CHAPTER 10: OUTPUT, INFLATION, AND

UNEMPLOYMENT: ALTERNATIVE VIEWS

ADDITIONAL QUESTIONS

Essay Questions and/or Problems:

1. According to the theory of the natural rate of unemployment, can the policymaker "peg" the
unemployment rate at some arbitrarily determined target rate? Why or why not? What is the
eventual result of attempting such an action?

According to the theory of the natural rate of unemployment, the policymaker cannot peg the
unemployment rate at some arbitrarily determined target rate. Any attempt to lower the
unemployment rate below the natural rate by raising the rate of growth in aggregate demand can only
be achieved in the short run but will lead to accelerating inflation in the long run. The unemployment
rate will slowly return to the natural rate and the lasting effect of an expansionary policy will be a
higher rate of inflation.

2. What is meant by the natural rate of unemployment? Is the natural rate of unemployment a constant
value? According to the monetarist view, does expansionary monetary policy lower the natural rate
of unemployment temporarily or permanently?

The natural rate of unemployment is that rate of unemployment that is consistent with the long-run
equilibrium level of employment. It changes with the productive capacity of the economy and is not
necessarily constant over time. According to the monetarists, monetary policy can influence the
actual level of unemployment, but it cannot influence the natural rate.

3. Assume that there is a positive supply shock, such as an increase in the productivity of labor. What
impact will this have on the short-run and long-run Phillips curve? What will be the observed
relationship between inflation and unemployment? Provide a graph of the Phillips curve and AD/AS
to illustrate.

An increase in productivity will shift the aggregate supply curve to the right as well as shift both the
short-run and long-run Phillips curve upward, resulting in higher inflation and lower unemployment.
This runs counter to the traditional Phillips curve relationship between inflation and unemployment.

4. Use the natural rate Phillips curve to analyze a change in regime at a central bank that is committed to
maintaining a lower level of inflation than previous regimes. What will be the short-run impact of
such a change in policy? The long-run impact?

This change in regime will lead to lower actual inflation and, moving along the Phillips curve in the short-
run, higher unemployment. However, once the public realizes that inflation will be lower in the future,
they will reduce their expected price level, resulting is a shift down in the short-run Phillips curve. As a
result, in the long-run there will be lower inflation and unemployment will be equal to the natural rate of
unemployment.
5. Does the Keynesian view of the short-run Phillips curve differ from the monetarist view?

Yes. According to Keynesians, the short-run Phillips curve is stable and does not change over time.
According to monetarists, the short-run Phillips curve is unstable because changes in the expected price
level change the tradeoff between inflation and unemployment in the short-run.

6. If Keynesians acknowledge that there does exist a vertical aggregate supply curve in the long-run,
then, does that invalidate their belief in the use of monetary and fiscal policy to stabilize output?
Explain.

In the Keynesian view, aggregate demand policies are aimed at stabilizing output and employment
in the short run that are caused by unstable movements in spending. Even if they are ineffective at
influencing output in the long-run, they believe the long-run is a very long time away.

7. What is meant by "hysteresis?" Is hysteresis consistent with Friedman's natural rate hypothesis?

There is an alternative explanation for the high unemployment in Europe that focuses on the idea
that the current value of the unemployment rate may be strongly influenced by its past values.
This is referred to as hysteresis. Hysteresis implies that sustained unemployment can affect the
natural rate of unemployment. As a result, it is possible for changes in the money supply that have
short run effects on unemployment to have long run effects on unemployment as well.

8. The divergent behavior of unemployment in the United States and Europe, especially in the 1990s,
been attributed to different structural characteristics of labor markets in the two regions. Describe the
labor market in the United States, making sure to discuss differences in the natural rate of
unemployment across the two regions.

