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CHAPTER 28 - INFLATION AND MONETARY POLICY PROBLEM SET 2. The tax hike is a negative spending shock, which would shift the AD curve to the left. If the Fed left the money supply unchanged, the economy would slide down the AS curve from point E to point F (see graph on the right). Both output and the price level would fall. If the Fed decides to use monetary policy to neutralize the spending shock, it would have to increase the money supply. This would lead to a lower interest rate (at point C, in the graph on the left), which would stimulate consumption and investment spending by enough to offset the initial spending shock. The economy would return to point E (in the graph on the right). 4. Possibly, the announcement of the new dovish Chair itself would be enough to change the behavior of workers and firms. Understanding that the new Chair would fight unemployment even at the cost of inflation, they would expect higher inflation in the future. People would build higher inflation into their contracts and the Phillips curve would shift upward. At each level of unemployment, there would be a higher inflation rate. If the announcement were not enough to change expectations, but the Chair did, in fact, turn out to be more concerned with unemployment than inflation, the aggregate demand curve would begin shifting rightward more rapidly. The economy would ride up the Phillips curve in the short run, and once a higher inflation rate were built in to contracts, the Phillips curve itself would shift upward. Chapter 28 Inflation and Monetary Policy 6. The Fed would have to increase the money supply more rapidly in each successive year. This year, for example, it could increase the money supply by enough to hit the unemployment rate-inflation rate combination of U2 and 9%. But, as the Phillips curve shifts rightward to PCbuilt-in inflation = 9%, the Fed would have to increase the money supply even more next year, in order to move the economy to point K. But this, in turn, would make the Phillips curve shift rightward again. The inflation rate would rise continuously. MORE CHALLENGING QUESTIONS 8. Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes that the natural rate of unemployment is higher and acts to bring the economy back to its supposed potential, it will decrease the money supply. This will cause the interest rate to rise from r1 to r2, causing the AD curve to shift leftward from AD1 to AD2. The economy will experience a lower price level and higher unemployment (at point F). With no more intervention, wage rates will eventually fall, causing the AS curve to shift rightward from AS1 to AS2, returning the economy to full employment (at point G). If the Fed, however, continues to decrease the money supply in an effort to maintain output below potential, the public will come to expect deflation in the future, and the economy will experience ongoing deflation.
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