Chapter 17 - Stabilization in an Integrated World Economy.doc

258Miller•Economics Today, Nineteenth Edition Chapter 17Stabilization in an Integrated World Economy259 Answers to Questions for Critical Analysis Policy Uncertainty and Reduced Total Planned Expenditures (p. 378) Why do you suppose that uncertainty about tax rates is a key element of Baker, Bloom, and Davis’s policy-uncertainty index? Tax rates affect people’s after-tax disposable income and businesses’ after-tax incomes. Hence, uncertainty about tax rates is a key element of policy uncertainty. What Policy-Relevant Inflation Rate Should the Public Try to Predict? (p. 388) Why might Fed policymakers, in turn, experience difficulties determining which of the public’s inflation expectations are the best signals of inflationary pressures in the economy? When the public has more diverging interpretations about the Fed’s inflation measures, it would be more difficult for the Fed to determine which inflation expectations are the best signals of inflationary pressures in the economy. Do Distorted Beliefs Influence Real GDP and the Unemployment Rate? (p. 389) Why might it be the case that even if distorted beliefs alter real GDP and the unemployment rate today, such beliefs might be unlikely to arise among households and firms again in the future? Explain your reasoning. Distorted beliefs among households and firms tend to diminish as time passes, and thus such beliefs would be unlikely to arise again in the future. You Are There Are National Inflation Rates Mysteriously “Too Low”? (pp. 390–391) 1. How might low inflation expectations on the part of the public help to hold down actual inflation? Explain. Low inflation expectations would induce businesses to raise less of their product prices and workers to negotiate less for a wage increase than what if inflation expectations were higher. 2. According to the quantity equation, how else besides using interest-rate-based policies might central banks be able to generate higher inflation if they really wished to do so? According to the quantity equation, higher inflation can arise if central banks raise the money supply or the velocity of money, or both. Issues and Applications Does the Usual Phillips Curve Consider the Wrong Unemployment Rate? (pp. 391–392) 1. Would a U6 version of the natural unemployment rate likely be higher or lower than the traditional natural unemployment rate? Explain your reasoning? Including part-time and discouraged workers raises the number of unemployed. A persistent increase in the number of unemployment and thus the U6 unemployment rate result in a higher natural unemployment rate. 2. Why would using the U6 unemployment rate instead of the traditional unemployment rate almost certainly yield difference “appropriate” activist macroeconomic policies? Because of a higher unemployment rate based on the U6 measure of unemployment instead of the traditional unemployment rate, “appropriate” activist policy responses based on the U6 unemployment rate would be more accommodative macroeconomic policy actions. Research Project 1. To view descriptions of the various measures of the unemployment rate traced by the Bureau of Labor Statistics, as well as current values of each measure, see the Web Links in MyEconLab. 2. See values of various unemployment rates over the past several months in the Web Links in MyEconLab. Answers to Problems 17-1. Suppose that the government altered the computation of the unemployment rate by including people in the military as part of the labor force. a. How would this affect the actual unemployment rate? b. How would such a change affect estimates of the natural rate of unemployment? c. If this computational change were made, would it in any way affect the logic of the short-run and long-run Phillips curve analysis and its implications for policymaking? Why might the government wish to make such a change? a. The actual unemployment rate, which equals the number of people unemployed divided by the labor force, would decline because the labor force would rise while the number of people unemployed would remain unchanged. b. Natural unemployment rate estimates also would be lower. c. The logic of the short-and long-run Phillips curves would not be altered. The government might wish to make this change if it feels that those in the military “hold jobs” and therefore should be counted as employed within the U.S. economy. 17-2. The natural rate of unemployment depends on factors that affect the behavior of both workers and firms. Make lists of possible factors affecting workers and firms that you believe are likely to influence the natural rate of unemployment. For both workers and firms, these include access to information and the degree of competition in product markets. For firms, the extent of government taxation and regulation are important factors affecting their willingness to hire workers and, consequently, the natural rate of unemployment. For workers, training and skills are crucial factors that affect that natural unemployment rate. 17-3. Suppose that more unemployed people who are classified as part of frictional unemployment decide to stop looking for work and start their own businesses instead. What is likely to happen to each of the following, other things being equal? a. The natural unemployment rate b. The economy’s Phillips curve a. The measured unemployment rate when all adjustments have occurred will now always be lower than before, so the natural unemployment rate will be smaller. b. The Phillips curve will shift inward, because the unemployment rate will decline at any given inflation rate. 17-4. Suppose that people who previously had held jobs become cyclically unemployed at the same time the inflation rate declines. Would the result be a movement along or a shift of the short-run Phillips curve? Explain your reasoning. Because the unemployment rate has increased as a consequence of a short-run cyclical adjustment in conjunction with a decline in the inflation rate, there would be a movement downward and rightward along the short-run Phillips curve. 