Chapter 11 Mishkin (11)

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Macreconomics: Policy and Practice (Mishkin)

Chapter 11 Aggregate Supply and the Phillips Curve

11.1 The Phillips Curve

1) The idea behind the Phillips curve is that ________. A) tight labor markets lead to inflationary pressures

B) when the unemployment rate is low, wages will increase

C) when firms raise wages to attract new workers, prices will also increase D) all of the above

E) none of the above Answer: D

Topic: 11.1 The Phillips Curve AACSB: Reflective Thinking

2) The idea behind the Phillips curve is that ________.

A) tightness in the labor market raises wages but has little impact on prices B) when the unemployment rate is low, wages will decrease

C) when firms raise wages to attract new workers, prices will also increase D) all of the above

E) none of the above Answer: C

3) The idea behind the Phillips curve is that ________. A) when the unemployment rate is low wages will decrease

B) tightness in the labor market puts upward pressures on wages and prices C) when firms raise wages to attract new workers, prices decrease

D) all of the above E) none of the above Answer: B

4) The idea behind the Phillips curve is that ________.

A) tightness in the labor market puts downward pressures on wages and prices B) when the unemployment rate is low wages will increase

C) when firms raise wages to attract new workers, prices decrease D) all of the above

E) none of the above Answer: B

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5) ________ is (are) the endogenous variable(s) in the Phillips curve. A) Expected inflation

B) Inflation

C) The natural rate of unemployment D) all of the above

Topic: 11.1 The Phillips Curve

6) In the 1960s, the Phillips curve was ________. A) a very popular explanation for inflation fluctuations

B) consistent with a clear negative relationship between inflation and unemployment C) suggestive of a permanent trade off between inflation and unemployment

D) all of the above E) none of the above Answer: D

7) In the 1960s, the Phillips curve was ________.

A) consistent with a positive relationship between inflation and unemployment B) suggestive of a temporary trade off between inflation and unemployment C) a very popular explanation for inflation fluctuations

D) all of the above E) none of the above Answer: C

8) In the 1960s, advocates of the Phillips curve suggested ________ .

A) an "optimal" goal of 1% unemployment and 1% to 2% inflation rates could be achieved B) a "realistic" goal of 7% unemployment and 6% to 7% inflation rates could be achieved C) a "nonperfectionist" goal of 3% unemployment and 4% to 5% inflation rates could be achieved

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9) The Phillips curve was ________. A) never very popular in policy circles

B) influential in efforts to bring the unemployment rate down to low levels

C) generally confirmed in the 1970s, when low unemployment persisted despite rising inflation D) all of the above

10) The Phillips curve was ________.

A) adopted by economic policy teams in the Kennedy and Johnson administrations B) influential in efforts to bring the unemployment rate down to low levels

C) discredited in the 1970s, when both inflation and unemployment were relatively high D) all of the above

11) Milton Friedman and Edmund Phelps contributed which insight(s) to Phillips curve analysis? A) that firms and workers care about nominal, not real wages

B) that wages have a one-to-one relationship with inflation

C) that, in the long run, the level of unemployment is independent of inflation D) all of the above

12) Milton Friedman and Edmund Phelps contributed which insight(s) to Phillips curve analysis? A) that a "realistic" goal of 7% unemployment and 6% to 7% inflation rates could be achieved B) that, in the long run, sticky wages and staggered prices prevent unemployment from remaining low

C) that firms and workers care about real wages D) all of the above

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13) Milton Friedman and Edmund Phelps contributed which insight(s) to Phillips curve analysis? A) that firms and workers care about nominal, not real wages

B) that wage changes have a one-to-one relationship with changes in expected inflation C) that, in the long run, prices are flexible, so unemployment cannot remain above zero D) all of the above

14) Milton Friedman and Edmund Phelps contributed which insight(s) to Phillips curve analysis? A) that firms and workers care about real wages

B) that inflation and expected inflation influence each other

C) that, in the long run, the level of unemployment is independent of inflation D) all of the above

15) Milton Friedman and Edmund Phelps contributed which insight(s) to Phillips curve analysis? A) that inflation is directly related to expectations of future inflation

B) that inflation is negatively related to the unemployment gap C) that in the long run unemployment will be at the natural rate D) all of the above

16) What can be concluded from Milton Friedman and Edmund Phelps' expectations-augmented Phillips curve?

