41) The expectations-augmented Phillips curve is
π = πe – 2(u – 0.06).
(a) Graph the long-run Phillips curve and the short-run Phillips curve for an expected inflation
rate of 0.04. If the Fed chooses to keep the actual inflation rate at 0.04, what will be the
unemployment rate? Label the equilibrium point “A”. What is the numerical value of the natural
rate of unemployment?
(b) An aggregate demand shock (resulting from increased exports of goods) raises the inflation
rate to 0.06 (the natural rate of unemployment and the expected inflation rate are not affected).
Show what happens on your graph. Label the equilibrium point “B”. What is the numerical value
of the unemployment rate?
(c) In response to the aggregate demand shock, suppose the Fed allows the inflation rate of 0.06
to persist. Show what happens on your graph, labeling the equilibrium point “C”. In the long run,
what is the numerical value of the unemployment rate?
(d) From the situation in part (c), suppose a supply shock raises the natural rate of
unemployment by .01 from its original value. If both the inflation rate and the expected inflation
rate do not change, show what happens in your graph, labeling the equilibrium point “D”. What
is the numerical value of the unemployment rate?
42) Starting on a Phillips curve with expected inflation equal to 5% and unemployment at its
natural rate, show what happens to unemployment if the Fed tries to reduce inflation, but has no
credibility. As time passes and people realize that the inflation rate is now lower, what happens
to the short-run Phillips curve?
43) What is the Lucas critique, and why was it so important to macroeconomists in the 1970s?
12.2 The Problem of Unemployment
1) When the economy goes into a recession, there’s an increase in
A) frictional unemployment.
B) structural unemployment.
C) cyclical unemployment.
D) voluntary unemployment.
2) According to Okun’s law, if full-employment output is $5,000 billion, then each percentage
point of unemployment sustained for one year reduces output by
A) $50 billion
B) $100 billion
C) $150 billion
D) $200 billion
3) Some economists argue that Okun’s Law overstates the cost of cyclical unemployment
because
A) the cost of retraining workers must be offset against the loss in output that occurs when
workers are unemployed.
B) if efficiency wages prevail, and workers are paid their real wage, already employed workers
will reduce their effort, reducing output.
C) it ignores the fact that leisure increases during a recession.
D) it ignores the loss of government revenue and additional government expenditures that occur
when unemployment rises.
4) The natural rate of unemployment in the United States generally ________ from 1960 to 1980
and ________ from 1980 to 1995.
A) fell; rose
B) fell; fell
C) rose; fell
D) rose; rose
5) One reason for the fall in the natural rate of unemployment since 1980 is
A) changes in the demographic composition of the work force.
B) the decline in inflation.
C) increased competition from foreign workers.
D) the depreciation of the dollar relative to foreign currencies.
6) The bulk of the decline in the natural rate of unemployment since 1980 is because of
A) a decline in the inflation rate.
B) a decline in the share of young workers in the labor force.
C) increased competition from foreign workers.
D) the depreciation of the dollar relative to foreign currencies.
7) A difficulty faced by policymakers who wish to use the unemployment rate as a guide to
whether the economy is weak or strong is that
A) the natural rate of unemployment is hard to measure.
B) the natural rate of unemployment almost never changes.
C) policymakers must use data on output to tell whether the unemployment rate is too high or too
low.
D) the impact of policy on the economy is subject to long and variable lags.
8) Because the natural rate of unemployment is not known precisely, policymakers who use it as
a guide for policy must be
A) less aggressive with policy changes than they would be if they knew the value of the natural
rate.
B) more aggressive with policy changes than they would be if they knew the value of the natural
rate.
C) ready to change policy more quickly.
D) aware of other data.
9) Describe the principal costs of unemployment. Are there any benefits to unemployment?
10) If you were president of the United States, what would you do to reduce the natural rate of
unemployment? Propose at least three different methods.
12.3 The Problem of Inflation
1) One cost of a perfectly anticipated inflation is that it
A) transfers wealth from lenders to borrowers.
B) transfers wealth from borrowers to lenders.
C) increases menu costs.
D) damages the role of prices as signals in the economy.
2) The costs in time and effort incurred by people and firms who are trying to minimize their
holdings of cash because of inflation are called
A) menu costs.
B) shoe leather costs.
C) transactions costs.
D) imperfect competition costs.
3) Shoe leather costs are
A) the costs in time and effort incurred by people and firms who are trying to minimize their
holdings of cash because of inflation.
B) the costs of changing prices, such as printing and mailing catalogues.
C) the costs of the redistribution of wealth between lenders and borrowers.
D) the costs associated with the confusion of prices as signals.
4) When actual inflation is greater than expected inflation
A) unemployment falls, according to Phillips-curve analysis.
B) cyclical unemployment falls, according to Phillips-curve analysis.
C) there are transfers from borrowers to lenders.
D) there are transfers from lenders to borrowers.
5) One cost of an unanticipated inflation is that it
A) transfers wealth from lenders to borrowers.
