Chapter 21
Output, Inflation and Monetary Policy
Conceptual and Analytical Problems
1. Explain the determinants of potential growth. (LO1)
Answer: Growth of potential output depends on the growth rate of the capital stock,
2. *Explain how a recessionary output gap would emerge in an economy where the
long-run aggregate supply curve is persistently shifting to the right. (LO1)
Answer: Shifts to the right in the long-run aggregate supply curve reflects growth in
3. Describe the determinants of the long-run real interest rate and speculate on the sort
of events that would make it fluctuate. (LO1)
Answer: The long-run real interest rate equates aggregate expenditure with potential
output. If a component of aggregate expenditure that it not sensitive to changes in the
interest rate such as government spending rises, aggregate expenditure rises above
potential output at the original real interest rate. If potential output remains
4. Explain how and why the components of aggregate expenditure depend on the real
interest rate. Be sure to distinguish between the real and nominal interest rates, and
explain why the distinction matters. (LO2)
Answer: The real interest rate equals the nominal rate minus expected inflation; when
Aggregate expenditure equals consumption plus investment plus government
Higher real interest rates make U.S. financial assets more attractive to foreigners,
increasing demand for the dollar and raising its value. A rise in the inflation-adjusted
5. * Suppose that the aggregate expenditure curve for an economy can be expressed
algebraically as
AE = 3,000 – 2,000r,
where AE is aggregate expenditures and r is the real interest rate expressed as a
decimal. If the level of potential output in this economy is 2,900, what is the long-run
real interest rate? (LO2)
Answer: The aggregate expenditure curve shows the real interest rate at each level of
desired spending, including the interest rate associated with potential output. The
long-run real interest rate is the interest rate where aggregate expenditure equals
potential output. To find that rate, set AE equal to 2,900 and solve for r:
6. Suppose the U.S. economy is in equilibrium at the long-run real interest rate that
prevails when aggregate expenditure equals potential output. Draw a diagram of
aggregate expenditure showing this initial equilibrium. Then suppose that foreign
demand for U.S. exports falls due to a recession abroad. Show how the long-run real
interest rate will change and explain your results. (LO1)
Answer: The reduction in U.S. exports diminishes U.S. aggregate expenditures at
7. The European Central Bank’s primary objective is price stability. Policymakers
interpret this objective to mean keeping inflation below, but close to, 2 percent, as
measured by a euro-area consumer price index. In contrast, the FOMC has a dual
objective of price stability and high economic growth. How would you expect the
monetary policy reaction curves of the two central banks to differ? Why? (LO2)
Answer: The ECB is more aggressive in targeting inflation than the FOMC. For equal
deviations in current inflation from target inflation, the ECB will change interest rates
8. *Explain why the short-run aggregate supply curve is upward sloping. Under what
circumstances might it be vertical? (LO3)
Answer: The short-run aggregate supply curve is upward sloping due to stickiness in
If all input prices were perfectly flexible and adjusted instantly whenever demand
9. Assume the short-run aggregate supply curve can be expressed algebraically as
Ys= 4,800 + 3,000π
where YS is aggregate supply, and the dynamic aggregate demand curve can be
written as
Yd = 5,000 – 1,000π.
where Yd is aggregate demand. Find the numerical value for equilibrium output, Y, in
the short run. Find the numerical value for the short-run inflation rate, π. (LO4)
Answer: The answer requires that you solve these two simultaneous equations. To
start, rearrange the second equation, solving for π in terms of Yd:
10. Consider Panel B of Figure 21.16 where, at the initial short-run equilibrium point 0,
current inflation is below expected inflation and output is below potential output.
Suppose that the initial inflation target was at the level corresponding to point 1, but
the central bank chooses to stimulate demand to speed the adjustment to long-run
equilibrium. What action must the central bank take and what are the costs and
benefits of such a policy? (LO4)
Answer: The central bank must raise its inflation target, shifting both the monetary
policy reaction curve and the aggregate demand curve to the right. The cost is higher
11. Suppose the real interest rate unexpectedly falls in the absence of other economic
changes. What would you expect to happen to (a) consumption, (b) investment, and
(c) net exports in the economy? (LO3)
Answer:
a. Consumption will rise as borrowing to purchase consumer durables becomes
less costly. In addition, the reward to saving falls, reducing saving and
increasing consumption.
12. * Economy A and Economy B are similar in every way except that in Economy A, 70
percent of aggregate expenditure is sensitive to changes in the real interest rate and in
economy B, only 50 percent of aggregate expenditure is sensitive to changes in the
real interest rate. (LO2)
a. Which economy will have a steeper aggregate expenditure curve?
b. How would the dynamic aggregate demand curves differ given that the
monetary policy reaction curve is the same in both countries?
Explain your answers.
Answer:
a. Economy B will have a steeper aggregate expenditure curve. For a given fall
b. Economy B will also have a steeper dynamic aggregate demand curve. As the
two countries have the same monetary policy reaction curves, an increase in
inflation will result in the same increase in the real interest rate in both
13. Given the expected relationship between the real interest rate and investment, how
would you explain a scenario where investment continued to fall despite low or even
negative real interest rates? (LO3)
Answer: Changes in the level of investment depend on both the level of real interest
rates and changes in expectations about future business conditions. If firms are
pessimistic about the economic outlook, investment may remain weak despite low or
14. State whether each of the following will result in a movement along or a shift in the
monetary policy reaction curve and in which direction the effect will be. (LO2)
a. Policymakers increase the real interest rate in response to a rise in current
inflation.
b. Policymakers increase their inflation target.
c. The long-run real interest rate falls.
Answer:
a. This would result in a movement up along the monetary policy reaction curve.
b. This would result in a shift in the monetary policy reaction curve to the right
15. Suppose a natural disaster wipes out a significant portion of the economy’s capital
stock, reducing the potential level of output. What would you expect to happen to the
long-run real interest rate? What impact would this have on the monetary policy
reaction curve and the dynamic aggregate demand curve? (LO2)
Answer: The reduction in the potential level of output in the economy would lead to
an increase in the long-run real interest rate in the economy. The higher real interest
rate would drive down the interest-sensitive components of aggregate expenditure to
16. Suppose there were a wave of investor pessimism in the economy. What would the
impact be on the dynamic aggregate demand curve? (LO2)
Answer: A wave of investor pessimism would reduce investment and therefore
17. Explain how each of the following affects the short-run aggregate supply curve.
(LO3)
a. Firms and workers reduce their expectations of future inflation.
b. There is a rise in current inflation.
c. There is a fall in oil prices.
Answer
a. A reduction in inflationary expectations means that nominal wages will rise by
18. Suppose the economy is in short-run equilibrium at a level of output that exceeds
potential output. How would the economy self-adjust to return to long-run
equilibrium? (LO4)
Answer: The expansionary gap exerts upward pressure on costs, shifting the short-run
aggregate supply curve to the left until the economy reaches the long-run equilibrium
19. Why do you think the surge in oil prices in 2007–2008 had a much smaller impact on
inflation expectations compared with the oil price shocks of the 1970s? (LO4)
Answer: The response of inflation expectations to changes in economic conditions
depends to a large extent on the credibility of the monetary policymaker. If the central
bank is credible due, for example, to a long record of matching its actions with its
20. You read a news story blaming the central bank for pushing the economy into
recession. The article goes on to mention that not only has output fallen below its
potential level but that inflation had also risen. If you were to respond defending the
central bank, what argument would you make? (LO4)
Answer: You should state that monetary policy actions by the central bank affect the
dynamic aggregate demand curve and that shifts in the aggregate demand curve move