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Chapter 19 - Current Issues in Macro Theory and Policy
Chapter 19 - Current Issues in Macro Theory and Policy
McConnell Brue Flynn 20e
DISCUSSION QUESTIONS
1. According to mainstream economists, what is the usual cause of macroeconomic instability?
What role does the spending-income multiplier play in creating instability? How might adverse
aggregate supply factors cause instability, according to mainstream economists? LO1
Answer: The mainstream view of macroeconomic instability is Keynesian-based
and focuses on aggregate spending and its components. Particularly significant
In the mainstream view, a second source of instability could arise on the supply
2. What is an efficiency wage? How might payment of an above-market wage reduce shirking by
employees and reduce worker turnover? How might efficiency wages contribute to downward
wage inflexibility, at least for a time, when aggregate demand declines? LO1
Answer: An efficiency wage is one that minimizes the firm’s labor cost per unit
of output. Normally, we could assume that the market wage for the particular type
First, the above average wage raises the opportunity cost of losing the job and
Second, motivated workers require less supervision. If the firm needs fewer
Third, the above-market pay discourages workers from voluntarily leaving their
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Chapter 19 - Current Issues in Macro Theory and Policy
Efficiency wages are likely to contribute to downward wage inflexibility. Wage
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Chapter 19 - Current Issues in Macro Theory and Policy
3. How might relationships between so-called insiders and outsiders contribute to downward
wage inflexibility? LO1
Answer: Insiders are workers who retain employment even during recession.
Outsiders are workers laid off from a particular firm and other unemployed
4. Briefly describe the difference between a so-called real business cycle and a more traditional
“spending” business cycle. LO1
Answer: In the real-business-cycle theory, business fluctuations result from
significant changes in technology and resource availability. These changes affect
5. Craig and Kris were walking directly toward each other in a congested store aisle. Craig moved
to his left to avoid Kris, and at the same time Kris moved to his right to avoid Craig. They
bumped into each other. What concept does this example illustrate? How does this idea relate to
macroeconomic instability? LO1
Answer: This example illustrates a coordination failure that occurs in macroeconomics
Expectations of households and business firms can create an undesirable outcome. If
individuals expect others to cut spending and anticipate excess capacity, they will cut
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Chapter 19 - Current Issues in Macro Theory and Policy
6. State and explain the basic equation of monetarism. What is the major cause of macroeconomic
instability, as viewed by monetarists? LO1
Answer: The fundamental equation of monetarism is the equation of exchange.
MV = PQ. The left side, MV, represents the total amount spent [M, the money
Monetarists believe changes in the money supply, in particular, inappropriate
7. Use the equation of exchange to explain the rationale for a monetary rule. Why will such a rule
run into trouble if V unexpectedly falls because of, say, a drop in investment spending by
businesses? LO1
Answer: MV = PQ. If we assume that V (velocity) is constant, increasing the
8. Explain the difference between “active” discretionary fiscal policy advocated by mainstream
economists and “passive” fiscal policy advocated by new classical economists. Explain: “The
problem with a balanced-budget amendment is that it would, in a sense, require active fiscal
policy—but in the wrong direction—as the economy slides into recession.” LO3
Answer: Active discretionary fiscal policy entails the use of deficit spending
New classical economists, monetarists and rational expectationists see the
Mainstream economists vigorously defend the use of both discretionary fiscal and
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Chapter 19 - Current Issues in Macro Theory and Policy
9. You have just been elected president of the United States, and the present chairperson of the
Federal Reserve Board has resigned. You need to appoint a new person to this position, as well as
a person to chair your Council of Economic Advisers. Using Table 19.1 and your knowledge of
macroeconomics, identify the views on macro theory and policy you would want your appointees
to hold. Remember, the economic health of the entire nation—and your chances for reelection—
may depend on your selections. LO4
Answer: The appointments to chair the Federal Reserve Board and the Council of
A Democratic president is likely to appoint economists with a mainstream
During the Reagan administration (1981-1988) supply-side policies were
implemented. One of the first actions taken was to fire striking air traffic
expectationists since both favor a reduced role for government and would be
10. LAST WORD Compare and contrast the Taylor rule for monetary policy with the older,
simpler monetary rule advocated by Milton Friedman.
Answer: The monetary rule advocated by Friedman, the “monetarist rule,” is
passive. It requires consistent expansion of money supply regardless of economic
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Chapter 19 - Current Issues in Macro Theory and Policy
REVIEW QUESTIONS
1. If prices are sticky and the number of dollars of gross investment unexpectedly increases, the
_________ curve will shift ____________ . LO1
a. AD; right.
b. AD; left.
c. AS; right.
d. AS; left.
