Lecture Friday 24 Sep (Week 10, lecture 3)

Question 1

Explain why with an expansionary gap, inflation tends to rise (part 1)

Answer 1

An expansionary gap comes about when there is an increase in AD. At this new point, πa > πe.
At the long run equilibrium, πa = πe. At the point after AD has increased, cyclical unemployment is negative so u < u*.

Question 2

Explain why with an expansionary gap, inflation tends to rise (part 2)

Answer 2

When the economy is producing more than potential, workers demand higher wages. We are producing more than normal so we are overworking workers and they demand higher pay so their wages increase. This means that the costs of production increase and the increased cost is passed onto consumers so πa > πe

Question 3

Explain why with an expansionary gap, inflation tends to rise (part 3)

Answer 3

Over time, producers are only able to supply at higher costs so the SRAS curve shifts backwards. Firms adjust their inflationary expectations causing the SRAS curve to shift to the left. At the same time, because you are overworking resources, workers demand higher wages, costs of repairs increase so costs of production increase

Question 4

Explain why with an expansionary gap, inflation tends to rise (part 4)

Answer 4

The economy goes back to potential output u = u*

but the π is even higher. The economy is at potential but without government intervention, π gets even higher

Question 5

Explain why with a recessionary gap, inflation tends to fall (part 1)

Answer 5

During a recessionary gap, AD has shifted to the left and therefore Y < Y. πa < πe so the inflationary expectations adjust downwards which causes the SRAS curve to shift to the right. Inflation rates decrease and there is movement along the AD curve back to the Y at a lower inflation rate.

Question 6

Explain why when there is a recessionary gap, inflation tends to fall (part 2)

Answer 6

At the recessionary gap, resources are under-utilised, u > u* and the wage demands are too low. Capital resources are not being used at normal rates so you are able to increase production and output

Question 7

Will output really return to Y*? What is the classical response and what is the Keynesian response to this question?

Answer 7

Classical believes that it could go back to normal and fiscal or monetary policy could be worse that the problem itself.
Keynesian says that the gap can be large and correction takes time.

Question 8

What are three problems with fiscal policy as a stabilisation tool?

Answer 8

1. fiscal policy affects AD in the SR as well as potential output (in the LR)
2. the problem of deficits
3. the relative inflexibility of fiscal policy

Question 9

One of the issues of fiscal policy as a stabilisation tool is that fiscal policy affects AD (in the SR) as well as the potential output in the long run. Explain why this is a problem

Answer 9

Fiscal policy increases AD due to the increase in government spending, transfer payments or decreasing taxes.
The increase in government spending on skill training programmes, research and development etc. may lead to improvements in human capital and technological progress. This increases Y. Y determines LRAS.
The issue comes when the increase in government spending my not be enough to eliminate the output gap or can be too much and we overshoot.

Question 10

Give an example of the issue with fiscal policy meaning that it increases AD and LRAS. Assume that the economy is in recession

Answer 10

Initially the economy is in recession because Y is smaller than Y* (Y* is at the level of LRAS and the intersection of SRAS and AD crosses before this point). The government can use fiscal stimulus to get rid of this. This leads to an increase in AD which shifts it to the right. This meets the LRAS curve which means that the recession is eliminated. However, if the fiscal stimulus leads to an increase in technological progress, this could shift the LRAS to the right which means that Y* has increased and now we are still in recession, and at a higher inflation rate.

Question 11

How does the fiscal stimulus affect the SRAS curve? What are the potential issues with this?

Answer 11

Anything that shifts the LRAS curve also shifts the SRAS curve. This means that when the government uses fiscal policy to increase AD and LRAS also increases, the SRAS curve could increase too

Question 12

How does the fiscal stimulus affect the SRAS curve? What are the potential issues with this?

Answer 12

Anything that shifts the LRAS curve also shifts the SRAS curve. This means that when the government uses fiscal policy to increase AD and LRAS also increases, the SRAS curve could increase too. This could be a good things because the increase in SRAS could mean that the still-existing recessionary gap was eliminated if the SRAS curve shifted to the right by the correct amount. However, it may increase too much and overshoot and now we are in an expansionary gap, or it may not increase enough and so we are still in recession

Question 13

One of the issues of the fiscal policy is the problem of deficits. Explain this

Answer 13

A deficit occurs when the tax earned by the Government is less than the Government’s spending. Deficits could reduce savings and investment in new capital goods. This means that public savings decreases so the supply of loanable funds decreases and national savings decreases.

Question 14

What makes up national savings?

Answer 14

Public savings + private savings

Question 15

One of the issues of fiscal policy is the relative inflexibility of fiscal policy. Explain this

Answer 15

• the problem of time lags and the legislative process: it take time to approve budgets to address a recession or expansion. It could have already self-corrected by the time it is approves or the situation could be worse
• competing political objectives: this refers to changes to fiscal policy that would stimulate aggregate demand when asn economy foes into a recession without policy makers having to take deliberate action

Question 16

What is one way to offset the inflexibility of the fiscal policy. Explain how this works

Answer 16

Automatic stabilisers.
This is any mechanism in the economy that decreases the amount by which output changes in response to a change in the autonomous spending
eg. transfer payments: unemployment benefits allow the unemployed to consume even without a job, so consumption does not fall as much compares to what it would have been without benefits
taxes: this lowers the multiplies, less fluctuations

Question 17

Within the context of the AD-AS model, there are two categories of sources of inflation:

Answer 17

1. aggregate demand shocks

2. aggregate supply shocks: inflation shocks to SRAS and a decline in LRAS

Question 18

Explain how a demand shock causes inflation

Answer 18

• it could be because there is an increase in C, I, G or X which causes an increase in AD
• it could also be due to increases in the money supply because the money demand increases too and/or the government prints money due to budget deficits
• it could also be due to inflation rates in the rest of the world: as prices overseas increase, imports decrease and exports increase
  This is demand-pull inflation

Question 19

Explain how a government spending could lead to inflation

Answer 19

For example, we are in LR equilibrium and the government wants to reduce poverty to increase transfer payments and government spending. This shifts the AD curve to the right. At the new SR equilibrium, there is an expansionary gap. Actual inflation is more than inflationary expectations. Expected inflation adjusts upwards. Because of this, and the fact that resources are being over utilised which causes the production costs to increase, the SRAS curve can shift to the left. We are now back at Y=Y* but the inflation rate is higher

Question 20

Explain how shocks to SRAS lead to inflation

Answer 20

If there is an increase in wages or the price of inputs (or raw materials) unrelated to the business cycle then the supply curve shifts to the left. This leads to an increase in inflation referred to as cost-push inflation. We are now at stagflation because we are at lower output and higher inflation

Question 21

How can a decline in potential output be a source of inflation?

Answer 21

If there is a destruction of physical or human capital eg. war then the potential output decreases from Y1* to Y2* and the LRAS curve also decreases. Because of this, the SRAS curve decreases and this leads to in an increase in inflation

Question 22

What is an aggregate supply shock?

Answer 22

This is the generic term for both an inflation shock to SRAS or a shock to potential output (LRAS).
Inflation shocks will self-correct eventually (in the long-run) but shocks to potential output will not return to the original Y*