A) that there is no long run tradeoff between unemployment and inflation B) that there is a short run tradeoff between unemployment and inflation C) that there are two types of Phillips curves

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17) What can be concluded from Milton Friedman and Edmund Phelps' expectations-augmented Phillips curve?

A) that there is a long run tradeoff between unemployment and inflation B) that there is a short run tradeoff between unemployment and inflation C) that inflation is positively related to the unemployment gap

18) In Milton Friedman and Edmund Phelps' expectations-augmented Phillips curve, ________. A) unemployment will, in the long run, reach the natural rate

B) in the long run, expected inflation will reach the NAIRU C) inflation is positively related to the unemployment gap D) all of the above

E) none of the above Answer: A

19) The Long-Run Phillips Curve is vertical, suggesting that ________. A) allowing inflation to rise will not succeed in keeping unemployment low B) changes in unemployment have no lasting impact on inflation

C) shifts of the short-run Phillips curve impact inflation, but have no effect on unemployment D) all of the above

20) Observations of inflation in the 1970s prompted what further addition to the Phillips curve? A) price shocks

B) expected inflation

C) personal consumption expenditures D) all of the above

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21) Which of the following might cause an upward shift of the modern Phillips curve? A) an increase in oil prices

B) an increase in the price of imports

C) wage agreements that include compensation for inflation D) all of the above

22) ________ will cause a movement along the modern Phillips curve. A) An increase in oil prices

B) An increase in the price of imports

C) Wage agreements that include compensation for inflation D) all of the above

E) none of the above Answer: E

23) On the modern Phillips curve, the initial impact of an increase in the world price of steel is shown by ________.

A) an upward movement along the Phillips curve to a higher inflation rate

B) an upward shift of the Phillips curve leading to higher inflation rates for any unemployment rate

C) a downward shift of the Phillips curve leading to lower inflation rates for any unemployment rate

D) a downward movement along the Phillips curve to higher unemployment rates E) none of the above

Answer: B

24) On the modern Phillips curve, the initial impact of government policies to stimulate the economy is shown by ________.

Answer: A

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25) On the modern Phillips curve, the initial impact of productivity improvements that lower the costs of production is shown by ________.

Answer: C

26) On the modern Phillips curve, the beginning of a recession is shown by ________. A) an upward movement along the Phillips curve to a higher inflation rate

Answer: D

27) As wages and prices become more flexible ________.

A) wages becomes less responsive to unemployment deviations from the natural rate B) it becomes easier to differentiate the short-run from the long-run Phillips curve C) inflation becomes more responsive to unemployment deviations from the natural rate D) all of the above

28) If wages and prices become extremely flexible ________. A) there is no trade off between inflation and unemployment B) unemployment can hardly deviate from the natural rate

C) it becomes very difficult to differentiate the short-run from the long-run Phillips curve D) all of the above

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29) As wages and prices become more sticky ________.

A) inflation becomes more responsive to unemployment deviations from the natural rate B) wages become less responsive to unemployment deviations from the natural rate C) it becomes more difficult to differentiate the short-run from the long-run Phillips curve D) all of the above

30) As wages and prices become more sticky ________. A) the short-run Phillips curve gets flatter

B) wages become less responsive to unemployment deviations from the natural rate C) it becomes easier to differentiate the short-run from the long-run Phillips curve D) all of the above

31) If expectations about inflation are adaptive, they are ________. A) formed by looking at the future

B) likely to change rapidly C) based on past inflation D) all of the above E) none of the above Answer: C

32) If expectations about inflation are adaptive, they are ________. A) not based on all available, relevant information

B) backward-looking C) likely to change slowly D) all of the above

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33) If expectations about inflation are adaptive, they are ________. A) quick to respond to price shocks

B) consistent with the notion of sticky prices C) based on changes in productivity

34) According to the accelerationist Phillips curve, ________. A) expectations adjust continually to the latest information B) increases in inflation cause the unemployment gap to widen C) inflation will change so long as an unemployment gap persists D) all of the above

35) An example of a price shock is ________.

A) an increase in wages as a result of higher expected inflation B) the arrival of immigrants seeking employment

C) the decline in autonomous spending that results from rising unemployment D) all of the above

36) Given the accelerationist Phillips curve △π = - 0.3 (U - 6) + ρ, suppose that inflation in the preceding period was 3 percent, unemployment is 6 percent, and there is a price shock of 2 percent. The current inflation rate is ________.

