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The Short-Run Tradeoff

15. The Short-Run Tradeoff. CHAPTER. CHECKPOINTS. Checkpoint 15.1. Checkpoint 15.2. Checkpoint 15.3. Problem 1. Clicker version. Problem 1. Problem 1. Problem 2. Problem 2. Problem 2. Clicker version. Problem 3. Problem 3. Problem 3. Problem 4. Problem 4. Problem 5.

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The Short-Run Tradeoff

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  1. 15 The Short-Run Tradeoff CHAPTER CHECKPOINTS

  2. Checkpoint 15.1 Checkpoint 15.2 Checkpoint 15.3 Problem 1 Clicker version Problem 1 Problem 1 Problem 2 Problem 2 Problem 2 Clicker version Problem 3 Problem 3 Problem 3 Problem 4 Problem 4 Problem 5

  3. Practice Problem 1 The table describes 5 possible outcomes for 2006, depending on the level of aggregate demand in that year. Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent. Calculate the inflation rate for each possible outcome. CHECKPOINT 15.1

  4. Solution The inflation rate equals the price level minus 100. So for A, the inflation rate is 102.5 – 100 = 2.5 percent. So for B, the inflation rate is 105.0 – 100 = 5 percent. Calculate the other inflation rates in the same way. CHECKPOINT 15.1

  5. Practice Problem 2 The table describes 5 possible outcomes for 2006, depending on the level of aggregate demand in that year. Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent. Use Okun’s Law to find real GDP at each unemployment rate in the table. CHECKPOINT 15.1

  6. Solution Okun’s law is that the output gap = –2 x (U – U*), where U is the unemployment rate and U* is the natural unemployment rate. For example, for A,the output gap = –2 x (9 – 5) = –8, which means that real GDP is 8 percent below potential GDP. Real GDP is $9.2 trillion. CHECKPOINT 15.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

  7. Okun’s law is that the output gap = –2 x (U – U*), where U is the unemployment rate and U* is the natural unemployment rate. For example, for D,the output gap = –2 x (4 – 5) = 2, which means that real GDP is 2 percent above potential GDP. Real GDP is $10.2 trillion. CHECKPOINT 15.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

  8. Practice Problem 3 The table describes 5 possible outcomes for 2006, depending on the level of aggregate demand in that year. Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent. What are the expected price level and the expected inflation rate in 2006? CHECKPOINT 15.1

  9. Solution The expected price level is the price level at full employment—the economy is at full employment. The expected price level is 106 in row C. The expected inflation rate is 6 percent a year. CHECKPOINT 15.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

  10. Practice Problem 4 The table describes 5 possible outcomes for 2006, depending on the level of aggregate demand in that year. Plot the short-run Phillips curve for 2006 and mark the points A, B, C, D, and E that correspond to the data in the table. CHECKPOINT 15.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

  11. Solution The short-run Phillips curve plots the inflation rate against the unemployment rate. The figure shows the short-run Phillips curve. CHECKPOINT 15.1

  12. Practice Problem 5 The table describes 5 possible outcomes for 2006, depending on the level of aggregate demand in that year. Plot the aggregate supply curve for 2006 and mark the points A, B, C, D, and E that correspond to the data in the table. CHECKPOINT 15.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

  13. Solution Plot the price level against real GDP to draw the aggregate supply curve. For example, at A, the price level is 102.5 and real GDP is $9.2 trillion (8 percent below potential GDP of $10 trillion). CHECKPOINT 15.1

  14. Practice Problem 1 The figure shows a short-run Phillips curve and a long-run Phillips curve. Identify the curves and label them. What is the expected inflation rate and what is the natural unemployment rate? CHECKPOINT 15.2

  15. Solution The long-run Phillips curve is the vertical curve, LPRC. The short-run Phillips curve is the downward-sloping curve SPRC0. The expected inflation rate is the inflation rate at which LPRC and SPRC0 intersect—5 percent a a year. The LPRC is vertical at the natural unemployment rate—6 percent. CHECKPOINT 15.2

  16. Practice Problem 2 The figure shows a short-run Phillips curve and a long-run Phillips curve. If the expected inflation rate increases to 7.5 percent a year, show the new short-run and long-run Phillips curves. CHECKPOINT 15.2

