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chapter
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Short-Run Economic
Fluctuations
1. Suppose potential output grows 2 percent per year and the natural rate of unem-
ployment is constant at 6 percent. In 2020, the unemployment rate is 7 percent.
a. Assuming Okun’s law, what is the output gap in 2020?
ANSWER: Okun’s law is represented by the following equation:
(Y– Y*)/Y* = –2(U– U*). The output gap is calculated based on level data for Y(data
that are measured in dollars, not percentage changes) and is valid for constant po-
b. If output grows 5 percent from 2020 to 2021, what is the unemployment rate
in 2021?
ANSWER: The output gap will be unchanged when actual output, Y, grows at the
same rate as potential output, Y*. Since actual output is growing at a faster rate (5
2. Suppose the growth rate of potential output rises. The behavior of the output gap
(the fluctuations of output around potential) does not change. Do NBER recessions
become more or less common? Explain.
ANSWER: With a higher growth rate of potential output, NBER recessions become
less common. This can be most easily understood if you contrast the situation of con-
stant potential output with growing potential output. With constant potential output, a
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3. Suppose a country bans trade with other countries, so net exports are always zero.
How would this affect the slope of the AE curve? Explain.
ANSWER: In the model presented in Chapter 12, all expenditure components, with
the exception of government purchases, adjust to changes in the real interest rate.
4. Suppose the Fed raises the real interest rate and consumer confidence falls around
the same time (as occurred in 1990). Show with a graph what happens to the AE
curve and to output.
ANSWER: The drop in consumer confidence will likely decrease consumption,
household spending on goods and services. Graphically, this negative expenditure
5. Suppose the economy starts with output at potential. Then a supply shock occurs:
oil prices rise sharply. The Fed is partly accommodative: it raises the real interest
rate, but not by enough to keep inflation from rising. Show with graphs what happens
to the AE and Phillips curves and to output and inflation.
ANSWER: As the Fed raises the real interest rate, output falls below potential. The
increase in ris graphically shown as a leftward movement along the AE curve (AE
6. Suppose oil prices jump up and the Fed is completely accommodative: it keeps the
real interest rate constant. How must the Fed adjust the nominal interest rate? How
must it adjust the money supply? Explain.
ANSWER: An adverse supply shock with completely accommodative monetary pol-
icy results in constant output Yand a permanently higher inflation rate. While the price
CHAPTER 12 Short-Run Economic Fluctuations A-81
7. Suppose again that oil prices increase. This has two effects: (a) firms’ costs jump
up and (b) since more of consumers’ income goes to pay for oil imports, there is less
to spend on U.S. goods. (We emphasized (a) but ignored (b) in the chapter.) Assume
the Fed holds the real interest rate constant. Show what happens to the AE and
Phillips curves and to output and inflation.
ANSWER: The reduced consumer spending on U.S. goods and services shifts the
8. Suppose the economy starts with output at potential and constant inflation. In 2020,
oil prices jump up. Initially, the Fed is accommodative. In 2023, a new Fed chair is ap-
pointed and resolves to return inflation to the level before 2020. Show with graphs
what happens over time to the real interest rate, output, and inflation.
ANSWER: The increase in oil prices is a case of an adverse supply shock. When the
Fed reacts with accommodative monetary policy, real interest rates and output are
9. Suppose that expected inflation is the average of inflation over the two previous
years:
π
e= (1/2)[
π
(–1) +
π
(–2)]
a. Write the equation for the Phillips curve in this case.
ANSWER: The general equation for the Phillips curve is
π
=
π
e+ α(Y– Y*)/Y* + ν.
b. Redo the disinflation example in Figure 12.21. Assume the path of the real in-
terest rate is the same as before. Is the path of output different with the new
Phillips curve? The path of inflation? Explain.
ANSWER: As in Figure 12.21, the real interest rate increases in 2020, stays high in
2021, and drops back to its original level in 2022. The AE curve is not affected by the
10. The United States was on a gold standard from 1879 to 1914. During that period,
the average inflation rate was about zero. Inflation was sometimes positive and some-
times negative, and there was no relation between inflation in one year and the next.