A) 3 percent B) 0.2 percent C) 5 percent D) 1 percent

Topic: 11.1 The Phillips Curve AACSB: Analytical Skills

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37) Given the accelerationist Phillips curve △π = - 0.3 (U - 6) + ρ, suppose that inflation in the preceding period was 3 percent, unemployment is 7 percent, and there is no price shock. The current inflation rate is ________.

A) 2.7 percent B) 3 percent C) 0.9 percent D) 3.3 percent E) none of the above Answer: A

38) Given the accelerationist Phillips curve △π = - 0.7 (U - 5) + ρ, suppose that inflation has increased from 8 percent to 10 percent. If the unemployment rate is 4 percent, then the price shock is ________.

A) 2.7 percent B) 0.6 percent C) 1.3 percent D) 1 percent

39) Based on the data in this table,

U ρ π

period 1 6 1 4

period 2 8 0 2.2

period 3 8 2 2.4

if the inflation rate in period zero had been 3 percent, then the accelerationist Phillips curve is ________.

A) △π = - 1.8 (U - 7) + ρ B) △π = - 1.1 (U - 6) + ρ C) △π = - 0.9 (U - 6) + ρ D) △π = - 0.4 (U - 9) + ρ E) none of the above Answer: C

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U ρ π

period 1 6 1 4

period 2 8 0 3.2

period 3 8 2 4.4

If the natural rate of unemployment is steady at 7 percent, and, in period four, there is no price shock and unemployment is 8 percent, then the inflation rate in period 4 will be ________ percent.

A) 4.4 B) 3.6 C) 3.4 D) 1.6

U ρ π

period 1 6 1 4

period 2 7 0 4.5

period 3 6 2 ??

If the natural rate of unemployment is steady at 8 percent, what is the inflation rate in period 3? A) 8.5 percent

B) 7.5 percent C) 5.5 percent D) 6.3 percent E) none of the above Answer: B

42) Why is there no long-run trade-off between unemployment and inflation?

Answer: Because when the labor market is so tight as to cause wages and prices to rise, the resulting inflation intensifies the pressure on wages and prices (by reducing the real wage and increasing expected inflation). Since the inflation in no way "balances" or "compensates" for the low level of unemployment, the condition of "too low" unemployment is unsustainable in the long run.

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43) What are price shocks? Why were they not included in the original formulation of the Phillips curve? Why were they added to the modern Phillips curve?

Answer: In the Phillips curve, inflation is determined by expected inflation and the

unemployment gap. A price shock is anything other than those two factors that has an impact on inflation, such as a change in import prices. At first, Phillips and other economists were

interested in the relationship between unemployment and inflation, rather than in devising a comprehensive explanation addressing all causes of inflation. Once it became clear that a persistent unemployment gap will cause inflation to change repeatedly (shifts of the short-run Phillips curve), it was possible to ask how much of inflation is attributable to labor market conditions, which requires recognition of all other factors that influence inflation.

44) How do you suppose most people form an expectation of future inflation? Is that method consistent with the assumption of adaptive expectations?

Answer: Like any mechanic in the Bronx, most people distil a "gut opinion" from their personal experience and what they read in the papers, hear from others, etc. While "expert" analysis of projected trends has some influence, greater weight is placed, probably, on whether inflation has seemed recently high, or rising, or declining, or low, and expected inflation is an extrapolation from those observations. Adaptive expectations exaggerates to an exclusive reliance on the past, but seems a reasonable approximation of the actual method.

45) A. W. Phillips' 1958 paper examined unemployment and wage growth. What role, if any, does wage growth play in the modern Phillips curve?

Answer: The modern Phillips curve relates unemployment to inflation, rather than wages. This allows inclusion of expected inflation and price shocks as causes of inflation, in addition to the unemployment gap. But the central idea remains that changes in inflation are driven by wage changes. When wages are sticky, then unemployment gaps have a small impact on inflation, while flexible wages cause large changes in inflation.

46) Suppose the government lowers unemployment by hiring more government workers. How does it matter whether wages and prices are sticky?

