Question 1. Explain the two theories of aggregate supply. On what market imperfection does each theory rely? What do the theories have in common?
Sticky-price theory: price for the goods on the market do not change immediately to different occasions that might influence this changes. The goods on the market can’t be out bought instantly. Some firms respond to this by reducing the number of products, instead of price reduction. They do that, because they want to evade profit loss.
Imperfect information theory: this theory purpose is to model the relationship between changes in the money supply, prices and release. The prices for the goods occur due to changes in price levels on different departments because of increase or decrease in demand or by random processes that cannot be predicted.
Both theories bring a profit loss, due to the wrong information given about the product. In the first theory, the prices for one unit of product must be higher, then they are. It means it’s not worth its price. Imperfect information theory gives the higher price for the product, then it should be. It’s meant that product price is too high for the services it can provide. Imperfect information theory often leads to failure of the company, while sticky-price theory can avoid the failure.
Q2. How is the Phillips curve related to aggregate supply curve.
Aggregate supply curve provides the relationship between production and prices which can be changed due to the product production and inflation. Philips curve equation and the short run aggregate supply have the same macroeconomic ideas. Both equations show short term relationship between real and nominal changes that cause the classical dichotomy. Okun’s law represents the output and unemployment, while Phillips show the relationship between inflation and unemployment.
Question 4. Explain the differences between demand-pull inflation and cost-push inflation?
Demand-pull inflation - a kind of inflation that occurs when excessive in relation to the proposal of the demand. This type of inflation is manifested in the economic situation, when the total income of the population and businesses are growing faster than the real growth occurs volume of goods and services.
Cost-push inflation - a type of inflation, reflected in rising prices for resources, factors of production, thereby increasing the cost of production and circulation, as well as prices for manufactured products. The reasons for the growth of prices for resources are usually changes in world prices for resources and the depreciation of the domestic currency.
Problem and application:
Q1. In the sticky-price model, describe the aggregate supply curve in the following special cases. How do these cases compare to the short-run aggregate supply curve we discussed in chapter 9.
- There is no firms that have flexible prices, they do always change. (s = 1).
Sticky-price model gives detailed information about two different types of firms. A proportion of firms (s) have sticky prices, and a proportion (1-s) of the firms has flexible prices. Following equation describes the overall price level:
P = sEP + (1 – s)a(Y-Y
Overall price level depends on two states:
1) Expected Price level
2) Level of output
s=1 and (1-s) equal to zero bring (1 – s)a(Y-Y equal zero, which left P = EP. This circumstances apply when firms don’t have flexible prices. The aggregate supply curve are going to be horizontal.
(b) The desired price does not depend on aggregate output, a = 0.
If all firms have flexible prices, then: P = EP + (1 – s)a(Y-Y. P = EP + ∞ and Y = Y. Aggregate supply curve will be vertical.
Problem 3. According to the rational-expectations approach, if everyone believes that policy makers are committed to reducing inflation, the cost of reducing inflation -the sacrifice ratio -will be lower than if the public is skeptical about the policy makers’ intentions.
Why might this be true? How might credibility be achieved?
If the government can reduce the expected inflation to the desired level, then there is no need for unemployment to raise up, leaving people at home. People use different sources on the internet and form personal statement or expectations about the inflation. The inflation will disappear, as soon, as people will start believing that government is doing their best to prevent it’s grow or stop it for some time. Inflation reduction depends on the government. Inflation might grow up or stay at current level, if those individuals believes will stay the same.
Q7. Some economists believe that taxes have an important effect on labor supply. They argue that higher taxes cause people to want to work less and that lower taxes cause them to want to work more. Consider how this effect alters the macroeconomic analysis of tax changes.
- If this view is correct, how does a tax cut affect the natural rate of outputs?
- How does a tax cut affect the aggregate demand curve? The long-run aggregate supply curve? The short run aggregate supply?