Greater flexibility in the United States labor market, due to less regulation and lower unionization,
has meant that increased global competition and skill-biased technological change has resulted in
stagnant real wages in the United States, especially for low skilled workers, instead of slower job
growth and higher unemployment. Furthermore, in the post-1990s, any hysteresis effects have been
favorable in the United States as a low unemployment environment has been maintained for a long
period. All of these things have led to a lower natural rate of unemployment in the United States.

9. Milton Friedman argued that the Phillips curve is most accurately described by the following
equation:

e
Pt Pt
Ut – UNR = -( - )
Pt Pt

How does this differ from a traditional Keynesian Phillips curve? What does this imply about the ability
of the Fed to control unemployment using monetary policy? What will the effect of a Fed policy aimed at
permanently keeping unemployment below the natural rate?

In this equation, central banks only influence the difference between the level of actual
unemployment and the natural rate of unemployment, not the level of unemployment itself. They do
this by increasing inflation above the expected rate of inflation. However, a central bank attempts to
 permanently keep unemployment below the natural rate of unemployment and if the public realizes
this and raises their expected rate of inflation over time, then the actual rate of inflation will rise over
time.

10. Milton Friedman often referred to money as "neutral". What do you think that he meant by this? He
also termed the phrase "the natural rate of unemployment". What is natural about the natural rate of
unemployment?

Money is neutral because in the long run it does not affect any real variables, which are the variables
that really affect individual’s standards of living. Instead, they only affect nominal variables that are
measured in prices.

The natural rate of unemployment is natural because it is always occurring and will not change
without structural changes in the economy.

Additional Essay Questions and/or Problems:

11. Suppose that a central bank thinks that the natural rate of output is above where the “true” natural rate
of output actually is (i.e. Utarget < UNR). What will be the long run impact of such a policy? Use a
Phillips curve graph to illustrate. How does your answer depend upon what you assume to be true
about how the public forms their expectations?

12. Milton Friedman believes that there will be only a temporary trade-off between inflation and
unemployment. Explain why.

13. Suppose that there is a decline in autonomous investment. Would a monetarist favor an expansionary
monetary policy to offset the short-run effects of this shock? Explain why or why not.

14. Why is the assumption that the expected inflation rate is constant crucial to the concept of the Phillips
curve? Why is it crucial to its use in stabilization policy? Under what circumstances do you think
that constant expected inflation is a good assumption?

15. Suppose that there is a permanent increase in the level of government spending financed by a larger
budget deficit. What would Keynesians predict would happen to inflation and unemployment as a
result? What would Monetarists predict would happen to inflation and unemployment as a result?
Provide graphs of the Phillips curve to illustrate.

Multiple-Choice Questions:

1. According to s, when the expected rate of inflation rises, the short-run Phillips curve
a. shifts upward.*
b. shifts downward.
c. is unaffected.
d. None of the above

2. In the Keynesian model, and increase in government spending financed with an increase in taxes will
a. move an economy left along its Phillips curve.
b. shift the Phillips curve to the up.
c. move an economy right along its Phillips curve.*
 d. shift the Phillips curve down.
e. not affect the Phillips curve.

3. According to the Monetarists, average inflation is higher today than it was a hundred years ago
because of
a. the lack of fiscal responsibility.
b. the increased use of stabilization policy.*
c. high interest rates, which increase the cost of borrowing.
d. unstable investment demand.
e. unstable money demand.

4. In the long run, according to Monetarists

a. the natural rates of output and employment depend on factor supplies.
b. the natural rates of output and employment depend on technology.
c. the influence of the money stock is mainly on the price level and other nominal variables.
d. All of the above*

5. In the monetarist view, the long-run Phillips curve is

a. horizontal.
b. downward sloping.
c. downward sloping but steeper than the short-run curve.
d. downward sloping but flatter than the short-run curve.
e. none of the above.*

6. In the monetarist view, if there is an increase in money growth then

a. the money supply and inflation will grow proportionally, with no effect on output and employment.
b. the money supply grows faster than the inflation rate, with unfavorable effects on output and
employment.
c. the money supply grows faster than the inflation rate, leading to an increase in output and
employment in the short-run.
d. there will be no effect on output, employment, or inflation, in the long-run.
e. both c and d.

