Questions for Review
1. The two theories are the Sticky-Price Model and the imperfect information model. The fist, sticky-price model, explains the market imperfection as prices in the goods market do not adjust immediately to changes in demand conditions. Or in other words the goods market does not clear right away. If the demand for goods falls some firms respond by reducing output not changing prices. The second model, the imperfect information model, assumes that there is imperfect information about the prices. Some suppliers confuse changes in the price level with changes in relative prices. If a producer notices the nominal price of the firm’s goods rising then the producer assumes some of the rise is due to an increase in relative price, even if it is only a general price increase. This then leads them to increase production. In both models what is really happening differs from what is thought to be happening.
2. The Phillips curve is a demonstration of the short-run aggregate curve, as policymakers move the economy on the short-run aggregate supply curve, unemployment and inflation move in the opposite way. The Phillips curve helps express aggregate supply because inflation and unemployment are two important measures of economic performance.
4. The difference between demand-pull inflation and cost-push inflation are the causes. Demand-pull inflation is directed by changes in the unemployment rate while cost-push inflation is influenced by adverse supply shocks. Low unemployment rates cause an upward pull in inflation rates because there is an increased money supply and the demand then raises the inflation rate. If the unemployment rate is high there a reduced money supply as well as less demand which then lowers inflation. The cost-push inflation causes rises through supply shocks. An example would be a huge change in oil prices, the inflation rate follows that of the oil prices, if they rise so will inflation, if they fall, once again so will inflation.
Problems and Applications
1. a. the price level in this model is given by: P=Pe + ((1-s)a/s)(Y-Y), from this the aggregate supply curve is: Y=Y + (s/(1-s)a)(P-Pe). If no firms have flexible prices then s=1 and P=Pe. The price level is fixed at the expected price level and the aggregate supply curve will be horizontal.
b. Here a would = 0 in the equation for the price level. This means that the aggregate supply curve is horizontal again.
3. The cost of reducing inflation comes from the cost of changing the expectations about inflation. If this can be changed without cost then the cost of reducing inflation also comes at no cost. The Phillips curve tells us that π = πe −β(u−un) +ν. According to the rational-expectations approach, expectations are formed based on the information that is available to them, included in this is the information about policies in effect. If everyone believes that policy makers are committed to reducing inflation then expected inflation would fall right away. In the Phillips curve formula the πe would fall immediately with virtually no cost to the economy, meaning the sacrifice ratio will be small. However, if people do not believe that the policymakers are committed to reducing inflation the πe stays high and expectation will not adjust. Based on the rational-expectations approach the cost of reducing inflation depends on how credible the government is.
7. a. The normal labor supply would increase causing the natural rate of output to increase as well. As supply increases so does the output.
b. The tax cut would shift the curves to the right. This would result in an increase in Y and P or output.
9. The difference between headline and core inflation is who the inflation is affecting. Headline inflation affects the average person and core inflation affects the economists and the central bank. Core inflation foes not take food and energy into account. Headline inflation will have more drastic shifts in the aggregate