Chapter 24

Question 1

describe an overview of the short and long runs and the adjustment of factor prices

Answer 1

Short Run:
determine Y–> factor prices and technology constant

Adjustment process:
Y eventually returns to Y* –>factor prices adjust
and technology remains constant

Long run:
changes in Y* determine changes in Y –>factor prices have adjusted and technology changes

Question 2

What happens when Y> Y*

Answer 2

the demand for labour (and other factor services) is relatively high
• an inflationary output gap

During an inflationary output gap there are high profits for firms
and unusually large demand for labour
• wages and unit costs tend to rise

Question 3

What happens to close the inflationary gap (describe process)?

Answer 3

This increase in factor prices will increase firms’ unit costs–> As unit
costs increase firms will require higher prices in order to supply any given level of output –> AS shifts up

Y moves back towards Y* –> inflationary gap begins to close

Question 4

What happens when Y < Y*?

Answer 4

the demand for labour (and other factor services) is relatively low
• recessionary output gap

During a recessionary gap there are low profits for firms and low
demand for labour
• wages and unit costs tend to fall

Question 5

What happens to close the recessionary gap? (describe process)

Answer 5

This reduction in factor prices will reduce firms’ unit costs –> As unit
costs decrease firms will require lower prices in order to supply any given level of output –> AS shifts down

Y moves back towards Y* –> recessionary gap begins to close

Question 6

Describe adjustment asymmetry:

Answer 6

• inflationary output gaps typically raise wages rapidly
• recessionary output gaps often reduce wages only slowly
(downward wage stickiness)

Question 7

The general adjustment process is summarized by what?

Answer 7

This general adjustment process—from output gaps to factor

prices—is summarized by the Phillips curve.

Question 8

describe the Philips curve

Answer 8

The Phillips curve was originally drawn as a negative relationship
between the unemployment rate and the rate of change in nominal
wages.
Y > Y* => excess demand for labour => wages rise
Y < Y* => excess supply for labour => wages fall
Y = Y* => no excess supply/demand => wages constant

Question 9

describe Y* as an “anchor” for output

Answer 9

Suppose an AD or AS shock pushes Y away from Y* in the short run.

As a result, wages and other factor prices will adjust, until Y returns
to Y. => Y is an “anchor” for output

Question 10

what does the economy’s adjustment process do with expansionary AD shocks?

Answer 10

The economy’s adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*.

Question 11

describe an expansionary AD shock and the economy’s response

Answer 11

There is an increase in autonomous expenditure
• AD shifts up: price increases and level of GDP increases
•An inflationary gap opens up

• Wages increases
• AS begins to shift up
• Prices increase and GDP reduces – back to Y*
• The inflationary gap is being removed

Question 12

T or F: The economy’s adjustment process works following negative demand shocks typically faster than following positive demand shocks

Answer 12

False:
it may be
slower because of
“sticky wages”

Question 13

describe speed of the adjustment: if wages are flexible

Answer 13

wages will fall rapidly whenever there is

unemployment, the resulting shift in the AS curve could quickly eliminate recessionary gaps.

Question 14

describe speed of the adjustment: if wages are sticky

Answer 14

AS curve shifts more slowly. In such cases the recessionary gap may have to be closed with an expansion in AD (increase in private sector demand or government stabilization
policy).

Question 15

describe a negative supply shock and the adjustment process

Answer 15

After a negative supply shock, the adjustment of factor prices reverses the AS shift and returns real GDP to Y*

Assume there is an increase in the price of oil.
•AS shifts up, prices increase and GDP falls (stanflation).
•A recessionary gap opens
up.

•Excess	supply	of	labour:	
eventually	pushes	wages	
down	(speed?)	
•AS	shifts	back towards	its	 starting	point.	
•NOTE:	Relative	prices have	 changed!!

Question 16

what does the speed that output returns to Y* depend on with either a demand or supply shock?

Answer 16

wage flexibility

Question 17

flexible wages provide an adjustment process that _______

Answer 17

quickly pushes

the economy back toward potential output.

Question 18

if wages are slow to adjust, the economy’s adjustment process is ___________

Answer 18

sluggish and thus output gaps tend to persist

Question 19

Describe the business cycle dynamics and their role in bringing the economy back to Y=Y*

Answer 19

When Y > Y* => shortages eventually arise and restrict further expansion
=> revision of firm’s expectations, reduce desired investment => Reduction of consumer’s confidence, reduce desired consumption
==> Real GDP tends to move back toward Y*

When Y < Y* =>consumer’s durable goods become obsolete =>normal
replacement expenditure recover. Firm’s replacement investment also recover => Revival of favorable expectations
==>Real GDP rises back toward Y*

Question 20

when is the economy in a state of long-run equilibrium?

Answer 20

when factor prices are no longer adjusting to output gaps:

==> Y=Y*

Question 21

what is the vertical line at Y* sometimes called?

