Economics Study Set 17

Business

Quiz 34 :

The Trade-Off Between Inflation and Unemployment

Quiz 34 :

The Trade-Off Between Inflation and Unemployment

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Explain why expectations of inflation affect the wages that result from labor-management bargaining.
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Effect of rise in expected inflation on wage rate
Increase in inflation rate reduces the real wage (nominal wage divided by inflation). A rise in price level reduces the purchasing power of the consumer; this means that the same amount of income will enable purchase of less amount of commodity.
The expectation of rise in rate of inflation will reduce the real income of the labor in future. Hence, to equalize the income to the rise in price level, labor will bargain for a higher wage rate.

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What is meant by "rational" expectations Why does the hypothesis of rational expectations have such stunning implications for economic policy Would believers in rational expectations want to shorten a recession by expanding aggregate demand Would they want to fight inflation by reducing aggregate demand Relate this analysis to your answer to Test Yourself Question 1. Reference Test Yourself Question 1. Show that if the economy's aggregate supply curve is vertical, fluctuations in the growth of aggregate demand produce only fluctuations in inflation with no effect on output.
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Meaning of rational expectation
Rational expectation is the use of all relevant available information to forecast the rate of inflation. Hence, predictor will not commit any systematic error.
No systematic error
Rational expectation has a stunning application in economic policy because it does not believe in committing any systematic error.
Recession cannot be shut out by expanding aggregate demand
Rational expectation believes that recession cannot be shut out by expanding aggregate demand. A predictable change in demand will change the expected rate of inflation; hence, output will remained unaffected.
Aggregate demand will not change the unexpected rate of inflation
Rational expectation believes that an anticipated change in aggregate demand will not change the unexpected change in rate of inflation. Hence, rational expectation theory do not want to fight inflation by reducing aggregate demand.

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It is often said that the Federal Reserve Board typically cares more about inflation and less about unemployment than the administration. If this is true, why might presidents often worry about what the Fed might do to interest rates
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It is said that the Federal Reserve Board cares more about inflation and less about unemployment than administration.
Reason for the president's worries about the interest rates
The change in rate of interest will change the level of investment as well as demand side of an economy. A faster economic growth can be achieved by regulating rate of interest.
Since interest rate is a key variable in determining economic growth, the president often worries to change the interest rates when the president wants.

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"There is no sense in trying to shorten recessions through fiscal and monetary policy because the effects of these policies on the unemployment rate are sure to be temporary." Comment on both the truth of this statement and its relevance for policy formulation.
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What is a Phillips curve Why did it seem to work so much better in the period from 1954 to 1969 than it did in the 1970s
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Show that if the economy's aggregate supply curve is vertical, fluctuations in the growth of aggregate demand produce only fluctuations in inflation with no effect on output.
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The year 2007 closed with the unemployment rate around 5 percent, real GDP barely growing, inflation above 2 percent and apparently rising a bit, and the federal budget showing a large deficit. a. Give one or more arguments for engaging in expansionary monetary or fiscal policies under these circumstances. b. Give one or more arguments for engaging in contractionary monetary or fiscal policies under these circumstances. c. Which arguments do you find more persuasive
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Long-term government bonds now pay approximately 4 percent nominal interest. Would you prefer to trade yours in for an indexed bond that paid a 3 percent real rate of interest What if the real interest rate offered were 2 percent What if it were 1 percent What do your answers to these questions reveal about your personal attitudes toward inflation
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When inflation and unemployment fell together in the 1990s, some observers claimed that policy makers no longer faced a trade-off between inflation and unemployment. Were they correct
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Why is it said that decisions on fiscal and monetary policy are, at least in part, political decisions that cannot be made on "objective" economic criteria
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