The Short-Run Policy Tradeoff

31 The Short-Run Policy Tradeoff CHECKPOINTS

Checkpoint 31.1 Checkpoint 31.2 Checkpoint 31.3 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 In the news Problem 5 In the news In the news

Practice Problem 1 The table describes 5 possible outcomes for 2012 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 31.1

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 31.1

Practice Problem 2 The table describes 5 possible outcomes for 2012, 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 31.1

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 31.1 • Potential GDP is $10 trillion, and the natural unemploy-ment rate is 5 percent.

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 31.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

Practice Problem 3 The table describes 5 possible outcomes for 2012, 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 2012? CHECKPOINT 31.1

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 31.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

Practice Problem 4 The table describes 5 possible outcomes for 2012, depending on the level of aggregate demand in that year. Plot the short-run Phillips curve for 2012 and mark the points A, B, C, D, and E that correspond to the data in the table. CHECKPOINT 31.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

Solution The short-run Phillips curve plots the inflation rate against the unemployment rate. The figure shows the short-run Phillips curve. CHECKPOINT 31.1

Practice Problem 5 The table describes 5 possible outcomes for 2012, depending on the level of aggregate demand in that year. Plot the aggregate supply curve for 2012 and mark the points A, B, C, D, and E that correspond to the data in the table. CHECKPOINT 31.1 • Potential GDP is $10 trillion, and the natural unemployment rate is 5 percent.

Solution Plot the price level against real GDP to draw the AS curve. At A, the price level is 102.5 and real GDP is $9.2 trillion (8 percent below potential GDP of $10 trillion). CHECKPOINT 31.1

In the news Canada’s inflation rises and unemployment falls After two months of little change, inflation rose to 3.1 percent a year in September and pushed the unemployment rate down to 7.1 percent. Source: TradingEconomics.com, October 7, 2011 With expected inflation steady at 2.5 percent a year, did the economy move along its short-run Phillips curve? Or did the economy move off its short-run Phillips curve? CHECKPOINT 31.1

Solution With the expected inflation rate steady at 2.5 percent a year, the increase in inflation was unexpected. The Canadian economy remained on its short-run Phillips curve and moved leftward up along it as the inflation rate rose and the unemployment rate. CHECKPOINT 31.1

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 31.2

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 31.2

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 31.2

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 31.2

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 31.2

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 31.2

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. How do unemployment and inflation change? CHECKPOINT 31.2

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 31.2

In the news From the Fed’s minutes The Fed expects the unemployment rate will drop from 9.8 percent today to 9.25 percent by the end of 2010 and to 8 percent by the end of 2011. Private economists predict that the unemployment rate won’t drop to a more normal 5 or 6 percent until 2013 or 2014. Inflation should stay subdued, but the Fed needs to keep its eye on inflation expectations. Source: The New York Times, October 14, 2009 Is the Fed predicting that the U.S. economy will move along a short-run Phillips curve or that the short-run Phillips curve will shift through 2011? CHECKPOINT 31.2

Solution If inflation remains subdued and inflation expectations do not change, the economy is on a short-run Phillips curve at a point to the right of the LRPC. The economy is predicted to move leftward up along the SRPC toward the LRPC. CHECKPOINT 31.2

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 31.3

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 31.3

CHECKPOINT 31.3 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 _________. • the inflation rate will fall, but the unemployment rate will not change as the economy moves down the long-run Phillips curve • the inflation rate will fall, and the unemployment rate will increase as the economy moves down the short-run Phillips curve • nothing will happen. It takes more than a year for unemployment and inflation to begin to respond to a slowdown in money growth • the unemployment rate will increase, but inflation will not change

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 31.3

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 31.3

CHECKPOINT 31.3 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 • the unemployment rate will increase, but inflation will not change • 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 • nothing will happen. It takes more than a year for unemployment and inflation to begin to respond to a slowdown in money growth

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 31.3

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. CHECKPOINT 31.3

The unemployment rate will start to decrease. Eventually, inflation is 2.5 percent a year and the unemployment rate returns to 6 percent. CHECKPOINT 31.3

Practice Problem 4 FOMC Press Release, September 21, 2011 The FOMC anticipates a slow growth in the context of price stability and substantial resource slack will keep inflation subdued for some time. Source: Board of Governors of the Federal Reserve System Where on the short-run Phillips curve does the Fed believe the economy to be? What is the Fed anticipating will happen to the short-run Phillips curve? CHECKPOINT 31.3

Solution With substantial resource slack, the Fed believes that the economy is at a point on the short-run Phillips curve where the unemployment rate is above the natural unemployment rate and the inflation rate is below the expected inflation rate. That is, on the SRPC to the right of the LRPC. The Fed anticipates that the SRPC will shift downward and inflation rate will fall. CHECKPOINT 31.3

The Short-Run Policy Tradeoff