Each year inflation was equally likely to be positive or negative, regardless of past in-
flation.
a. For the gold-standard era, is the assumption of adaptive expectations a good
one? If not, what assumption about inflation expectations would be more rea-
sonable?
ANSWER: When inflation in one year has no relation to inflation in the previous pe-
b. Write the Phillips curve for the alternative assumption about expectations.
e= 0 leads to the following equation for the Phillips
c. Suppose the real interest rate rises temporarily, as in Figure 12.21. Compare
the effects on inflation under adaptive expectations and under the alternative as-
sumption in parts (a) and (b).
ANSWER: With the real interest rate rising in 2020, output falls below potential. The
Phillips curve from (b) indicates that the inflation rate will become negative:
π
= α(Y
11. The data in Figure 12.14 suggest an unemployment coefficient of approximately
–1.0 in the Phillips curve. That is, the Phillips curve is
π
–
π
(–1) = –(1.0)(U– U*) . As-
sume the natural rate, U*, is 5 percent. Actual unemployment is 5 percent in 2020, 7
percent in 2021, 6 percent in 2022, and 5 percent in 2023. Inflation is 5 percent in
2020. What is inflation in 2023? (Assume there are no supply shocks.)
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ANSWER:
Year Unemployment Rate Inflation Rate
To calculate the inflation rate in 2021, use the Phillips curve relationship
π
(2021) – 5%
ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
12. The text Web site has U.S. data on output, unemployment, and inflation from
1960 through 2010, along with estimates of potential output and the natural rate of un-
employment. Focus on the data for the year 2010.
a. Do the data for 2010 fit Okun’s law? (The relationship is graphed in Figure
12.4).
ANSWER: For the United States Okun’s law is given as (Y–Y*)Y* = –2(U– U*). A one
percent increase in the unemployment rate Uabove the natural unemployment rate
b. Do the data for 2010 fit the unemployment Phillips curve? (The relationship is
graphed in Figure 12.14.)
ANSWER: The text Web site contains data through 2009 only. Creating a scatterplot
from this data (change in inflation and the deviation of unemployment from the natu-
c. If you find deviations from Okun’s law or the Phillips curve in 2010, what might
explain the deviations?
ANSWER: The most recent data match both Okun’s law and the Phillips curve very
CHAPTER 12 Short-Run Economic Fluctuations A-83
13. From the text Web site, link to the site of the Federal Reserve Bank of St. Louis;
also, see the “Guide to St. Louis Fed Data.” Get annual data on the inflation rate, the
interest rate on 3-month Treasury bills, and the unemployment rate.
a. According to the AE curve and Okun’s law, what is the relationship between the
real interest rate and unemployment?
ANSWER: Okun’s law states that there is a negative relationship between unem-
b. Using data from 1960 to the present, plot the unemployment rate against the
real interest rate, defined as the nominal T-bill rate minus inflation. That is, make
a graph with the unemployment rate on one axis, the real interest rate on the
other, and a point for each year. What relationship, if any, do you see?
ANSWER: A graph with unemployment on the horizontal axis and the real interest
c. Are the relationships in parts (a) and (b) similar or different? If they are differ-
ent, try to explain why. Do the results in (b) show that our theory about the AE
curve is wrong?
ANSWER: The relationships from part (a) and (b) are different. The theory behind the
AE curve together with Okun’s law postulates a positive relationship between the real
A SMALL RESEARCH PROJECT
14. Interview a few people who are not economists but are old enough to remember
the 1970s. Ask them what caused the high inflation of the 1970s and the deep re-
cession of the early 1980s. Also ask about the 1990s: Why was there a recession at
the start of the decade and a roaring economy at the end? Do their answers agree
with this chapter? If not, whom do you believe?
ANSWER: While the answers of your interview partners will vary, recall that the high
inflation of the 1970’s was largely caused by adverse supply shocks in the form of
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CHAPTER 12 Short-Run Economic Fluctuations A-85