chapter 9

Question 1

distinguish from short run to long run and in between on factor prices and technology assumptions

Answer 1

The Short Run
* factor prices are assumed to be constant
* technology and factor supplies are assumed to be constant
The Adjustment of Factor Prices
* factor prices are flexible
* technology and factor supplies are constant
The Long Run
* factor prices have fully adjusted
* technology and factor supplies are changing

Question 2

Describe the concept of adjustment asymmetry

Answer 2

• inflationary output gaps typically raise wages rapidly
• recessionary output gaps often reduce wages only slowly
  (downward wage stickiness)
  This general adjustment process—from output gaps to factor
  prices—is summarized by the Phillips curve.

Question 3

Expand on phillips curve

Answer 3

originally drawn as a negative relationship
between the unemployment rate and the rate of change in nominal
wages.
Y > Y* => excess demand for labour => wages rise
Y < Y* => excess supply for labour => wages fall
Y = Y* => no excess supply/demand => wages constant

Question 4

What does the speed of adjustment usually depend on

Answer 4

• If wages are flexible: wages will fall rapidly whenever there is
  unemployment, the resulting shift in the AS curve could quickly
  eliminate recessionary gaps.
• If wages are sticky: AS curve shifts more slowly. In such cases the
  recessionary gap may have to be closed with an expansion in AD
  (increase in private sector demand or government stabilization
  policy).

Question 5

Describe the long run equilibrium

Answer 5

The economy is in a state of long-run equilibrium when factor prices
are no longer adjusting to output gaps:
è Y = Y*
The vertical line at Y* is sometimes called:
* the long-run aggregate supply curve, or
* the classical aggregate supply curve
There is no relationship in the long run between the price
level and potential output.

Question 6

When an AD or AS shock pushes Y away from Y* the alternatives are:

Answer 6

• use fiscal stabilization policy
• wait for the recovery of private sector demand
  è a shift in the AD curve
• wait for the economy’s adjustment process
  è a shift in the AS curve

Question 7

A recessionary gap may be closed by

Answer 7

1. a rightward shift in AD due to recovery of private sector demand
2. a (possibly slow) rightward shift in the AS curve
3. a rightward shift in AD due to an expansionary fiscal policy

Question 8

Adv disadv of using fiscal policy in case of recession

Answer 8

Advantage: it may shorten what might otherwise be a long recession.
Disadvantage: may stimulate the economy before private-sector
recovery and economy may overshoot its Y* à creating instability

Question 9

What is the paradox of thrift in the short run and in the long run

Answer 9

In the short run, an increase in desired saving leads to a reduction in GDP
(shift AD to the left and reduce GDP).

The paradox of thrift does not apply in the long run:
à In the long run AD does not influence the level of GDP.
à The increase in savings has the long-run effect of increasing investment
and therefore increasing potential output (we will see that in chapter 10).

Question 10

Difference between automatic and discretionnary fiscal policy

Answer 10

Discretionary fiscal stabilization policy occurs when the government
actively changes G and/or T in an effort to steer real GDP.
Automatic fiscal stabilization occurs because of the design of the tax
and transfer system:
* as Y changes, net tax revenue changes
* the size of the simple multiplier is reduced
* the output response to shocks is dampened

Question 11

Practical limitation of discretionnary fiscal policy

Answer 11

• long and uncertain lags
• temporary versus permanent changes in policy
• the impossibility of “fine tuning

Question 12

Describe the problem of uncertain lags

Answer 12

• Decision lags: the period of time between perceiving some
  problem and reaching a decision on what to do about it.
• Execution lag: the time that it takes to put policies in place after a
  decision has been made.
• And when the new policies are in place it can still take time for
  their economic consequences to be felt.
  à It is possible that by the time a given policy decision has any
  impact on the economy, circumstances will have changed such that
  the policy is no longer appropriate

Question 13

Temporary versus permanent changes in policy

Answer 13

Temporary changes in taxation are generally less effective than
measures that are expected to be permanent.
More forward-looking are households, the smaller will be the effects
of what are perceived to be temporary changes in taxes.

Question 14

The impossibility of ``fine tuning’’

Answer 14

Fine tuning: the attempt to maintain output at its potential level by
means of frequent changes in fiscal policy.
Gross tuning: the use of macroeconomic policy to stabilize the
economy such that large deviations from potential output do not
persist for extended periods of time.