7. According to the monetarists,

a. stable growth in the money supply is needed for economic stability.*
b. aggregate demand is unstable, mostly because of unstable investment demand.
c. there is a need for fiscal policies to stabilize output.
d. stable money growth is not needed for the economy to be stable.

8. In the Keynesian view,

a. the short-run Phillips curve is unstable and money demand is stable.
b. the short-run Phillips curve is vertical but the long-run Phillips curve is downward sloping.
c. the short-run Phillips curve is unstable and money demand is stable.*
d. both the short-run and long-run Phillips curves are vertical.
e. none of the above.

9. For each Phillips curve, there

a. is no relationship between the short run aggregate supply curve.
b. is many short run aggregate supply curves.
 c. is a unique long run aggregate supply curve.
d. is a unique short run aggregate supply curve.*

10. In the monetarist view, if the money supply has been rising too quickly for years, the resulting
inflation can be brought under control by slowing money growth. This will
a. quickly reduce inflation with no side effects.
b. quickly reduce inflation with higher unemployment.
c. increase unemployment depending upon how quickly the public changes their expected price level.
d. slowly reduce inflation with higher unemployment.
e. both c and d.*

11. According to Friedman, changes in the level of aggregate demand

a. are dominated by changes in the supply of money.
b. cause the levels of output and employment to deviate from their natural rate for short periods of
time.
c. can cause movements of the economy away from the natural rate for at least 2 years.
d. are dominated by changes in the demand for money.
e. Both a and b.*

12. With respect to Friedman's natural rate theory, expansionary monetary policies can
a. move output above the natural rate but leave unemployment at the natural rate in the short-run.
b. only affect inflation and not unemployment in the long-run.*
c. leave output at its natural rate with a simultaneous decrease in the natural rate of employment.
d. move output and employment below the natural rate.

13. Stagflation can be explained by a

a. shift in the short run Phillips curve to the left.
b. shift in the short run Phillips curve to the right.*
c. a movement along the short run Phillips curve to the right.
d. a movement along the short run Phillips curve to the left.

14. The rate of unemployment can be calculated by

a. simply dividing all unemployed persons by all employed persons.
b. subtracting those employed from the total labor force to find the number of unemployed and
express this number as a percent of the total labor force.*
c. subtract those unemployed from the total labor force and express this number as a percent of
the total labor force.
d. dividing all unemployed by the population.

15. Monetarists assume that suppliers of labor

a. always have perfect information about the real wage.
b. base their decisions on the expected real wage.*
c. may or may not know the real wage.
d. could not possibly have perfect information.

16. The short-run Phillips curve shifts when there is a change in

a. technology
b. money demand.
c. the expected price level.
d. the labor force.
 e. all of the above.*

17. In the short run, an increase in the money stock growth rate
a. moves the economy up the short-run Phillips curve.
b. moves the economy down the short-run Phillips curve.*
c. shifts the short-run Phillips curve to the right.
d. results in a decline in the natural rate of unemployment and a rise in the inflation rate.
e. both b and d are correct.

18. The long-run Phillips curve is consistent with

a. a negative relationship between unemployment and the rate of expected inflation.
b. the expected real wage being equal to the actual real wage.
c. the actual price level being equal to the expected price level.
d. no relationship between inflation and unemployment.
e. all of the above except a.*

19. The most significant cost to a central bank of reducing unemployment is the costs
a. incurred by printing and distributing new money.
b. of lower output.
c. of higher real wages.
d. of inflation.*

20. According to monetarists, the natural rate theory

a. denies the tradeoff between inflation and output.
b. argues that there is a stable tradeoff between inflation and output.
  c. shows that activist policies work best.
d. believes that the Phillips curve relationship breaks down when policymakers attempt to use it.*

21. If the short run aggregate supply curve is flat, the Phillips curve will be
a. flat*
b. steep
c. horizontal
d. upward sloping

22. The Keynesian model

a. assumes a stable, downward sloping Phillips curve in the short run.*
b. implies a horizontal Phillips curve in the long run.
c. shows that the Phillips curve is can be downward or upward sloping in the short run.
  d. differs from Friedman's analysis pertaining to the vertical long-run Phillips curve.