  17. Solution If the expected inflation rate increases to 7.5 percent a year, the SRPC curve shifts upward to intersect the LRPC curve at 7.5 percent a year, but the long-run Phillips curve does not change. CHECKPOINT 15.2

  18. Practice Problem 3 The figure shows a short-run Phillips curve and a long-run Phillips curve. If the natural unemployment rate increases to 8 percent, show the new short-run and long-run Phillips curves. CHECKPOINT 15.2

  19. Solution An increase in the natural unemployment rate shifts the long-run Phillips curve rightward. The short-run Phillips curve shifts rightward so that it intersects the LRPC curve at the expected inflation rate and the higher natural unemployment rate. CHECKPOINT 15.2

  20. Practice Problem 4 The figure shows a short-run Phillips curve and a long-run Phillips curve. Aggregate demand starts to grow more rapidly, and eventually the inflation rate rises to 10 percent a year. Explain how the unemployment rate and the inflation rate change. CHECKPOINT 15.2

  21. Solution The figure shows that as inflation expectations rise above 7.5 percent a year, the inflation rate rises and unemployment decreases. As expectations rise closer to 10 percent a year, unemployment starts to increase. When the expected inflation is 10 percent a year, unemployment is at the natural unemployment rate. CHECKPOINT 15.2

  22. Practice Problem 1 The current inflation rate is 5 percent a year. The Fed announces that it will slow the money growth rate so that inflation will fall to 2.5 percent a year. If no one believes the Fed and expected inflation remains at 5 percent a year, explain the effect of the Fed’s action on inflation and unemployment next year. CHECKPOINT 15.3

  23. Solution As the actual inflation rate falls with no change in the expected inflation rate, the unemployment rate increases as the economy moves down along its short-run Phillips curve. The long-run Phillips curve does not change. CHECKPOINT 15.3

  24. Study Plan Problem The inflation rate is 5 percent a year. The Fed announces that it will slow the money growth rate so that inflation will fall to 2.5 percent a year. If no one believes the Fed and expected inflation remains at 5 percent a year, then next year A. the inflation rate will fall, but the unemployment rate will not change as the economy moves down the long-run Phillips curve. B. the inflation rate will fall, and the unemployment rate will increase as the economy moves down the short-run Phillips curve. C. nothing will happen. It takes more than a year for unemployment and inflation to begin to respond to a slowdown in money growth. D. the unemployment rate will increase, but inflation will not change. CHECKPOINT 15.3

  25. Practice Problem 2 The current inflation rate is 5 percent a year. The Fed announces that it will slow the money growth rate so that inflation will fall to 2.5 percent a year. If everyone believes the Fed, explain the effect of the Fed’s action on inflation and unemployment next year. CHECKPOINT 15.3

  26. Solution Because people believe the Fed the expected inflation falls to 2.5 percent a year. The short-run Phillips curve shifts downward to SPRC1. The inflation rate falls to 2.5 percent a year, and unemployment remains at 6 percent. CHECKPOINT 15.3

  27. Study Plan Problem The inflation rate is 5 percent a year. The Fed announces that it will slow the money growth rate so that inflation will fall to 2.5 percent a year. If everyone believes the Fed, then next year. The inflation rate will fall and the unemployment rate will increase in a movement down the short-run Phillips curve. B. The unemployment rate will increase, but inflation will not change. C. The inflation rate will fall to 2.5 percent a year, but unemployment will not change as the economy moves down the long-run Phillips curve. The short-run Phillips curve shifts downward. D. Nothing will happen. It takes more than a year for unemployment and inflation to begin to respond to a slowdown in money growth. CHECKPOINT 15.3

  28. Practice Problem 3 The current inflation rate is 5 percent a year. The Fed announces that it will slow the money growth rate so that inflation will fall to 2.5 percent a year. If no one believes the Fed, but the Fed keeps inflation at 2.5 percent for many years, explain the effect of the Fed’s action on inflation and unemployment. CHECKPOINT 15.3

  29. Solution Initially, inflation falls below 5 percent a year and unemployment rises above 6 percent. The longer the Fed maintains the slower money growth rate, the more people will start to expect lower inflation and the short-run Phillips curve will start to shift downward. The unemployment rate will start to decrease. CHECKPOINT 15.3

  30. Eventually, inflation is 2.5 percent a year and the unemployment rate returns to 6 percent. CHECKPOINT 15.3

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