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.