Stabilization Policy and the Phillips Curve: Practice Problems and Solutions

Problem 51: Which of these policy lags contribute to the reduced effectiveness of fiscal and monetary policy? More than one correct answer is possible.

(a) Division lags: The government needs to divide the economy into different sectors and interest groups and give each of them a custom-tailored solution to their problems. This takes time and resources.
(b) Supervision lags: There is not enough timely oversight of all branches that implement fiscal and monetary policy, and so there are insufficient guarantees that agreed-upon policy measures will actually be carried out.
(c) Decision lags: Governmental decisions take time to make – especially with regard to fiscal policy.
(d) Inflation lags: It takes time for an increase in the money supply to be reflected in prices.
(e) Information lags: It takes time for past economic data to be compiled and verified.
(f) Litigation lags: Any government agency wishing to implement fiscal or monetary policy changes is likely to get sued by the affected parties. This leads to prolonged legal battles before the policy gets implemented.
(g) Implementation lags: Even after a policy decision has been made, it takes time for it to be actualized and for its effects to be manifest.

Solution 51: The following are the three policy lags that explain why fiscal and monetary policy are “long and variable”:

(e): Information lags: It takes time for past economic data to be compiled and verified.
(c): Decision lags: Governmental decisions take time to make – especially with regard to fiscal policy.
(g): Implementation lags: Even after a policy decision has been made, it takes time for it to be actualized and for its effects to be manifest.

Problem 52. Which of these phenomena may reduce the effectiveness of fiscal and monetary policy? More than one correct answer is possible.

(a) If a tax cut is thought to be temporary, people will tend to save it rather than spending it, seeing it as transitory rather than permanent income.
(b) Government spending and investment tend to raise interest rates and thus crowd out private investment, thus exacerbating any already existing economic problems.
(c) If monetary policy is perceived to be unreliable and non-credible, individuals will tend to ignore central bank promises to reduce inflation or stabilize the economy.
(d) The principle of Ricardian equivalence states that, when governments engage in deficit spending, households will tend to save enough money to pay for anticipated future tax increases. Thus, instead of spending money, individuals will tend to save more of it.
(e) Economic stabilization is not the same as growth. By trying to reduce the variations in output, fiscal and monetary policymakers might also slow down the overall economic growth rate and thus render virtually everyone worse off in the long run.

Solution 52. All of the above are valid possibilities for phenomena that reduce the effectiveness of fiscal and monetary policy.

Problem 53. Which of these statements about time inconsistency are true?

(a) Time inconsistency is minimized when individual actors are in some manner bound to follow through with a decision before they actually face making that decision.
(b) Time inconsistency is minimized when individual actors have the maximum possible discretion to choose the best response to situations as they arise.
(c) According to time inconsistency, whatever policy is optimal in one period is optimal in all periods.
(d) According to time inconsistency, a policy that is optimal in the first period may no longer be optimal in the next period.
(e) An alcoholic man drives by a liquor store on his way from work every day. If he decides to simply use his force of will to restrain his desire to enter the liquor store every time he drives by it, then he has solved his time inconsistency problem.
(f) An alcoholic man drives by a liquor store on his way from work every day. If he decides to pick a different route home from work – along which there are no liquor stores – then he has solved his time inconsistency problem.

Solution 53. The following statements about time inconsistency are true:
(a): Time inconsistency is minimized when individual actors are in some manner bound to follow through with a decision before they actually face making that decision.
(d): According to time inconsistency, a policy that is optimal in the first period may no longer be optimal in the next period.
(f): An alcoholic man drives by a liquor store on his way from work every day. If he decides to pick a different route home from work – along which there are no liquor stores – then he has solved his time inconsistency problem.

Problem 54. Which of these is true according to the Phillips Curve model?

(a) There exists a direct correlation between inflation and unemployment.
(b) There exists an inverse correlation between inflation and unemployment.
(c) There exists a direct correlation between inflation and trade deficits.
(d) There exists an inverse correlation between inflation and trade deficits.
(e) There exists a direct correlation between output and unemployment.
(f) There exists an inverse correlation between output and unemployment.

Solution 54: The Phillips Curve model states that

(b): There exists an inverse correlation between inflation and unemployment.

Problem 55. What is the equation for the Phillips Curve? Here, U = actual rate of unemployment, U* = natural rate of unemployment, gw = wage growth, and �µ = speed of wage adjustment to the employment gap.

(a) gw = �µUU*
(b) gw = Ã?µ(U – U*)
(c) gw = -Ã?µ(U – U*)
(d) gw = �µ(U + U*)
(e) gw = -�µ(U + U*)
(f) gw = Ã?µ/(U – U*)

Solution 55. The equation for the Phillips Curve is

(c): gw = -Ã?µ(U – U*)

Problem 56. What is the equation for the Expectations Augmented Phillips Curve? Here, U = actual rate of unemployment, U* = natural rate of unemployment, Ï� = actual inflation, Ï�_e = expected inflation, and �µ = speed of wage adjustment to the employment gap.

