Chapter 20
Answers to Questions in Chapter 20
Note: No. before Ø indicates a page number
Page
474Ø 1. In the extreme Keynesian model, is there any point in supply-side policies?
Yes. Successful supply-side policies, by increasing potential output, will shift the vertical portion of the AS curve to the right. As a result, expansionary demand management policies could now increase output to a higher level than before.
474 Ø 2. In the new classical model, is there any point in using supply-side policies as a weapon against inflation?
No. Demand-side policy must be used to control inflation (which for a monetarist means monetary policy). Supply-side policy will be the policy to use to reduce unemployment. If successful, it will shift the (vertical) AS curve to the right, and shift the (vertical) Phillips curve to the left by reducing the equilibrium level of unemployment. [These issues are explored throughout this chapter.]
476 Ø Under what circumstances would this interdependence of firms give a vertical long-run AS curve?
When costs rise by the same percentage as the increase in demand. This will occur at full employment (which under classical assumptions of perfectly flexible wages and prices will be the case anyway). At full employment, a rise in aggregate demand could not allow an increase in total output in the economy. An individual firm could only expand its output by attracting labour and other resources away from other firms. But when all firms try to do this, the effect will be for wages and prices to rise by the same percentage as the increase in demand, leaving real aggregate demand unaffected. Aggregate supply will not have changed. The long-run curve is vertical.
The same effect could occur at less than full employment if individual firms decided to raise their prices in response to an increase in demand rather than increasing output, even if they had the spare capacity to do so. Firms may not be rational profit maximisers.
476 Ø 1. Will the shape of the long-run AS curve here depend on just how the `long' run is defined?
If the long run is defined so as to include the possibility of technological change (strictly speaking this would be defined as the `very long run'), then if this technological change is the result of investment, which in turn had resulted from the increased aggregate demand, the (very) long-run aggregate supply curve will be relatively elastic.
476 Ø 2. If a shift in the aggregate demand curve from AD to AD1 in Figure 20.5 causes a movement from point a to point d in the long run, would a shift in aggregate demand from AD1 to AD cause a movement from point d back to point a in the long run?
Yes, if there were disinvestment as the result of the fall in aggregate demand, and if there had been no technological progress as a result of the previous shift from AD to AD1. If, however, earlier investment had led to new more productive plant and machinery being used, then a fall in aggregate demand will lead to the older, less efficient plant and machinery being scrapped. The result will be that the eventual equilibrium will be below point a.
476 Ø Assume that there is a fall in aggregate demand (for goods). Trace through the short-runm and long-run effect on employment.
Prices fall. This causes the real wage to rise above We in Figure 20.6. At this real wage rate there is a deficiency of demand for labour. In the short run there will be an increase in unemployment. In the long run the deficiency of demand will drive down the money wage rate until the real wage rate has returned to We.
483 Ø What will determine the speed at which inflation accelerates?
It will accelerate faster
(a) the more quickly expectations adjust
(b) the more quickly people can adjust their wages in line with their expectations.
487 Ø Show these effects of an increase in aggregate demand from both the adaptive expectations and rational expectations points of view, only this time show the effects on Phillips curves.
Refer to Figure 20.10 on page 481. Let us assume that the effect of the increase in aggregate demand is eventually to raise inflation from 2 to 4%.
In the adaptive expectations model, there will initially be a move from point a to b. Then as price expectations increase towards 4%, so the short-run Phillips curve will shift upwards towards curve : the economy will move towards point c. The short-run curve is downward sloping; the long-run curve is vertical (through points a and c).
In the rational expectations model, although curve still represents the relationship between inflation and unemployment if expectations are of 2% inflation, the moment the economy moves away from point a expectations will adjust. Assuming that expectations are correct, the economy will move immediately to point c. Thus in the rational expectations model, not only the long-run but also the short-run curve is vertical through point a.
487 Ø Should the government therefore simply give up as far as curing unemployment is concerned?
Unless the government believes that it can go on fooling people, it might as well give up using demand-side policies to try to reduce unemployment below the natural level. This does not mean, however, that there is no way to reduce unemployment. It can use supply-side policies to reduce the natural level of unemployment and shift the vertical Phillips curve to the left.
488 Ø If the government announced that it would, come what may, reduce the growth of money supply to zero next year, what (according to new classical economists) would happen? How might their answer be criticised?
Provided people believed that the government actually would reduce the growth in money supply to zero, and that as a result of this and also of increased output, the level of prices would fall, then people would expect a negative inflation. The result would be that prices would fall, provided they were not `sticky downwards'.
Even if people did believe that the government would reduce money supply growth to zero, (money) wages and prices may be sticky downwards, and as a result prices may not fall.
489 Ø Assume that there are two shocks. The first causes aggregate supply to shift to the left. The second, occurring several months later, has the opposite effect on aggregate supply. Show that if both these effects persist over a period of time, but gradually fade away, the economy will experience a recession which will bottom out and be followed in smooth succession by a recovery.
A fall (leftward shift) in aggregate supply in the new classical model will reduce output and hence cause a recession. If the shock pushing the AS curve to the left persists for a period of time, then the recession will deepen as aggregate supply falls, but less and less quickly as the effect fades away. If the second shock has a rightward pushing effect on the AS curve, then, as the first effect fades away, the second effect will become relatively stronger. Output will begin to rise again and gather pace as the first effect disappears. Whether output will continue falling initially after the appearance of the second effect depends on the relative size of the two effects at that particular stage.
490 Ø 1. What effect will these developments have had on (a) the Phillips curve; (b) the aggregate supply curve?
(a) It will have shifted to the right.
(b) It will have shifted to the right less quickly than if labour had been more mobile.
490 Ø 2. What policy implications follow from these arguments?
Interventionist supply-side policies are required, such as regional policy or industrial policy (e.g. government encouragement of training or research and development).
491 Ø Would it in theory be possible for this long-run Phillips curve to be horizontal or even upward sloping over part of its length?
Yes, if the effects described in the two bullet points on page 656 are strong enough to completely offset the upward pressure on costs from the increased aggregate demand.
493 Ø Why is it important in the Keynesian analysis for there to be a steady expansion of demand?
To create a climate of confidence and certainty so as to encourage investment.
494 Ø 1. If constant criticism of governments in the media makes people highly cynical about any government's ability to manage the economy, what effect will this have on the performance of the economy?
It will become less manageable! It may become less stable and as a result investment and growth may be lower and inflation higher. The worse people believe the long-term economic prospects are for the country, the more pessimistic they are likely to become, and thus the worse is likely to be the actual performance of d~e economy.
494 Ø 2. Suppose that, as part of the national curriculum, everyone in the country had to study economics up to the age of sixteen. Suppose also that the reporting of economic news by the media became more thorough (and interesting!). What effects would these developments have on the government's ability to manage the economy? How would your answer differ if you were a Keynesian from if you were a new classicist?
People's predictions would become more accurate (at least that’s what teachers of economics would probably hope!). Thus the government would be less able to fool people. In the new classical world there would be less shifting of the short-run vertical Phillips curve. The government would find it even more useless to try to reduce unemployment by demand-side policy. On the other hand a tight monetary policy would be more likely to reduce inflation very rapidly.
In the Keynesian world, correctly executed demand management policy would be seen to be so. This would create a climate of confidence which would help to encourage stable growth and investment. On the other hand, poorly executed government policy would again be seen to be so. This could cause a crisis of confidence, a fall in investment and a rise in unemployment and/or inflation.
3