Unit VI Inflation, Unemployment and Stabilization Policies (20-25% of AP Macro Exam)

Unit VI – Inflation, Unemployment and Stabilization Policies (20-25% of AP Macro exam)

Objectives:

·  NCEE Content Standard 18 – A nation’s overall levels of income, employment, and prices are determined by the interaction of spending and production decision made by all households, firms, government agencies, and others in the economy.

·  NCEE Content Standard 19 – Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future prices.

·  NCEE Content Standard 20 – Federal government budgetary (fiscal) policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices.

Vocabulary: (Big topics in bold)

Aggregate Demand Aggregate Supply Fiscal Policy Monetary Policy Expansionary Policy Contractionary Policy Automatic Stabilizers Discretionary Spending Inflationary Gap Recessionary Gap Multiplier Effect Crowding Out Effect

Supply Side Laffer Curve Monetarism

Velocity of Money Quantity theory of money Phillips Curve

Natural Rate Hypothesis Supply Shock Stagflation Sacrifice Ratio Rational Expectations Okuns Law NAIRU

Numbers and Formulas:

Money Multiplier

Spending Multiplier

Tax Multiplier

Quantity Equation

Visuals:

Aggregate Model

Money Market Model

Loanable Funds Model

Short run and Long Phillips Curves

AP Macroeconomics Activity Book (answers to Unit 5 M/C sample questions for Unit 6)

1. D 6. D 11. B 16. D

2. B 7. B 12. B 17. B

3. C 8. B 13. C 18. D

4. E 9. C 14. A 19. C

5. A 10. B 15. D 20. B

Unit 4: 20. B

Unit VI Calendar:

Monday / Tuesday / Wednesday / Thursday / Friday
January 8 / 9 / 10 / 11
Fiscal Policy
Hwk: Read Modules 20-21 and Unit 6 Review Problems due Thurs., 1/18 (optional) / 12
Fiscal Policy
Hwk: AP Macro Activities 5-1, 5-2, 5-3
15
No School / 16
Fiscal Policy
Hwk: Read Modules 35-36 and AP Macro Activities 5-4 to 5-7 / 17
Macroeconomic Analysis
Hwk: Read Module 34, Activity 4-8, and Economic Notebooks due Tomorrow in class / 18
Phillips Curve
Hwk: AP Macro Activities 5-8, 5-9 / 19
Expectations and Policy
Hwk: Read Module 45
22
Exams / 23
AP Midterm 1-3 / 24
Exams / 25
Exams / 26

AP Macroeconomics Resource Manual (answers to Unit 6 activities)

Activity 5-1

1.  Expansionary; The decrease in personal income taxes increase disposable income and thus increases consumption spending. The business tax cut increases investment spending, and the increase in government spending increases government demand.

2.  Contractionary; Business income and personal disposable income decrease because of the tax increases, thus reducing consumption and investment spending. Government demand is unchanged.

3.  Expansionary; Higher government spending without a corresponding rise in tax receipts increases aggregate demand in the economy.

4.  Contractionary; Reduction in government spending results in a decrease in AD. Increases in taxes on consumers reduce disposable income and consumption, and increased business taxes will reduce investment. The decrease in both consumption and investment will reduce aggregate demand.

5. 

a.  Increase, Decrease, Increase, Toward Deficit, Increase

b.  Decrease, Increase, Decrease, Toward Surplus, Decrease

c.  Increase, Decrease, Increase, Toward Deficit, Increase

d.  Decrease, Increase, Decrease, Toward Surplus, Decrease

e.  Demand Side Economics is not effective in response to Stagflation.

Activity 5-2

1.  D and E 2. D and C 3. A and C 4. A and E 5. D and C 6. D and E 7. D and C 8. A and C 9. D and C 10. D and E

Activity 5-3

1.  Decrease and Decrease 2. Increase and Increase 3. Increase and Increase 4. Increase and Increase 5. Decrease and Decrease

Activity 5-4

1.  a. Increase b. Increase c. Increase d. Increase e. Decrease f. Increase g. Increase h. Increase

2.  It will decrease them.

3.  Increase SRAS curve

4.  Decrease SRAS curve

5.  Unemployment increases

6.  Product prices and wages will decrease

7.  They increase production

8.  SRAS increases

Activity 5-5

1. 

a.  Increase; Both policies are expansionary – C, G and I will all increase.

b.  Increase; The increase in aggregate demand will increase the price level.

c.  Decrease; The increase in aggregate demand will increase employment and output.

d.  Question mark; Fiscal policy would result in an increase in interest rates; monetary policy would result in lower interest rates. The net effect depends on the relative strength of the two policies. The graph here shows a slight increase in interest rates; the effect on interest rates is indeterminate.

e.  Questions mark; Because we cannot tell what happens to interest rates, we cannot say what happens to investment because of changes in the interest rate.