Answer 21

• the long-run aggregate supply curve, or

* the classical aggregate supply curve

Question 22

T or F: there is no relationship in the long run between the price level and potential output

Answer 22

True

Question 23

in the long run, Y is determined only by
____________ —
aggregate demand
determines _______

Answer 23

determined only by potential output

AD determines P

Question 24

For a given AD curve,
long-run growth in Y*
results in a _______
price level

Answer 24

lower

Question 25

what is the motivation for fiscal stabilization policy?

Answer 25

to reduce the volatility of aggregate outcomes

Question 26

when an AD or AS shock pushes Y away from Y*, what are the alternatives?

Answer 26

use fiscal stabilization policy
• wait for the recovery of private sector demand
=> a shift in the AD curve
• wait for the economy’s adjustment process
=> a shift in the AS curve

Question 27

How may a recessionary gap be closed?

Answer 27

A recessionary gap may be closed by a (possibly slow) rightward shift in the AS curve or by a rightward shift in AD.

Question 28

how may an inflationary gap be removed?

Answer 28

An inflationary gap may be removed by a leftward shift of AS or
by a leftward shift in AD.

Question 29

Describe the basic theory of fiscal stabilization

Answer 29

A recessionary gap may be closed by:

1. a rightward shift in AD due to recovery of private sector demand
2. a (possibly slow) rightward shift in the AS curve
3. a rightward shift in AD due to an expansionary fiscal policy

Question 30

what is the main advantage of fiscal stabilization?

Answer 30

: it may shorten what might otherwise be a long recession

Question 31

what is the main disadvantage of fiscal stabilization?

Answer 31

may stimulate the economy before private-sector

recovery and economy may overshoot its Y*=> creating instability

Question 32

describe the paradox of thrift

Answer 32

In the short run, an increase in desired saving leads to a reduction in GDP (shift AD to the left and reduce GDP).
==> What may be good for any individual when viewed in isolation ends up being undesirable for the economy as a whole.
==>Major and persistent recession can be battled by encouraging
governments, firms and households to increase their spending.

Question 33

does the paradox of thrift apply in the long run?

Answer 33

NO

==> In the long run AD does not influence the level of GDP.
==>The increase in savings has the long-run effect of increasing investment and therefore increasing potential output

Question 34

def. discretionary fiscal stabilization policy

Answer 34

occurs when the government

actively changes G and/or T in an effort to steer real GDP.

Question 35

def. automatic fiscal stabilization

Answer 35

occurs because of the design of the tax
and transfer system:
• as Y changes, net tax revenue changes
• the size of the simple multiplier is reduced
• the output response to shocks is dampened

The marginal propensity to spend on national income is:
z = MPC(1 – t) – m
The simple multiplier is:
Simple multiplier = 1/ (1 – z)

**The lower is the net tax rate (t), the larger is the simple multiplier
and thus the less stable is real GDP in response to shocks to
autonomous spending.

Question 36

what are the main limitations of discretionary fiscal policy

Answer 36

• long and uncertain lags
• temporary versus permanent changes in policy
• the impossibility of “fine tuning”

Question 37

describe uncertain lags with regards to discretionary fiscal stabilization policy

Answer 37

• Decision lags: the period of time between perceiving some
problem and reaching a decision on what to do about it.
• Execution lag: the time that it takes to put policies in place after a
decision has been made.
• And when the new policies are in place it can still take time for
their economic consequences to be felt.

==>It is possible that by the time a given policy decision has any
impact on the economy, circumstances will have changed such that
the policy is no longer appropriate

Question 38

______ changes in taxation are generally less effective than
measures that are expected to be ____

Answer 38

temporary less than permanent

Question 39

more ______ are households, the smaller will be the effects of what are perceived to be temporary changes in taxes

Answer 39

forward-looking

Question 40

def. fine tuning

Answer 40

: the attempt to maintain output at its potential level by

means of frequent changes in fiscal policy.

Question 41

def. gross tuning

Answer 41

: the use of macroeconomic policy to stabilize the economy such that large deviations from potential output do not persist for extended periods of time

Question 42

what will an increase in G do with regards to economic growth

Answer 42

• An increase in G temporarily increases real GDP
• Adjustment: Y will return to Y* but at a higher prices
• GDP composition will be altered: Y = Ca +Ia +Ga +NXa
–Problem if investment is lower in the new long-run equilibrium
• Slower rate of accumulation of capital. This may reduce the rate of
growth of potential output.

Question 43

what will a decrease in t do with regards to economic growth

Answer 43

• A decrease in t temporarily increases real GDP
• Adjustment: Y will return to Y* but at a higher prices
• Long-run effect: e.g: lower corporate income-tax rates make
investment more profitable to firms
• Any increase in investment will tend to increase the future growth
rate of potential output.
• It appears to be no trade-off between short and long run

Question 44

Fiscal policy : increase in G general effects/considerations

Answer 44

The short-run stimulative benefits of the fiscal
expansion need to be weighted against the possible long-run costs of lower
growth.

But, some of the rise in G may be government investment. Then, the overall effect on the path of Y* depends on the productivity of public investment compared with the private investment that was crowded out.

Question 45

fiscal policy: decrease in t general effects/ considerations

Answer 45

It appears to be no trade-off between short and long run.
But, this means less public spending on many of the things that citizens
value: national parks, public education, health care, roads, etc