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Chapter 19 Current Issues in Macro Theory and Policy
QUESTIONS
1. 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
29.3, 29.4, and 29.5 in Chapter 29). LO1
Answer: In the immediate-short-run the aggregates supply schedule is horizontal. This is
because all prices are fixed (input and output prices). If there is a decrease in aggregate
2. 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 are changes
3. 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
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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 of labor
4. 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 workers who would like
5. 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 productivity and
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6. 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
when people do not reach a mutually beneficial equilibrium because they lack some way
7. State and explain the basic equation of monetarism. What is the major cause of macroeconomic
instability, as viewed by monetarists? LO2
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 supply x V, the
8. 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? LO2
Answer: MV = PQ. If we assume that V (velocity) is constant, increasing the money
9. 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 outcome as viewed by mainstream economists. LO3
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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 immediately moves
10. 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.” LO4
Answer: Active discretionary fiscal policy entails the use of deficit spending during
recessions, that is, increasing government spending, and/or cutting taxes to expand
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11. 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.
12. 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 36.1 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
Economic Advisors would depend on what coalition of interest groups contributed to my
campaign and helped put me in office.
13. Last Word: Compare and contrast the Taylor rule for monetary policy with the older, simpler
monetary rule advocated by Milton Friedman.
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Answer: The monetary rule advocated by Friedman, the “monetarist rule,” is passive. It
requires consistent expansion of money supply regardless of economic conditions. The
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? LO2
Feedback: Consider the following example. 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?
The key equation here is the equation of exchange:
M (Money Supply) V (Velocity) = P (Price Level) Q (Real GDP)
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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. LO2
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: Consider the following example. 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.
a. What is the level of nominal GDP in year 1?
To find nominal GDP for year 1 we use the equation of exchange:
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?
First, we need to find Nominal GDP for year 2 at a 3% rate of annual growth.
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