Feedback: If prices are sticky and the number of dollars of gross investment
2. First, imagine that both input and output prices are fixed in the economy. What does the
aggregate supply curve look like? If AD decreases in this situation, what will happen to
equilibrium output and the price level? Next, imagine that input prices are fixed, but output prices
are flexible. What does the aggregate supply curve look like? In this case, if AD decreases, what
will happen to equilibrium output and the price level? Finally, if both input and output prices are
fully flexible, what does the aggregate supply curve look like? In this case, if AD decreases, what
will happen to equilibrium output and the price level? (To check your answers, review Figures
12.3, 12.4, and 12.5 in Chapter 12). LO1
Answer: In the immediate-short-run the aggregates supply schedule is horizontal.
In the short-run the aggregates supply schedule slopes upward. That is, as prices
increase output increases as well. This is because input prices are fixed and output
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Chapter 19 - Current Issues in Macro Theory and Policy
3. Suppose that the money supply is $1 trillion and money velocity is 4. Then the equation of
exchange would predict nominal GDP to be: LO1
a. $1 trillion.
b. $4 trillion.
c. $5 trillion.
d. $8 trillion.
Feedback: The equation of exchange would predict nominal GDP to be $4
trillion. You can see that this has to be true by examining the equation of
exchange, which states that MV = PY. Because P is the price level and Y is real
4. If the money supply fell by 10 percent, a monetarist would expect nominal GDP to _________.
LO1
a. Rise.
b. Fall.
c. Stay the same.
Feedback: If the money supply fell by 10 percent, a monetarist would expect
nominal GDP to fall. The monetarist would expect nominal GDP to fall because
that is the outcome that is predicted by the equation of exchange that monetarists
believe to be a good model of the macroeconomy. As you will recall, the equation
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Chapter 19 - Current Issues in Macro Theory and Policy
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Chapter 19 - Current Issues in Macro Theory and Policy
5. An economy is producing at full employment when AD unexpectedly shifts to the left. A new
classical economist would assume that as the economy adjusted back to producing at full
employment, the price level would ___________. LO2
a. Increase.
b. Decrease.
c. Stay the same.
Feedback: A new classical economist would expect the price level to decrease as the
economy adjusted back to producing at full employment. When AD unexpectedly shifts
to the left, prices will for a time be sticky. The result will be a level of real GDP that is
6. Use an AD-AS graph to demonstrate and explain the price-level and real-output outcome of
an anticipated decline in aggregate demand, as viewed by RET economists. (Assume that the
economy initially is operating at its full-employment level of output.) Then demonstrate and
explain on the same graph the immediate outcome as viewed by mainstream economists. LO2
Answer: See the graph and the decline in aggregate demand from AD1 to AD2.
RET view: The Economy anticipates the decline in the price level and
7. Place “MON,” “RET,” or “MAIN” beside the statements that most closely reflect monetarist,
rational expectations, or mainstream views, respectively: LO4
a. Anticipated changes in aggregate demand affect only the price level; they have no effect on real
output.
b. Downward wage inflexibility means that declines in aggregate demand can cause long-lasting
recession.
c. Changes in the money supply M increase PQ; at first only Q rises because nominal wages are
fixed, but once workers adapt their expectations to new realities, P rises and Q returns to its
former level.
d. Fiscal and monetary policies smooth out the business cycle.
e. The Fed should increase the money supply at a fixed annual rate.
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Chapter 19 - Current Issues in Macro Theory and Policy
Answer:
PROBLEMS
1. Suppose that the money supply and the nominal GDP for a hypothetical economy are $96
billion and $336 billion, respectively. What is the velocity of money? How will households and
businesses react if the central bank reduces the money supply by $20 billion? By how much will
nominal GDP have to fall to restore equilibrium, according to the monetarist perspective? LO1
Feedback: The key equation here is the equation of exchange:
M (Money Supply) V (Velocity) = P (Price Level) Q (Real GDP)
Note that P (Price Level) Q (Real GDP) = Nominal GDP.
Rearranging the equation we can find the velocity:
Given the reduction in the money supply by $20 billion households and businesses will
reduce spending for a given velocity of money.
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Chapter 19 - Current Issues in Macro Theory and Policy
2. Assume the following information for a hypothetical economy in year 1: money supply = $400
billion; long-term annual growth of potential GDP = 3 percent; velocity = 4. Assume that the
banking system initially has no excess reserves and that the reserve requirement is 10 percent.
Also suppose that velocity is constant and that the economy initially is operating at its full-
employment real output. LO1
a. What is the level of nominal GDP in year 1?
b. Suppose the Fed adheres to a monetary rule through open-market operations. What amount of
U.S. securities will it have to sell to, or buy from, banks or the public between years 1 and 2 to
meet its monetary rule?
Feedback:
Part a:
To find nominal GDP for year 1 we use the equation of exchange:
M (Money Supply) V (Velocity) = P (Price Level) Q (Real GDP)
Note that P (Price Level) Q (Real GDP) = Nominal GDP.
P (Price Level) Q (Real GDP) = Nominal GDP = MV = $400 billion x 4 = $1600
billion
Part b:
This implies that the money supply for the entire banking system must increase by $12
Finally, since the Fed needs to increase the money supply by $12 billion it must buy
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