Class performance – 25.07.

2018

1. According to the economy's self-correcting mechanism, how does the economy return to
potential output following a negative demand shock? How is the recovery process different, if
the government implements a policy of economic stimulus?

Answer: The negative demand shock causes output to decline, which causes a negative output
gap, which causes inflation to decline. Then, expected inflation adjusts down, shifting the short-
run aggregate supply curve along the (new) aggregate demand curve: lower inflation causes an
automatic response of monetary policy to lower the real interest rate, which stimulates planned
expenditures, causing output to rise and the output gap to shrink (in absolute value). The short-
run aggregate supply curve will continue to shift down until the output gap is eliminated. A
demand stimulus shifts the aggregate demand curve back to the right, closing the output gap
more quickly, so inflation does not fall as much (perhaps, not at all), so the short-run aggregate
supply curve does not shift down as much (perhaps, not at all).

2. Suppose that households and businesses increase autonomous expenditures, driving output well
above potential. Describe, in detail, how monetary policy might react to minimize the increase
in inflation.

Answer: A positive output gap puts upward pressure on wages and other input prices, so prices
and inflation rise. Rising inflation induces an automatic monetary policy response to increase
the real interest rate; the increase in expenditure and output is muted by the response of
expenditures to the higher real interest rate. If there is no autonomous monetary policy, the
increase in inflation will cause an updating of expected inflation, shifting the aggregate supply
curve up. Even though the output gap is now shrinking, inflation continues to rise as workers
press for nominal wage increases to compensate for inflation (recent, current, and anticipated).
An autonomous monetary policy response can short-circuit the expectations driven shifting of
the aggregate supply curve by increasing the speed and size of the increase in the real interest
rate (the aggregate demand curve shifts to the left). If it is widely believed that the central bank
will not tolerate an increase in the inflation rate, then the aggregate supply curve might not shift
at all, and the economy will return to potential output and to the original rate of inflation.

3. Consider an economy in a long-run equilibrium with Y = 40 and π = 3. A demand shock in

period one causes output to rise to 45 and inflation rises to 4. Then, the updating of expected
inflation to equal 4 causes output in period two to decline to 43.85, and inflation to rise to 4.77.
Assuming no further shocks, calculate the values of output and inflation for period three.

Answer: Moving from period one to period two, the change in expected inflation is 1, which
causes output to decline by 1.15. Since the next change in expected inflation is 0.77, the
resulting change in output will be 0.77 × 1.15 = 0.89, so output in period three is 42.96.
Output is falling as the short-run aggregate supply curve shifts along the aggregate demand
curve. Moving from period one to period two, a change in inflation of 0.77 caused output to
decline by 1.15. Thus, a further output decline of 0.89 implies that inflation has increased by
0.89 × 0.77 ÷ 1.15 = 0.596. Inflation in period three is 5.36.

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