Deck 16: Inflation and the Phillips Curve

Question 1

How do the quantity theorists and the institutional theorists differ in their views about the relationship between inflation and growth and its implications for policy?

Answer 1

Quantity theorist prefer to err on the side of keeping output well below estimated potential output to avoid even small rises in the price level.To them,having a little bit of inflation is like being a little bit pregnant.The little bit of inflation will set in motion a process that will make inflation grow and grow.They believe that inflation undermines long-term growth.It does so by making it more difficult for businesses to enter into long-term contracts.It also forces people to spend their time trying to avoid the costs of inflation.For them,a government policy that creates stable prices is most likely to promote long-term growth.The institutional theorists are not convinced of the inverse relationship between inflation and growth suggested by the quantity theorists.They agree that price-level rises have the potential of generating inflation,and that high accelerating inflation undermines growth,but they do not agree that all price level increases start a high and accelerating inflation.They feel that if the government is careful,it can prevent minor price level increases from growing into a major inflation.They argue that if institutional reforms are made in labor markets,the government can pursue expansionary policies without the fear of inflation.(LO6)Short Answer Questions

Question 2

How does the short-run Phillips curve differ from the long-run Phillips curve? At what level of unemployment will the two curves intersect?

Answer 2

The short-run Phillips curve is a downward-sloping curve showing the relationship between the rate of inflation and the rate of unemployment when expectations of inflation are constant.The long run Phillips curve is vertical.It shows the lack of a long-run tradeoff between inflation and unemployment when the expectations of inflation equal the actual rate of inflation.Whereas the expected rate of inflation is the same at every point along the short-run Phillips curve,they are different at every point along the long run Phillips curve.The short run Phillips curve will intersect the long-run Phillips curve at the unemployment level where the assumed rate of inflation is equal to the actual level of inflation.(LO5)

Question 3

Explain how the quantity theory of money differs from the equation of exchange.

Answer 3

The equation of exchange is a tautology: an equation true by definition.It says that the quantity of money times the velocity of money equals the price level times the quantity of real goods sold.The quantity theory of money comes about by taking the equation of exchange and adding to it three assumptions.The three assumptions are 1)velocity is constant; 2)real output is independent of the money supply; and 3)causation goes from left to right.When the equation of exchange is combined with these three assumptions we get the quantity theory that says that any increase in the money supply will lead to a proportional increase in the price level.

Question 4

Explain how policymakers use changes in productivity and wages to predict inflation.

Question 5

What are the three assumptions underlying the quantity theory of money?

Question 6

Define deflation,and discuss two economic problems associated with it.

Question 7

What role does the nature of labor markets play in the institutionalist model of inflation? Why is it important that labor markets are characterized by "outsiders" and "insiders"?

Question 8

Who wins and who loses when there is unexpected inflation? Explain and offer an example.

Question 9

Briefly describe three different ways that people form expectations of inflation.

Question 10

On which side of the economy is the policy focus implied by the quantity theory of money?

Question 11

What is the basic lesson/insight about the nature of inflation that is drawn from the quantity theory of money?

Question 12

In the institutionalist view of the Phillips curve trade-off,it is possible for existing workers to push up wages,despite the existence of unemployment.Explain by referencing the insider/outsider model.

Question 13

During the 1990s the historical relationship between money and prices predicted by the quantity theory of money broke down in the U.S.Why?

Question 14

How is the quantity theory of money related to the equation of exchange? What are the implications of the quantity theory for dealing with inflation? Why do economists who believe in the quantity theory advocate monetary growth rules?

Question 15

Explain the insider/outsider model of inflation.

Question 16

Describe three different ways that people form expectations of inflation and give an example of each method.

Question 17

What is the institutionalist theory of inflation? According to that theory,how does the price-setting process contribute to inflation?

Question 18

Who wins and who loses when there is an unexpected inflation? Explain and give two examples - one dealing with wages and other dealing with interest rates.

Question 19

Unexpected inflation redistributes income from lenders to borrowers.Explain using an example.

Question 20

What is the equation of exchange? State the equation and define its terms

Question 21

Demonstrate graphically and explain verbally the short-run Phillips curve relationship.

Question 22

What is stagflation?

Question 23

In what countries is the relationship between money supply growth and inflation most evident? What reason can you provide for this?

Question 24

Consider the following Phillips curve diagram:
Suppose an expansionary monetary policy has moved the economy from point A to point B.Is point B a long-run equilibrium? If yes,explain why.If no,explain how the economy will get to new long-run equilibrium.

Question 25

Explain how the institutional theorists view the relationship between inflation and growth.

Question 26

Explain the role that labor markets play in the institutionalist theory of inflation.

Question 27

Economists who believe in the quantity theory favor monetary policy set by rules.Why?

Question 28

Consider the following Phillips curve diagram:
(a)The economy is currently at point A with unemployment of 6% and inflation of 4%.The President has informed you that she is about to undertake an expansionary fiscal policy designed to lower unemployment from its current rate of 6% to 4%.She asks you what will happen in the economy as a result of her policy.Base your answer on the Phillips curve in the above diagram.
(b)How would your answer to (a)above change if you were to take into account potential changes in inflation expectations and their impact on actual inflation?

Question 29

What is an inflation tax? Who pays it?

Question 30

Using the equation of exchange,describe the difference between the quantity theory and the institutionalist theory of inflation.

Question 31

Do economists who believe in the quantity theory of money favor an activist monetary policy? Why or why not?

Question 32

Draw a short run and long-run Phillips curve.Why is the shape of the short-run Phillips curve different from the shape of the long-run Phillips curve?

Question 33

Distinguish between demand-pull and cost-push inflation.

Question 34

Assume the money supply is $1000,the velocity of money is 12,and the price level is $4.Using the quantity theory of money:
(a)Determine the level of real output.
(b)Determine the level of nominal output.
(c)Assuming velocity remains constant,what will happen if the money supply rises by 10%?

Question 35

Define the short-run Phillips curve.

Question 36

Suppose the money supply is $100 billion and nominal GDP is $500 billion.What is the velocity of money?

Question 37

Explain how the institutional theory of inflation uses the price-setting process of firms to explain inflation.

Question 38

Why do some central banks issue large quantities of money if they know that doing so will cause inflation?

Question 39

Use a Phillips curve diagram to explain the difference between the macroeconomic policy positions of the quantity theorists and the institutionalists.

Question 40

Consider the following Phillips curve diagram:
For the case where the economy is at Point A,Point B,or Point C,explain:
(a)whether actual inflation is above or below expected inflation (What is each exactly?)
(b)the likely shift in the short-run Phillips curve
(c)the likely change in unemployment

Question 41

Using the AD/AS and the Phillips curve models,demonstrate graphically and explain in words the changes to output,unemployment and inflation caused by an expansionary fiscal policy.Show the short-run and long-run adjustments.Assume that the economy is initially in both short-run and long-run equilibrium,and that expected inflation is 2%.

Question 42

Explain how the quantity theorists view the relationship between inflation and growth.The quantity theorists believe there is an inverse relationship between inflation and growth.(This is illustrated in the diagram below.)They feel that inflation undermines long-run growth: higher inflation leads to lower growth.