Answer: As long as wages and prices are sticky, then the decrease in the unemployment rate will not cause a substantial increase in wages. However, if workers throughout the economy perceive an opportunity to seek an increase in their real wage, employers may need to comply in order to retain and attract qualified workers. If nominal wages increase, producers will need to raise prices. The resulting inflation will cause expected inflation to rise, sparking further increases in the nominal wage.

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11.2 The Aggregate Supply Curve 1) In the long run ________.

A) the amount of output an economy can produce is determined by real variables like capital, labor and technological advances

B) aggregate supply is fixed at the potential level of output

C) there is enough time for prices to fully adjust so the classical dichotomy holds D) all of the above

Topic: 11.2 The AS curve AACSB: Reflective Thinking 2) In the long run ________.

A) the aggregate supply is vertical with respect to output B) the Phillips curve is vertical with respect to unemployment

C) fluctuations in the inflation rate have no impact on output and unemployment D) all of the above

Topic: 11.2 The AS curve AACSB: Reflective Thinking 3) In the long run ________.

A) the aggregate supply is vertical with respect to unemployment B) the Phillips curve is vertical at a given level of expected inflation

C) the economy reaches the potential output level consistent with the natural rate of unemployment

Topic: 11.2 The AS curve AACSB: Reflective Thinking

4) The natural rate of output is ________. A) independent of the inflation rate B) always lower than potential output

C) unrelated to the natural rate of unemployment D) all of the above

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5) When wages and prices are completely flexible ________. A) inflation is determined by expected inflation and price shocks B) labor hoarding occurs

C) unemployment is disconnected from the real economy D) all of the above

Topic: 11.2 The AS curve AACSB: Analytical Skills

6) Which of the following shows a negative relationship between the output and unemployment gaps?

A) the AS curve B) the Phillips curve C) Okun's law

D) the classical dichotomy E) none of the above Answer: C

7) Which of the following never assumes, either implicitly or explicitly, independence between nominal and real variables?

A) the AS curve B) the Phillips curve C) Okun's law

D) the classical dichotomy E) none of the above Answer: C

8) Which of the following best approximates Okun's law?

A) a 1 percent increase in output leads to a 2 percent decrease in unemployment B) a 1 percent increase in output leads to a 1 percent decrease in unemployment C) a 2 percent increase in output leads to a 4 percent increase in unemployment D) a 2 percent increase in output leads to a 1 percent decrease in unemployment E) none of the above

Answer: D

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9) According to Okun's law, an increase in which of the following is associated with an increase in unemployment? A) inflation B) output C) expected inflation D) autonomous expenditure E) potential output Answer: E

Topic: 11.2 The AS curve

10) Which of the following is true in regards to Okun's law?

A) employment does not increase commensurately with output rises because firms tend to hoard labor

B) when demand increases, firms tend to work their employees harder and longer

C) it is Okun's prediction of the negative relationship between the output and unemployment gaps that allows the modern Phillips curve to be translated into the AS curve

11) The short-run aggregate supply curve shows that inflation will change as a result of changes in ________.

A) output

B) potential output C) expected inflation D) price shocks E) all of the above Answer: E

Topic: 11.2 The AS curve

12) The short-run aggregate supply curve shows that a change in inflation will cause (a) change(s) in ________.

A) output

B) potential output C) expected inflation D) price shocks E) all of the above Answer: C

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13) According to the short-run aggregate supply curve, if output minus potential output equals zero, then ________.

A) unemployment might be zero B) inflation might be stable

C) expected inflation must be stable D) price shocks must be zero E) none of the above

Answer: B

Topic: 11.2 The AS curve 14) In the short run ________.

A) inflation is negatively related to the output gap

B) if output rises above its potential level, the unemployment rate falls and firms will lower wages

C) if the labor market tightens, firms will raise prices more rapidly to keep up with upward wage pressures and inflation will ensue

15) Which statement(s) is (are) consistent with a positive relationship between inflation and the output gap?

A) If output rises above its potential level, the unemployment rate falls and firms will raise wages and prices more rapidly.

B) In the short run, the AS curve is upward sloping.

C) Through Okun's law, the negative relationship between the output and unemployment gaps allows the modern Phillips curve to be translated into the AS curve.

Topic: 11.2 The AS curve AACSB: Reflective Thinking 16) In the short run ________.