17-5. Suppose that people who previously had held jobs become structurally unemployed due to establishment of new government regulations during a period in which the inflation rate remains unchanged. Would the result be a movement along or a shift of the short-run Phillips curve? Explain your reasoning. Because the unemployment rate has increased as a consequence of a rise in structural unemployment while the inflation rate has remained unchanged, the short-run Phillips curve will tend to shift rightward together with a rightward shift in the long-run Phillips curve as the natural rate of unemployment increases. 17-6. Suppose that the greater availability of online job placement services generates a reduction in frictional unemployment during an interval in which the inflation rate remains unchanged. Would the result be a movement along or a shift of the short-run Phillips curve? Explain your reasoning. Because the unemployment rate has decreased as a consequence of a reduction in frictional unemployment while the inflation rate has remained unchanged, the short-run Phillips curve will tend to shift leftward together with a leftward shift in the long-run Phillips curve as the natural rate of unemployment decreases. 17-7. Consider a situation in which a future president has appointed Federal Reserve leaders who conduct monetary policy much more erratically than in past years. The consequence is that the quantity of money in circulation varies in a much more unsystematic and, hence, hard-to-predict manner. According to the policy irrelevance proposition, is it more or less likely that the Fed’s policy actions will cause real GDP to change in the short run? Explain. Because monetary policy is now harder for people to predict, the unsystematic variations in the quantity of money in circulation will tend to be more likely to generate changes in equilibrium real GDP. Inflation expectations will not change and the short-run aggregate supply curve will remain in position as the aggregate demand curve shifts. 17-8. People called “Fed watchers” earn their living by trying to forecast what policies the Federal Reserve will implement within the next few weeks and months. Suppose that Fed watchers discover that the current group of Fed officials is following very systematic and predictable policies intended to reduce the unemployment rate. The Fed watchers then sell this information to firms, unions, and others in the private sector. If pure competition prevails, prices and wages are flexible, and people form rational expectations, are the Fed’s policies enacted after the information sale likely to have their intended effects on the unemployment rate? No, because then workers and firms will speedily adjust nominal wages and other input prices when the price level changes in response to Fed policy actions. As a result, real GDP will not change, so the actual unemployment rate will remain unaltered. 17-9. Suppose that economists were able to use U.S. economic data to demonstrate that the rational expectations hypothesis is true. Would this be sufficient to demonstrate the validity of the policy irrelevance proposition? No. It could still be true that wages and other prices of factors of production adjust sluggishly to changes in the price level. Then a rise in aggregate demand that boosts the price level brings about an upward movement along the short-run aggregate supply curve, causing equilibrium real GDP to rise. 17-10. Evaluate the following statement: “In an important sense, the term policy irrelevance proposition is misleading because even if the rational expectations hypothesis is valid, economic policy actions can have significant effects on real GDP and the unemployment rate.” This statement is correct. In this situation in which policy actions are completely unanticipated, the actions can still influence real GDP and the rate of unemployment. 17-11. Consider the diagram below, which is drawn under the assumption that the new Keynesian sticky-price theory of aggregate supply applies. Assume that at present, the economy is in long-run equilibrium at point A. Answer the following questions. a. Suppose that there is a sudden increase in desired investment expenditures. Which of the alternative aggregate demand curves—AD2 or AD3—will apply after this event occurs? Other things being equal, what will happen to the equilibrium price level and to equilibrium real GDP in the short run? Explain. b. Other things being equal, after the event and adjustments discussed in part (a) have taken place, what will happen to the equilibrium price level and to equilibrium real GDP in the long run? Explain. a. An increase in desired investment spending induces an increase in aggregate demand, so AD3 applies. The price level is unchanged in the short run, and equilibrium real GDP rises from $18 trillion at point A to $18.5 trillion at point C. b. Over time, firms perceive that they can increase their profits by adjusting prices upward in response to the increase in aggregate demand. Thus, firms eventually will incur the menu costs required to make these price adjustments. As they do so, the aggregate supply curve will shift upward, from SRAS to SRAS2, as shown in the diagram below. Real GDP will return to its original level of $18 trillion, in base-year dollars. The price level will increase to a level above 119, such as 124. 