3. *Monetary policymakers observe an increase in output in the economy and
believe it is a result of an increase in potential output. If they were correct, what
would the appropriate policy response be to maintain the existing inflation target?
If they were incorrect and the increase in output resulted simply from a positive
supply shock, what would the long-run impact be of their policy response? (LO3)
Answer: To maintain the existing inflation target, monetary policymakers should
shift their MPRC to the right, shifting the AD to the right. This would restore
If, however, the increase in output resulted simply from a positive supply shock,
the expansionary monetary policy would increase the expansionary gap. In the
4. *Consider a previously closed economy that opens up to international trade. Use
the aggregate demand–aggregate supply framework to illustrate a situation where
this would lead to lower inflation in the long run. (LO2)
Answer: Opening up to international trade increases potential output and the
SRAS and LRAS curves shift to the right. If monetary policymakers use this as an
5. *How could you use the aggregate demand–aggregate supply (AD/AS)
framework to explain the impact of the financial crisis of 2007–2009 on inflation
and output in the economy? (LO2, LO3)
Answer: You can think of the disruption in financial markets as an AD shock.
Lack of access to credit by consumers and businesses and loss of consumer and
6. Changes in oil prices shift the short-run aggregate supply curve (SRAS). Consider
how volatility in oil prices may influence the economy’s short-run equilibrium,
which occurs at the intersection of the dynamic aggregate demand (AD) curve and
the SRAS curve. (LO3)
. Suppose the monetary policy reaction curve is relatively steep. What does
this imply about the slope of the AD curve? What does it imply about the
variability of output and inflation when the SRAS curve shifts? Explain.
. Suppose the monetary policy reaction curve is relatively flat. What does
this imply about the slope of the AD curve? What does it imply about the
variability of output and inflation when the SRAS curve shifts? Explain.
Answer:
a. In the diagram below, suppose that SRAS fluctuates between SRAS’ and
SRAS”, with a typical position at SRAS. The impact of these fluctuations
on output and inflation in the short run depends on the slope of the
relatively flat. With a flat AD, the variability in output is fairly large,
b. If the MPRC is relatively flat, a given rise in the inflation rate leads to a
smaller policy-driven increase in the real interest rate, resulting in a
smaller decline of interest-sensitive purchases. So, the same increase in the
7. You are asked to advise a central bank of an advanced economy that is about to
set an inflation target for the first time. Officials are leaning toward adopting a 2
percent target, in line with the practice in many other countries. Suggest two
factors that the central bank should consider before settling on 2 percent. (LO3)
Answer: You might suggest the central bank officials consider: 1) estimates of the
neutral real interest rate in their economy; and 2) the historical depths of
recessions in their economy. In a situation where the neutral real interest rate is
8. Suppose that a government imposes trade barriers that raise the domestic cost of
production and lower potential output. What would you expect to happen to
inflation and output in the short run and the long run, assuming monetary
policymakers only recognize the fall in potential output with a lag and keep their
inflation target unchanged? (LO1)
Answer: The fall in potential output would be reflected in a shift to the left of both
the SRAS and LRAS curves. In the short run, before policymakers realize that
potential output has fallen, inflation will rise and output will fall as the economy
In the long run, the overall impact of the protectionist policies would be to lower
9. High debt ratios led many countries in recent years to reduce government
spending. Suppose the cut in spending started from a point with the economy at
long-run equilibrium. How might monetary policymakers react, assuming their
inflation target remained unchanged? (LO1)
Answer: The cut in government spending shifts the AD curve to the left, reducing
inflation below expected inflation and below the inflation target and also lowering
output below potential output. Realizing that the long-run real interest rate had
Data Exploration
1. Display as a bar chart the periods since 1854 that are designated as U.S.
recessions by the National Bureau of Economic Research (FRED code: USREC).
Why has the frequency of recessions declined over time? Could improvements in
monetary policy have played a role? Improvements in fiscal policy? Can you
think of any other causes? (LO1)
Answer: The frequency of recessions has notably diminished, especially after the
Great Depression. Monetary policy has improved over time, especially with the
advent of a monetary policy framework stressing transparency, credibility and
Fiscal policy usually is more difficult to use to counter recessions because these
At least two other possibilities exist. First, one hypothesis is that the data prior to
World War II, and especially prior to World War I, is not sufficiently accurate to
following the 2007-2009 recovery highlights the limits of the economy’s
self-correcting forces.
2. In the past, policymakers occasionally became aware of a recession only well
after it began. Can they do better? Plot the probability of a recession from a
statistical model (FRED code: RECPROUSM156N). To what extent could the
model help improve monetary or fiscal policy or both? (LO3)
Answer: The probabilities are plotted below. With the exception of the mild
downturn in 2001, a recession occurs whenever the statistical probability rises
above 50 percent. Furthermore, there are no “false signals” with the available
3. Compare the frequency and timing of recessions in key European economies
since 1960. Make separate bar charts for Germany (FRED code: DEURECM),
Italy (FRED code: ITARECM), and Spain (FRED code: ESPRECM). Do their
business cycles appear sufficiently well-aligned to make them operate easily in a
single currency area with a common monetary policy? (LO3)
Answer: The plots are below. While there appears to be some overlap, the timing
and duration of recessions in the European countries are not identical.
These differences may reflect differing mixes of goods and services, different
4. To keep inflation low and steady, central banks would like to keep output
reasonably close to its potential level, but can they anticipate changes in potential
GDP? Plot since 1960 the percent change from a year ago of the Congressional
Budget Office’s estimate of potential GDP (FRED code: GDPPOT). Suppose that
the FOMC assumed that the growth rate of potential GDP remained permanently
at its 1960s average. What would you expect to happen to inflation? Why? (LO1)
Answer: The plot appears below. According to the CBO, potential GDP growth
averaged 4.3 percent in the 1960s. From 1970 to mid-2016, it averaged 2.8
percent. Had the FOMC assumed that potential GDP growth of 4.3 percent would
* indicates more difficult problems