A) the more flexible wages and prices are, the more inflation responds to the output gap B) the more sticky wages and prices are, the more difficult to tell the difference between the short run and long run aggregate supply curves

C) if wages and prices are sticky, aggregate output is always at its potential level D) all of the above

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17) If the output gap is constant at minus 2 and the inflation rate has fallen from 6 percent to 5 percent, then next period's short-run aggregate supply curve might be ________.

A) π = 5 - 0.5 (13 - 15) B) π = 5 + 0.5 (13 - 15) C) π = 4 + 0.5 (13 - 15) D) π = 5 + 2 (11 - 15) E) none of the above Answer: B

18) When a price shock occurs, the inflation rate is affected ________. A) only in the period of the price shock

B) only in the period after the price shock

C) only if the price shock causes a change in output

D) only if the price shock persists for more than one period E) none of the above

Answer: E

19) When a price shock has occurred, inflation returns to its pre-shock rate ________. A) in the period following the price shock

B) in the period when output has returned to its pre-shock rate C) once the output gap has returned to zero

D) only in the long run E) none of the above Answer: E

20) Suppose the output gap is zero, and policy makers wish to reduce the inflation rate from 10 percent to 5 percent. Which of these policies seems best?

A) contractionary policies to reduce output at least 5 percent below potential output B) a convincing declaration of the inflation rate target, so that expected inflation falls to 5 percent

C) no policy action; inflation will fall on its own, eventually

D) no policy action; inflation will converge to its long-run rate, regardless of policy E) price and wage controls to counteract their stickiness

Answer: B

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21) If Okun's law is U - Un = - 0.5 (Y - YP), and potential output grows at 2% per year, then a recession that causes output to decrease by one percentage point will cause unemployment to increase by ________.

A) 1 percentage point B) 1.5 percentage points C) 2 percentage points D) 3 percentage points E) one-half percentage point Answer: B

22) If Okun's law is U - Un = - 0.6 (Y - YP), and the Phillips curve is π = πe - 2.5 (U - Un ) + ρ, then the short-run aggregate supply curve is ________.

A) π = πe - 1.5 (Y - YP) + ρ B) π = πe + 4.2 (Y - YP) + ρ C) π = πe - 2.5 (Y - YP) + ρ D) π = πe - 2.5 (Y + YP) + ρ E) none of the above

Answer: A

23) If the short-run aggregate supply curve is π = πe - 1.2 (Y - YP) + ρ, output equals potential output and there is a price shock of minus two, then the inflation rate is ________.

A) 2 B) πe - 2 C) minus 2 D) minus 2.4

24) Technological advances lead to ________. A) a shift of the short run AS curve up

B) a shift of the long run AS curve to the left

C) an upward movement along the long run AS curve D) all of the above

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25) If the natural rate of unemployment declines ________. A) labor is more heavily utilized

B) potential output increases

C) the long run aggregate supply curve shifts to the right D) all of the above

26) If the Fed were to announce that fighting inflation is not a high priority for the immediate future ________.

A) households might expect higher inflation

B) the short run aggregate supply would shift upwards

C) firms might begin raising their prices to keep up with expected inflation D) all of the above

27) In 2005 hurricane Katrina devastated large portions of the Gulf Coast economy. Many refineries went offline disrupting oil refining and distribution. What do you think was a likely result?

A) the restricted supply constituted a cost push shock that would have shifted the long run AS curve to the right

B) the restricted supply constituted a cost push shock that would have shifted the short run AS curve to the left

C) the restricted supply constituted a cost push shock that would have meant an upward movement along the Phillips curve

28) ________ may cause a shift of the long-run aggregate supply curve. A) A major earthquake

B) A change in expected inflation C) A price shock

D) all of the above E) none of the above Answer: A

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29) In the short run, if current output remains persistently above potential ________. A) inflation will rise causing a movement along the aggregate supply curve

B) expected inflation will rise causing an upward shift of the aggregate supply curve C) the aggregate supply curve will shift until current output returns to its potential level D) all of the above

Aggregate Supply Curves (1)

30) Based on the graph above, if the economy is at point 2, then (assuming no price shocks and no changes in actual and potential output) the inflation rate next period will be ________ percent.