- What is the short run impact of a tax cut on output and the price level? How does your answer differ from the case without the labor supply effect?
- What is the long run impact of a tax cut on output and the price level? How does your answer differ from the case without the labor supply effect?
- The natural rate of output is determined by the production function of capital and labor Y = F (K, L). If a tax cut raises work efforts and employment this will increases L and, thus, increases the natural rate of output.
- Tax cut will increase people’s disposable income, and increase consumption this will cause AD to shift outward to the right. Also it shifts the long-run aggregate supply curve outward because the natural rate of output rises.
SRAS curve depends on the model we use. Employees are willing to supply more labor at any given real wage while the labor demand curve is unchanged. In sticky wages or sticky prices models the amount of labor is demand determined, so SRAS curve does not move. Labor market is always in the same position: SRAS shifts.
c) AD rises causing output and prices both to rise, while AS keeps on the same level. Short-run aggregate supply shifts outward, so that the tax cut is less inflationary than the conventional model. a is the initial equilibrium, point SW is the new equilibrium, and point II is the new equilibrium in the imperfect-information model.
- Tax cut raises long-run output by increasing the supply of labor. The policy’s long-run effect on price is depends on part on whether SRAS, shifts. The change is long-term equilibrium is shown.
Questions for review:
Q1. What are the inside lag and the outside lag? Which has the longer inside lag-monetary or fiscal policy? Which has the longer outside lag? Why?
Inside lag: is a time government takes any actions to stop the shock in the economy. There are three stages of inside lag: recognition, decision and implementation. On the recognition stage all facts that are available give information about economic problem. Second stage is part where all options are summarized and policy created. The implementation stage, is where this changes take effect.
Outside lag: is a time government takes to form inside-monetary lag or fiscal policy. On this stage, there is always a question regarding implementation, because it’s not always needed. Outside lag speed is based on multiple processes speed such as fiscal policy or monetary policy.
Fiscal policy has a long inside lag, since one of the main methods of state intervention in the economy in order to reduce fluctuations of business cycles and provide a stable economic system in the short term
Monetary policy it is the policy of the state, affects the amount of money in circulation in order to ensure price stability, full employment, and the growth of real output. Usually monetary policy has a long outside lag.
Q2. Why would more accurate economic forecasting make it easier for policy makers to stabilize the economy? Describe two ways economists try to forecast developments in the economy.
One way economists try to forecast development in the economy is with the index of leading indicators. According to the above classification it is a correspondence of individual interviews. The advantages include the lowest labor intensity, to the shortcomings - less accuracy, as each expert performs prediction is only based on his presentation about forecasting and ignores the diversity of the information available to other experts.
A second way forecasters look ahead is using models of the economy. These large scale computer models have many equations, each representing a part of the economy. Once we make assumptions about the path of the exogenous variables—taxes, government spending, the money supply, the price of oil, and so forth—the models yield predictions about the paths of unemployment, inflation, output, and other endogenous variables.
Question 5. What is meant by the “time inconsistency” of economic policy? Why might policymakers be tempted to renege on an announcement they made earlier? In this situation, what is the advantage of a policy rule?
Policymakers announce a new policy that influences the private decision maker expectations. Policymaker may fail on their announcement, because decisions didn’t expect their expectations. Policymakers try to make a fixed policy rule, because policy announcements can be distrusted by private decision maker individual.
Problems and applications:
Q2. When cities pass laws limiting the rent landlords can charge on apartments, the laws usually apply to existing buildings and exempt any buildings not yet built. Advocates of rent control argue that this expectation ensures that rent control does not discourage the construction of new housing. Evaluate this argument in light of the time-inconsistency problem.
Landlords expect to receive high rents from the new housing they provide. The city has an incentive to renege on its promise not to extend rent control. Many renters get more profit, while few landlords have troubles loosing cash. The builders expect the city reverse the promise. If it all happens, the city will not build new houses.