17-12. Both the traditional Keynesian theory discussed in Chapter 11 and the new Keynesian theory considered in this chapter indicate that the short-run aggregate supply curve is horizontal. a. In terms of their short-run implications for the price level and real GDP, is there any difference between the two approaches? b. In terms of their long-run implications for the price level and real GDP, is there any difference between the two approaches? a. The traditional Keynesian approach and the sticky-price new Keynesian approaches have the same short-run implications: If aggregate demand increases (or decreases), the equilibrium price level remains unchanged in the short run. The largest possible rise (or fall) in equilibrium real GDP takes place, given by a movement along the horizontal aggregate supply curve. b. The long-run implications of the two approaches differ. The traditional Keynesian approach emphasizes only the short run and fails to contemplate how long-run adjustments will take place. In contrast, the new Keynesian approach suggests that in the long run, firms seeking higher profits will choose to incur menu costs and raise (reduce) their prices in responses to increases (decreases) in aggregate demand. As a consequence, equilibrium real GDP eventually returns to a long-run equilibrium level. 17-13. The real-business-cycle approach attributes even short-run increases in real GDP largely to aggregate supply shocks. Rightward shifts in aggregate supply tend to push down the equilibrium price level. How could the real-business-cycle perspective explain the low but persistent inflation that the United States experienced until 2007? The explanation would be that although aggregate supply increased over this period as a consequence of economic growth, aggregate demand also increased. If aggregate demand increased at a faster pace than the rise in aggregate supply, then this implies that the position of the aggregate demand curve shifted rightward faster than the rightward shift in aggregate supply. The result would be a higher equilibrium price level following both sets of rightward shifts. On net, therefore, this set of shifts of both curves could explain why the price level rose during those years. 17-14. Normally, when aggregate demand increases, firms find it more profitable to raise prices than to leave prices unchanged. The idea behind the small-menu-cost explanation for price stickiness is that firms will leave their prices unchanged if their profit gain from adjusting prices is less than the menu costs they would incur if they change prices. If firms anticipate that a rise in demand is likely to last for a long time, does this make them more or less likely to adjust their prices when they face small menu costs? (Hint: Profits are a flow that firms earn from week to week and month to month, but small menu costs are a one-time expense.) Increasing the price of a product in response to a long-lasting increase in demand will yield higher profits for several periods. The value of this stream of future profits is more likely to be sufficiently large to outweigh a small, one-time menu cost. In this situation, it is more likely that firms will raise their prices. 17-15. The policy relevance of new Keynesian inflation dynamics based on the theory of small menu costs and sticky prices depends on the exploitability of the implied relationship between inflation and real GDP. Explain in your own words why the average time between price adjustments by firms is a crucial determinant of whether policymakers can actively exploit this relationship to try to stabilize real GDP. If the average time between price adjustments by firms is significant, then the short-run aggregate supply curve could be regarded as horizontal, as hypothesized by the New Keynesian theorists. As a consequence, there would be a short-run trade-off between inflation and real GDP that policymakers potentially could exploit. 17-16. Take a look at Figure 17-1. What is the most recent approximate interval during which the cyclical unemployment rate has been positive? During what most recent approximate interval was the cyclical unemployment rate negative? Explain briefly. The cyclical unemployment rate is positive when the actual unemployment rate exceeds the natural rate of unemployment, and this has been the case since about 2007. During a short period encompassing most of 2005 and 2006, the actual unemployment rate was less than the natural rate of unemployment, so the cyclical unemployment rate over this latter interval was negative. 