(a) Ï� = Ï�_e + �µ(U + U*)
(b) ÏÂ? = ÏÂ?_e – Ã?µ(U + U*)
(c) ÏÂ? = ÏÂ?_e – Ã?µ(U* – U)
(d) ÏÂ? = ÏÂ?_e – Ã?µ(U – U*)
(e) ÏÂ?_e = ÏÂ? – Ã?µ(U – U*)
(f) ÏÂ?_e = ÏÂ? – Ã?µ(U* – U)

Solution 56. The equation for the Expectations Augmented Phillips Curve is

(d): ÏÂ? = ÏÂ?_e – Ã?µ(U – U*)

Problem 57. In Inflationville, expected annual inflation is 53%. The actual rate of unemployment is 1%, and the natural rate of unemployment is 10%. The speed of wage adjustment to the employment gap is 0.42. Use the equation for the Expectations Augmented Phillips Curve to find the actual annual inflation in Inflationville.

Solution 57. We use the equation ÏÂ? = ÏÂ?_e – Ã?µ(U – U*), where ÏÂ?_e = 0.53, Ã?µ = 0.42, U = 0.01, U* = 0.1. So ÏÂ? = 0.53 – 0.42(0.01 – 0.1) = ÏÂ? = 0.5678 = 56.78%

Problem 58. Which of these statements about NAIRU are true? More than one correct answer is possible.

(a) NAIRU stands for National Average Intertemporal Rate of Unemployment.
(b) NAIRU stands for Non-Accelerating Inflation Rate of Unemployment.
(c) NAIRU stands for Naturally Anti-Inflationary Rate of Unemployment.
(d) Milton Friedman coined the term NAIRU.
(e) A. C. Phillips coined the term NAIRU.
(f) A. C. Pigou coined the term NAIRU.
(g) Robert Lucas coined the term NAIRU.
(h) NAIRU is the natural rate of unemployment, analyzed within the framework of the Phillips Curve.
(i) NAIRU is the actual rate of unemployment, analyzed within the framework of the Phillips Curve.
(j) NAIRU is the difference between the natural and actual rates of unemployment, analyzed within the framework of the Phillips Curve.
(k) Using expansionary monetary policy, it is possible to achieve a sustainable rate of unemployment below NAIRU.
(l) Using expansionary monetary policy, it is possible to only temporarily achieve a rate of unemployment below NAIRU, while only producing inflation in the long run.

Solution 58. The following statements about NAIRU are true:

(b): NAIRU stands for Non-Accelerating Inflation Rate of Unemployment.
(d): Milton Friedman coined the term NAIRU.
(h): NAIRU is the natural rate of unemployment, analyzed within the framework of the Phillips Curve.
(l): Using expansionary monetary policy, it is possible to only temporarily achieve a rate of unemployment below NAIRU, while only producing inflation in the long run.

Problem 59. Which of these ideas did Milton Friedman contribute to economists’ views of the Phillips Curve? More than one correct answer is possible.

(a) People suffer from persistent money illusion and can be duped into expecting inflation rates that deviate from actual inflation. Thus, Phillips curves will never shift out in response to changes in the money supply.
(b) In the long run, policies that assume the existence of a stable tradeoff between inflation and unemployment have no effect on unemployment while systematically increasing inflation.
(c) The long-run Phillips curve is concave up and decreasing.
(d) The long-run Phillips curve is concave up and increasing.
(e) The long-run Phillips curve is vertical.
(f) The long-run Phillips curve is horizontal.
(g) The long-run Phillips curve is concave down and decreasing.

Solution 59. Milton Friedman contributed the following ideas:

(b): In the long run, policies that assume the existence of a stable tradeoff between inflation and unemployment have no effect on unemployment while systematically increasing inflation.
(e): The long-run Phillips curve is vertical.

Problem 60. Which of these statements about the liquidity trap are true?

(a) The liquidity trap occurs when the LM curve is horizontal.
(b) The liquidity trap occurs when the LM curve is vertical.
(c) In a liquidity trap, people are highly sensitive to changes in interest rates.
(d) In a liquidity trap, people are not at all sensitive to changes in interest rates.
(e) Effective monetary policy to get out of a liquidity trap includes the systematic slashing of interest rates and the lowering of reserve requirements.
(f) In a liquidity trap, monetary policy is completely ineffective.
(g) In a liquidity trap, fiscal policy is completely ineffective.

Solution 60. The following statements about the liquidity trapare true:

(a): The liquidity trap occurs when the LM curve is horizontal.
(d): In a liquidity trap, people are not at all sensitive to changes in interest rates.
(f): In a liquidity trap, monetary policy is completely ineffective.

See Mr. Stolyarov’s complete index of Intermediate Macroeconomics Problems and Solutions here.