A) 5 B) 3.5 C) 4.5 D) 4

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31) Based on the graph above, a cause of movement from point 1 to point 2 might be ________. A) a positive price shock

B) government policy that lowers unemployment C) an increase in potential output

D) an increase in expected inflation E) none of the above

Answer: B

32) Based on the graph above, suppose the economy is at point 2, then output falls to 10 and there is a price shock of one percent. The inflation rate next period will be ________ percent. A) 5

B) 3.5 C) 4.5 D) 4

33) Based on the graph above, the short-run aggregate supply curve is ________. A) π = 2 + 1.5 (Y - 10) + ρ B) Y = 8 3 2 + 3 2 (π) + ρ C) π = 2 + (Y - 11) + ρ D) π = 3.5 + 2 (Y - 10) + ρ E) none of the above Answer: A

34) If the short-run aggregate supply curve is shifting down repeatedly, it is rather likely that ________.

A) output is declining repeatedly, relative to potential output B) the long-run aggregate supply curve is shifting to the left C) negative price shocks are recurring

D) all of the above E) none of the above Answer: E

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35) What factors cause a shift in the long-run aggregate supply curve? Might any of these cause the short-run aggregate supply curve to shift, also?

Answer: The factors that shift the long-run aggregate supply curve are (1) the size of the capital stock, (2) the labor supply, (3) available technology, and (4) the natural rate of unemployment (which determines how much of the labor supply is employed when wages and prices are flexible). A change in long-run aggregate supply is a change in potential output, which changes the output gap (ceteris paribus), which shifts the short-run aggregate supply curve, so that the rate of inflation at which the long-run and short-run curves intersect does not change.

36) The short-run aggregate supply curve is π = πe + 0.8 (Y - 20) + ρ. Suppose inflation last year was 5 percent, current output is 20, and there is a price shock of 2 percent. Suppose, further, that potential output rises next year to 21, while output remains at 20 and next year's price shock is zero. Calculate and explain next year's inflation.

Answer: Current inflation is 5 + 0.8 (20 - 20) + 2 = 7 percent. Next year, inflation is 7 + 0.8 (20 - 21) + 0 = 6.2. Moving from the current to next year, short-run aggregate supply has shifted up because of the increase in expected inflation from 5 to 7 percent, and shifted down by 0.8 x the increase in potential output = 0.8 x 1 = 0.8. The negative output gap corresponds, thru Okun's law, to an increase in the unemployment gap. Either the natural rate of unemployment has declined (a possible cause of the increase in potential output), or the failure of actual output to grow along with potential means that unemployment has risen. Either way, this loosening of the labor market causes wages and prices to rise less rapidly.

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Aggregate Supply Curves (2)

37) On the graph above,

(a) draw the new short-run aggregate supply curve that results when the economy has been at point 2 for one period, ceteris paribus (do not label the new output level or inflation rate)

(b) on the original AS curve, add a point "3" where output is 10.5. On the vertical axis, label the rate of inflation that corresponds to output of 10.5.

(c) draw the new short-run aggregate supply curve that results when the economy has been at point 3 for one period, ceteris paribus (do not label the new output level or inflation rate) Answer:

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38) Why are changes in the output gap larger than changes in the unemployment gap? Why is the relationship expressed in Okun's law not affected by inflation or expected inflation?

Answer: Common sense suggests that output and unemployment must be negatively-related. However, the link between the two is employment. Since the productivity of employed workers can vary, output has extra flexibility. Moreover, even when employment is changing along with output, not all of the employment change corresponds to a change in unemployment, since new employees might be new entrants to the labor force, and employees who leave their jobs might leave the labor force and not be counted among the unemployed. All these connections between output, employment, the labor force, and unemployment are real; they do not involve any price adjustments.

39) Unprecedented stimulative policies throughout the global economy have sparked debate over the inflationary implications. Defenders of the policies argue that, even if the policies raise inflationary expectations, actual inflation will remain low. Critics charge that current policies are nearly certain to result in excessive inflation. What does the aggregate supply curve have to say? Answer: As long as the negative output gap persists, rising expectations of inflation will not translate into much actual inflation. However, if the output gap shrinks in absolute value as policy makers intend, nothing will insulate inflation from expectations. To avoid the critics' prediction of excessive inflation, policy makers must somehow manage expectations (and avoid allowing a positive output gap from emerging).

11.3 Shifts in Aggregate Supply Curves 1) There are no questions for this section. Answer: