?

Answer 8

It creates pressure for nominal wages to rise by that rate

Question 9

What determines what happens to the AS curve?

Answer 9

The net effect of two macro forces acting on wages - output gaps and inflation expectations

Question 10

What is the best example of a non-wage supply shock?

Answer 10

It is a change in the prices of materials used as inputs in production

Question 11

If inflation and monetary policy have been unchanged for several years, what does the expected rate of inflation tend to be equal to?

Answer 11

The actual rate of inflation

Question 12

In the absence of supply shocks, if expected inflation equals actual inflation, then real GDP must equal to what?

Answer 12

Potential GDP

Question 13

When does the constant inflation with Y=Y* occur?

Answer 13

When the rate of monetary expansion, the rate of wages increase, and the expected rate of inflation are all consistent with the actual inflation rate

Question 14

When inflation is low and relatively stable, firms and consumers build it into their ___, central banks build it into their ___, and the economy can operate with real GDP equal to ___

Answer 14

Expectations
Policy decisions
Potential output

Question 15

Why are wage costs rising?

Answer 15

Because of expectations of inflation

Question 16

What are the expectations of inflation being validated by?

Answer 16

They are being validated by the central bank’s policy. Real GDP remains at Y*

Question 17

Demand inflation is arising from an inflationary output gap caused by what kind of shock?

Answer 17

A positive AD shock

Question 18

What does a demand shock that is not validated produce?

Answer 18

It produces temporary inflation

Question 19

What happens when a positive demand shock accepts monetary validation?

Answer 19

It causes the AD curve to shift further to the right, offsetting the upward shift in the AS curve

Question 20

What does continued validation of a demand shock do?

Answer 20

It turns what would have been a transitory inflation into sustained inflation fuelled by monetary expansion.

Question 21

Where does the AD curve shift when there is a positive AD shock?

Answer 21

To the left

Question 22

Where does the AS curve shift when there is a positive AD shock?

Answer 22

It shifts to the left

Question 23

What is supply inflation?

Answer 23

It is inflation that arises from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production

Question 24

With not monetary validation, the reduction in wages and other factor prices makes the AS curve shift slowly back to ___

Answer 24

Its original position, which is to the left (as it originally shifts to the right)

Question 25

With monetary validation during a supply shock, the AD curve shifts to the ___

Answer 25

left

Question 26

What is the result of a supply shock?

Answer 26

It is 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 27

What would happen if the Bank acted to maintain output above Y*?

Answer 27

The acceleration hypothesis is demonstrated as it states that when real GDP is held above potential, the persistent inflationary gap will cause inflation to accelerate

Question 28

What are the 3 causes of inflation?

Answer 28

1. Anything that shifts the AD curve to the right will cause the price level to rise (demand inflation).
2. Anything that shifts the AS curve upward will cause the price level to rise (supply inflation).
3. Increases in the price level caused by AD and AS
   shocks will eventually come to a halt unless they are
   continually validated by monetary policy.

Question 29

What kind of phenomenon is sustained inflation?

Answer 29

It is a monetary phenomenon

Question 30

What are the consequences of inflation?

Answer 30

1. In the short run, demand inflation tends to be
   accompanied by an increase in real GDP above its
   potential level.
2. In the short run, supply inflation tends to be
   accompanied by a decrease in real GDP below its
   potential level.
3. When all costs and prices are adjusted fully and
   real GDP has returned to its potential level, the only long-run effect of AD or AS shocks is a change in the price level.

Question 31

What are the conclusions of inflation?

Answer 31

1. 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.
2. 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.
3. Only with continuing monetary validation can inflation initiated by either supply or demand shocks continue indefinitely.
   Sustained inflation is always and everywhere caused by sustained monetary expansion.

Question 32

What is disinflation?

Answer 32

It is a reduction in the rate of inflation

Question 33

When does the central bank adopt a tight monetary policy which halts the growth of the money supply?

Answer 33

When the curves reach AS1 and AD1

Question 34

When is the AD curve stabilized?

Answer 34

When it is at AD1

Question 35

Why do wages continue to rise and the AS curve shifts leftward to AS2?

Answer 35

Because of the output gap and inflation expectations

Question 36

What leads to stagflation?

Answer 36

Expectations and wage momentum with falling outpur and continuing inflation

Question 37

What are the 2 possible scenarios that lead to the recovery that takes output Y* and stabilizes the price level?

Answer 37

Wages fall and the AS curve returns to AS2 or the central bank increases the money supply sufficiently to shift AD to AD2

Question 38

What is the sacrifice ratio?

Answer 38

It is the cumulative loss in real GDP as experessed by a percentage of potential output divided by the percentage-point reduction in the rate of inflation