B) transfers wealth from borrowers to lenders.
C) decreases menu costs.
D) increases the purchasing power of money.
6) A COLA is
A) a center of labor activity.
B) a cost of living adjustment.
C) a contract on long-term assets.
D) a crisis of labor analysis.
7) Hyperinflation occurs when
A) the inflation rate rises.
B) the inflation rate declines.
C) the inflation rate is extremely high.
D) the inflation rate is extremely low.
8) The reduction of the inflation rate is called
A) deflation.
B) disinflation.
C) unflation.
D) reflation.
9) The costs of disinflation would be low if
A) expected inflation falls as inflation falls.
B) wage and price controls were used.
C) the Phillips curve were nearly horizontal.
D) the Phillips curve adjusted slowly to changes in inflation.
10) A rapid and decisive reduction in the rate of growth of the money supply for the purpose of
disinflation is called
A) a salt water policy.
B) a cold shower policy.
C) gradualism.
D) a cold turkey policy.
11) Keynesians prefer a disinflation policy of
A) cold turkey.
B) stabilization.
C) gradualism.
D) aggregate demand management.
12) The sacrifice ratio is
A) the amount of output lost when the inflation rate is reduced by one percentage point.
B) the percentage reduction in inflation when output falls one percentage point below potential.
C) the percentage change in employment when output declines by one percentage point.
D) the number of percentage points that the unemployment rate rises when output declines by
one percentage point.
13) The amount of output lost when the inflation rate is reduced by one percentage point is called
A) Okun’s law.
B) the sacrifice ratio.
C) the Solow residual.
D) Planck’s constant.
14) Ball found that the disinflation of the early 1980s in the United States had a sacrifice ratio of
about
A) 0.
B) 1.
C) 2.
D) 3.
15) Ball’s research showed that the sacrifice ratio
A) was the same for all countries.
B) was nearly zero for most countries.
C) was about 10 for all countries except the United States, where it was about 2.
D) varied considerably across countries.
16) Ball found that an important factor affecting the sacrifice ratio is
A) the flexibility of the labor market.
B) the shape of the yield curve.
C) the real interest rate.
D) the tightness of fiscal policy.
17) Countries in which wages adjust slowly to changes in the supply of and demand for labor are
likely to have ________ sacrifice ratio.
A) an infinite
B) a high
C) a low
D) a zero
18) Countries in which wages adjust rapidly to changes in the supply and demand for labor are
likely to have ________ sacrifice ratio.
A) an infinite
B) a high
C) a low
D) a negative
19) Countries in which the government does not regulate the labor market are likely to have
________ sacrifice ratio.
A) an infinite
B) a high
C) a low
D) a negative
20) Ball’s research on disinflation across different countries found that
A) costs of disinflation were smaller for rapid disinflation than for gradual disinflation.
B) costs of disinflation were larger for rapid disinflation than for gradual disinflation.
C) costs of disinflation were about the same for both rapid and gradual disinflation.
D) costs of disinflation were smaller when the central bank had a strong inflation-fighting
reputation.
21) If a rapid disinflation has a lower sacrifice ratio than a slow disinflation, then reducing
inflation is best accomplished by
A) gradualism.
B) increasing money growth.
C) reducing interest rates.
D) a cold-turkey approach.
22) The main determinant of how quickly expected inflation adjusts to changes in monetary
policy is
A) the slope of the Phillips curve.
B) the slope of the short-run aggregate supply curve.
C) the credibility of the central bank.
D) the degree of indexation in the economy.
23) Inflation expectations in the United States generally
A) fell from 1971 to 1976, rose from 1977 to 1985, then fell from 1985 to 1995, and have been
stable since then.
B) fell from 1971 to 1985, then rose from 1985 to 2000, and have been stable since then.
C) rose from 1971 to 1987, then fell from 1987 to 2006.
D) rose from 1971 to 1982, then fell from 1982 to 2000, and have been stable since then.
24) Describe the major costs of inflation, being sure to distinguish between anticipated and
unanticipated inflation.
25) How is the sacrifice ratio measured? How big is the sacrifice ratio in the United States? In
other countries? What problems are there in measuring the sacrifice ratio?
26) Consider an economy in long-run equilibrium with an inflation rate (π) of 0.08 per year and a
natural unemployment rate of 0.05. Suppose Okun’s law holds and a one percentage point
increase in the unemployment rate reduces real output by 2% of full-employment output. The
expectations-augmented Phillips curve is given by
π = πe – 2.5 (u – 0.05).
Consider a two-year disinflation. In the first year, π = 0.06 and πe = 0.08. In the second year, π =
0.04 and πe = 0.05.
(a) In the first year, what is the value of the unemployment rate?
(b) In the first year, by what percentage does output fall short of full-employment output?
(c) In the second year, what is the value of the unemployment rate?
(d) In the second year, by what percentage does output fall short of full-employment output?
(e) What is the sacrifice ratio for this disinflation?