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ANSWERS, SOLUTIONS, AND EXERCISES
PROBLEM SET
1. a. In the case of a negative demand shock, the central bank would shift the aggregate
b. In the case of an adverse supply shock (shift to the left), the central bank would try
This would result in lower inflation, which would mean fewer resources wasted on
dealing with inflation. It would also make financial planning easier and borrowing
2.
The tax hike is a negative spending shock, which would shift the AD curve to the left.
If the Fed left the money supply unchanged, the economy would slide down the AS
curve from point E to point F (see graph on the right). Both output and the price level
would fall. If the Fed decides to use monetary policy to neutralize the spending shock,
3. The Fed may have incorrectly estimated the sensitivity of autonomous consumption
and investment to the interest rate. When it lowered the interest rate to shift the AD
curve back to its original position, it may have decreased interest rates too much, and
303
304 Instructor’s Manual for Economics: Principles and Applications, 6e
4. Possibly, the announcement of the new dovish Chair itself would be enough to change
the behavior of workers and firms. Understanding that the new Chair would fight
unemployment even at the cost of inflation, they would expect higher inflation in the
future. People would build higher inflation into their contracts and the Phillips curve
5. No, because the Fed’s influence is felt on the AD side of the economy. It does not
control the factors of AS necessary to shift the AS curve to cure this situation.
6.
The Fed would have to increase the money supply more rapidly in each successive
year. This year, for example, it could increase the money supply by enough to hit the
MORE CHALLENGING
7. The more credible the Fed is, the more believable is the announcement about
tolerating less inflation. If the Fed is highly credible, less inflation will be built in to
contracts, and inflation will fall. Ways to build credibility include establishing a
Chapter 28 Inflation and Monetary Policy 305
8.
Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes
that the natural rate of unemployment is higher and acts to bring the economy back to
its supposed potential, it will decrease the money supply. This will cause the interest
rate to rise from r1 to r2, causing the AD curve to shift leftward from AD1 to AD2. The
EXPERIENTIAL EXERCISES
1. The Federal Reserve Bank of Cleveland’s monthly publication, Economic Trends, is
available online at http://www.clevelandfed.org/research/trends.cfm?
CFID=8581540&CFTOKEN=68031117. Choose a recent issue and click on
“Monetary Policy.” What are some current developments in U.S. monetary policy?
2. Scan the Economy page in the First Section of The Wall Street Journal. You
are almost sure to find a discussion of a policy proposal that will affect
306 Instructor’s Manual for Economics: Principles and Applications, 6e
3. In January 1997, the U.S. Treasury began issuing inflation-indexed bonds. The bonds
pay a fixed rate of interest and the par value of the bond is increased each year by the
rate of inflation, as measured by the CPI. Look in the Money & Investing section of
