Economics 102
L. Stone
Spring 2003
Quiz 11—LAST ONE!!
1. Assume
that the economy is at full employment, and that people assume that this year’s
inflation rate will be equal to last year’s. The money supply has been
increasing at a rate of 5% per year for as long as anyone can remember. The
unemployment rate is 4%, which is the natural rate of unemployment for this
economy.
a. Carefully explain the impact of a
decrease in the growth rate of the money supply to 2% on both inflation, interest
rates, and unemployment in the short run. (Draw graphs as necessary…) (10 points)
The rate of increase of the money
supply now is LESS than the rate of increase of money demand, and thus
interest rates will RISE in the short run. (Note: must either have a graph
showing both curves shifting, or must clearly state rate of increase or percentage change is less, not just
something like money supply is less than money demand). This decreases the
quantity of investment, and causes a short-run decrease in output, and thus an
increase in unemployment. Inflation may begin to fall (it is equally correct to
say that prices are constant in the short run). Note that if AS-AD are shown, both curves should shift, but BOTH
are decreasing (that is, AS shifts left, as does AD).
b. What is the long run effect of this change
in the rate of money supply growth on inflation, and unemployment? Briefly
explain WHY, and state what the numerical value of each will be in the new
long-run equilibrium. (5 points)
Eventually, expectations adjust to a lower
rate of inflation; interest rates fall again, and the economy returns to full
employment. Inflation = 2%, and
unemployment = 4%.
2.
What is credibility, and why does credibility make reducing inflation
easier? (10 points)
Credibility is the belief that the Fed (or
whoever) will do what they say that they will do… follow through with a policy,
etc. (4 points)
Fighting inflation requires policies that
are recessionary. The severity and
length of the recession depends on how fast expectations adjust. The speed of adjustment of expectations
depends partly on credibility. If the
Fed is more credible, expectations will adjust rapidly, and the recession will
be short.