2. 

a.  Decrease; Decrease aggregate demand should lower GDP somewhat. AD decreases because of contractionary monetary and fiscal policy.

b.  Decrease; The decrease in aggregate demand should result in a lower price level.

c.  Increase; Lower output decreases employment on the SRAS curve.

d.  Question mark; The Fed decreases the money supply, which should result in an increase in interest rates. The increase in taxes and decrease in government spending result in a decrease in interest rates since the demand for loanable funds by the government should decrease. The demand for money decreases because of the decrease in real GDP. Interest rates will be higher if the decrease in demand is less than the decrease in supply in the money market. The interest rate effect is indeterminate.

e.  Question mark; If interest rates are higher, there would be a decrease in the level of investment. If interest rates are lower, there would be an increase.

3. 

a.  Question mark; The combined effect on aggregate demand is impossible to predict. The fiscal policy is expansionary, and the monetary policy is contractionary.

b.  Question mark; The impact on the price level is impossible to predict given the contradicting monetary and fiscal policies.

c.  Question mark; The impact on output and, hence, employment is impossible to predict given the contradicting monetary and fiscal policies.

d.  Increase; Interest rate will rise because of the increased demand for and reduced supply of loanable funds.

e.  Decrease; The increase in interest rates will tend to decrease investment.

Activity 5-6

1. 

a.  Increase, Decrease, Deficit, Increase, Increase, NC, Increase

b.  Decrease, Increase, Surplus, Increase, Decrease, Increase, Decrease

2.  Decrease Money Supply

3.  A decrease in the nominal interest rate results in a decrease in the real interest rate because the real interest rate equals the nominal interest rate minus inflation rate.

4.  When the central bank monetizes the debt it allows the government to borrow and spend freely. Monetizing the debt increases the money supply.

Activity 5-7

1.  AD shifts to the right, increasing Y and PL. Dlf shifts to the right, increasing r and Qlf.

2.  The increase in the price level will eventually cause a decrease in SRAS. In the long run, sticky wages will have time to adjust and will increase input costs so that SRAS decreases.

Activity 4-8

1.  M = Money Supply, V = the velocity of money; the number of times an average dollar bill is spent, P = the average price level, Q = real value of all final goods and services (real GDP)

2.  Nominal GDP

3.  Nominal GDP (PQ) would increase. If the economy is not at full employment, both P and Q could increase. If the economy is operating at full employment, only P would increase. This action could lead to extreme inflation if the economy is at full employment.

4.  Velocity would increase. A given stock of money could “work harder” and finance more transaction more quickly.

Activity 5-8

1.  Show decrease of AD

2.  PL decreases, Real GDP decreases, Unemployment Rate Increases, Real Wages Increases

3.  Inflation on vertical axis, Unemployment on horizontal axis, SRPC is downward sloping.

4.  Show decrease of SRAS

5.  PL Increases, Real GDP decreases, Unemployment Rate increases, Real Wages Decreases

6.  Short Run Phillips Curve increases from 1960s to 1970s.

Activity 5-9

1.  SRPC increases

2.  It increases expectations as AD shifts right

3.  People are confident in the Federal Reserve’s ability to control inflation so they do not expect inflation.

4.  If people expect inflation, they build the inflationary expectations into their decisions and actual inflation rises in the future.

5.  LRPC is a vertical curve

6.  In the long run there is no trade off between inflation and unemployment. People’s wages eventually adjust to the gap between inflationary expectations and the actual rate of inflation.

7.  LRAS shifts to the right if the natural rate of unemployment decreases.

8.  Inflationary expectations increase.

9.  The natural rate of unemployment

10.  Greater than, Right

What you should know at the end of this unit:

·  Fiscal Policy (An increase in government purchases or a cut in taxes shifts the aggregate demand curve to the right and vice versa.)

·  When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. The crowding out effect tends to dampen the effects of fiscal policy on AD.

·  Economists disagree about how active the government should be, but sometimes government uses policy to stabilize the economy. According to advocates of active stabilization policy, changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and unnecessary fluctuations occur in output and employment. According to critics, policy work with such long lags that attempts at stabilizing the economy often end up being destabilizing.

·  The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policy makers can choose a point on the Phillips curve with higher inflation and lower unemployment, vice versa.

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·  The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run. In the long run, expected inflation adjusts to changes in actual inflation, and the short run Phillips curve shifts. As a result, the long run Phillips curve is vertical at the natural rate of unemployment.

·  The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives policymakers a less favorable trade-off between inflation and unemployment. That is, after an adverse supply shock, policymakers have to accept a higher rate of inflation for any given rate of unemployment, or a higher rate of unemployment for any given rate of inflation.

·  When the Fed contracts growth in the money supply to reduce inflation, it moves the economy along the short-run Phillips curve, which results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall. Some economists argue that a credible commitment to low inflation can reduce the cost of disinflation by inducing a quick adjustment of expectations.