Chapter 21 – Output, Inflation, and Monetary Policy
100. Rank the components of aggregate demand by their sensitivity to changes in the real
interest rate. Start with the most sensitive to the least sensitive.
101. Why would central bankers have to pay attention to forecasts regarding consumer
sentiment and expectations of business owners and managers?
Chapter 21 – Output, Inflation, and Monetary Policy
102. What distinguishes the short-run real interest rate from the long-run real interest rate?
103. Why is it necessary to understand fluctuations in investment if we want to understand the
fluctuations in the business cycle?
104. If the economy is producing a level of output that is consistent with the potential output
level, and government purchases increase, describe what happens in terms of the long-run real
interest rate, and why, to keep the economy at its potential output level.
Chapter 21 – Output, Inflation, and Monetary Policy
105. Given a central bank’s monetary policy reaction curve, if inflation increases by 1% why
would policymakers likely have to increase the nominal interest rate by more than the
increase in the rate of inflation?
106. Discuss what happens to the monetary policy reaction curve if the Fed were to lower
their inflation target and why?
107. Is the monetary policy reaction curve applicable only to central banks that have an
explicit inflation target? Explain.
Chapter 21 – Output, Inflation, and Monetary Policy
108. If the monetary policy reaction curve were drawn with the nominal interest rate instead
of the real interest rate on the vertical axis, would the slope be the same or how would it
differ?
109. Explain what you suspect the slope of the monetary policy reaction curve would look
like for an economy that is experiencing a severe economic slowdown, with a large
recessionary gap, and high unemployment.
Chapter 21 – Output, Inflation, and Monetary Policy
110. Can central bankers set short-term interest rate targets and still control inflation in the
long run or are these goals mutually impossible? Explain.
111. Explain the impact on the monetary policy reaction curve and the nominal interest rate if
the level of government purchases were to decrease and the central bank does not change its
inflation target?
Chapter 21 – Output, Inflation, and Monetary Policy
112. Explain why a country that has a fixed exchange rate cannot have an independent
monetary policy reaction curve.
113. Explain why the dynamic aggregate demand curve reflects an inverse relationship
between the rate of inflation and real output. Be sure to state any key assumptions.
114. Use the monetary policy reaction curve to link a higher inflation rate to lower aggregate
demand.
Chapter 21 – Output, Inflation, and Monetary Policy
115. Explain the changes that would cause the dynamic aggregate demand curve to shift.
116. Explain why the short-run aggregate supply curve has a positive slope.
117. How would the discovery of a previously unknown large reserve of oil affect the short-
run aggregate supply curve and why? What other change could have the same effect?
Chapter 21 – Output, Inflation, and Monetary Policy
118. Is the actual amount of output that corresponds to the long-run aggregate supply curve
fixed? Explain.
119. Explain the self-correcting mechanism by which the economy returns to long-run
equilibrium.
Chapter 21 – Output, Inflation, and Monetary Policy
120. What are the conditions for long-run equilibrium?
121. Output and inflation movements can arise from either demand or supply shifts. How can
we tell them apart?
122. Evidence seems to point out that just before recessions interest rates rose. Why would
monetary policymakers choose to cause recessions?
Chapter 21 – Output, Inflation, and Monetary Policy
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Chapter 21 – Output, Inflation, and Monetary Policy
Essay Questions
123. Why might it be argued that prolonged recessionary or expansionary gaps could actually
affect potential output?
124. Discuss why many economists maintain that continued deficit spending by government
is likely to “crowd out” (decrease) investment spending in the long run.
Chapter 21 – Output, Inflation, and Monetary Policy
125. The Bank of England Governor Mervyn King, commenting on a speech given by then
Fed Chairman Greenspan, said “any (coherent) monetary policy can be written as an inflation
target plus a response to supply shocks.” What do these comments mean and what insight do
they provide us to the focus of central banks?
126. Most economists maintain that policy designed to increase aggregate demand cannot
have any long-run real effects. What lies behind this argument?
Chapter 21 – Output, Inflation, and Monetary Policy
127. At the conclusion of its meeting on December 16, 2009, the Federal Open Market
Committee released a statement that included the following sentence: “The committee will
maintain the target range for the federal funds rate at 0 to ¼ percent and continues to
anticipate that economic conditions, including low rates of resource utilization, subdued
inflation trends, and stable inflation expectations, are likely to warrant exceptionally low
levels of the federal funds rate for an extended period.” What is the significance of this
statement?