17-17. Consider Figure 17-2. Explain whether the cyclical unemployment rate is positive, zero, or negative at point E2, after the shift in the aggregate demand curve from AD1 to AD2. In addition, explain whether the cyclical unemployment rate is positive, zero, or negative at point E3, following the shift in the short-run aggregate supply curve from SRAS1 to SRAS2. At point E2, actual real GDP exceeds the long-run real GDP level, so the actual unemployment rate is less than the natural rate of unemployment, and cyclical unemployment is negative. At point E3, actual real GDP equals the long-run real GDP level, so the actual unemployment rate equals the natural rate of unemployment, and cyclical unemployment is zero. 17-18. Take a look at Figure 17-3. Explain whether the cyclical unemployment rate is positive, zero, or negative at point E2, after the shift in the aggregate demand curve from AD1 to AD2. In addition, explain whether the cyclical unemployment rate is positive, zero, or negative at point E3, following the shift in the short-run aggregate supply curve from SRAS1 to SRAS2. At point E2, actual real GDP is less than the long-run real GDP level, so the actual unemployment rate is greater than the natural rate of unemployment, and cyclical unemployment is positive. At point E3, actual real GDP equals the long-run real GDP level, so the actual unemployment rate equals the natural rate of unemployment, and cyclical unemployment is zero. 17-19. Consider Figure 17-4, and suppose that the economy initially operates at point A, at which the inflation rate is 0 percent and the unemployment rate is 6 percent, which is the natural rate of unemployment. Then the inflation rate decreases to ?1 percent. Does additional cyclical, frictional, or structural unemployment account for the resulting rise in the unemployment rate at point C? Explain briefly. The fall in the inflation rate to ?1 percent corresponds to a short-run reduction in real GDP below the long-run real GDP level, which is why the unemployment rate increases. The natural unemployment rate equals the sum of structural and frictional unemployment rates, so the increase in the actual unemployment rate above the natural rate corresponds to additional cyclical unemployment. 17-20. Take a look at Figure 17-4, and suppose that the economy initially operates at point A, at which the inflation rate is 0 percent and the unemployment rate is 6 percent, which is the natural rate of unemployment. Then the inflation rate increases to 3 percent. Does reduced cyclical, frictional, or structural unemployment account for the resulting decrease in the unemployment rate at point B? Explain briefly. The rise in the inflation rate to 3 percent corresponds to a short-run increase in real GDP above the long-run real GDP level, which is why the unemployment rate decreases. The natural unemployment rate equals the sum of structural and frictional unemployment rates, so the decrease in the actual unemployment rate below the natural rate arises because of a reduction in cyclical unemployment. 17-21. Consider Figure 17-5, and suppose that the economy initially operates at point A, at which the inflation rate is 0 percent and the unemployment rate is 6 percent, which is the natural rate of unemployment. In the long run, will an increase in the inflation rate to 3 percent result in the economy operating at point B or at point F1? Explain your reasoning. In the long run, expectations will adjust to reflect the actual inflation. People will recognize that higher nominal wages have not resulted in higher real wages, so higher nominal wages that accompany the inflation will not entice those people out of unemployment. Thus, the unemployment rate will remain at 6 percent at point F1 following an outward shift of the Phillips curve. Selected References Barro, R.J., “A Capital Market in an Equilibrium Business Cycle Model,” Econometrica, Vol. 48, September 1980, pp. 1393–1417. Friedman, Milton, “The Optimum Quantity of Money,” in The Optimum Quantity of Money and Other Essays, Chicago: Aldin, 1969. Friedman, Milton, A Program for Monetary Stability, New York: Fordham University Press, 1960. Friedman, Milton, “Nobel Lecture: Inflation and Unemployment,” Journal of Political Economy, Vol. 85, 1977. Froyen, Richard T., Macroeconomics: Theories and Policies, 3rd ed., New York: Macmillan, 1990. Humphrey, Thomas M., From Trade-Offs to Policy Ineffectiveness: A History of the Phillips Curve, Richmond, VA: Federal Reserve Bank of Richmond, 1986. “Some Current Controversies in the Theory of Inflation,” in Essays on Inflation, 5th ed., Richmond, VA: Federal Reserve Bank of Richmond, 1986. Long, J.B. and C.I. Plosser, “Real Business Cycles,” Journal of Political Economy, Vol. 91, No. 1, February 1983, pp. 39–69. Miller, Roger LeRoy and Raburn M. Williams, Unemployment and Inflation: The New Economics of the Wage-Price Spiral, St. Paul, MN: West Publishing Company, 1974. Miller, Roger L. and David D. VanHoose, Modern Money and Banking, New York: McGraw-Hill, 1993. Miller, Roger L. and Robert Pulsinelli, Macroeconomics, New York: Harper & Row, 1986. Sargent, T.J., Rational Expectations and Inflation, New York: Harper & Row, 1986. Sargent, T.J. and N. Wallace, “Rational Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule,” Journal of Political Economy, Vol. 83, 1975. Sijhen, J.J., Rational Expectations and Monetary Policy, Sijthoff and Noordhoff Int. Pub., 1980. Throop, Adrian W., “An Evaluation of Alternative Measures of Expected Inflation,” Economic Review, San Francisco: Federal Reserve Bank of San Francisco, Summer 1988, pp. 27–43. Winniski, Jude, The Way the World Works, New York: Basic Books, 1977.