23. According to the Keynesian view, the focus of stabilization policies

a. is to keep the economy at its equilibrium level in the face of shocks to aggregate demand.
b. should be to keep the economy at its equilibrium level in the face of shocks to aggregate supply.
c. is on the short run.
d. All of the above*
24. According to published data pertaining to unemployment rates in selected European countries,
the natural rate of unemployment
a. has been rising over the past three decades.*
b. declined sharply over the last three decades.
c. has been lower than in the U.S. in the 1990s.
d. has not changed much over the past three decades.
e. Both a and c

25. In the monetarist view, a bond-financed increase in government spending would have a strong effect
on real output in
a. both the short run and the long run.
b. the short run but not the long run.
c. the long run but not the short run.
d. neither the short run nor the long run.*

26. In the monetarist model,

a. the short run Phillips curve looks similar to the short run Phillips curve in the Keynesian model.*
b. stable money growth alone will not produce economic stability because of the unstable behavior
of the nonmonetary factors that are important in determining demand.
c. activist fiscal and monetary policies are favored to stabilize aggregate demand.
d. Both a and b
e. all of the above.

27. In response to an increase in the population and the labor force, we would expect
a. both the short run and long run Phillips curve to shift to the right.
b. the short run Phillips curve remains unchanged while the long run Phillips curve shifts to the
right.
c. the long run Phillips curve remains unchanged while the short run Phillips curve shifts to the right.
d. both the short run and long run Phillips curve to shift to the left.*
e. none of the above.

28. Which of the following statements is (are) correct?

a. Both the monetarists and classicists agree that output is completely supply determined, even in the
short run
b. The monetarists do not agree with the classical position that monetary policy cannot be used to
influence output.*
c. According to both the monetarists and the classicists, output is determined by demand side factors
in the short run
d. None of the above

29. Assume that the Phillips curve in an economy is  = 3 - .5(u - 5), where  is the inflation rate and u is
the unemployment rate. If unemployment is currently is currently 6 percent, then inflation should be
a. 2.0%
b. 3.5%
c. 2.5%*
d. 3.0%
30. If the government places a new tax on the firing of workers, then we would expect
a. both the short run and long run Phillips curve to shift to the right.
b. both the short run and long run Phillips curve to shift to the left.*
c. the long run Phillips curve remains unchanged while the short run Phillips curve shifts to the right.
d. the short run Phillips curve remains unchanged while the long run Phillips curve shifts to the right.
e. none of the above.

31. If the government places a new tax on the hiring of workers, then we would expect
a. both the short run and long run Phillips curve to shift to the right.
b. both the short run and long run Phillips curve to shift to the left.*
c. the long run Phillips curve remains unchanged while the short run Phillips curve shifts to the right.
d. the short run Phillips curve remains unchanged while the long run Phillips curve shifts to the right.
e. none of the above.

32. The short-run Phillips curve implied when all changes in aggregate demand are caused by changes in
the money supply is
a. upward sloping.
b. downward sloping.*
c. horizontal.
d. vertical.
e. None of the above

33. Which of the following statements is (are) correct? There is agreement between the Keynesians and
monetarists that
a. an increase in aggregate demand will increase both output and price in the short run.
b. there is a trade-off between inflation and unemployment in the short run.
c. in the long run, when the expected price level also has time to adjust, output will not be affected
by changes in aggregate demand.
d. All of the above*
e. None of the above

34. The following Phillips curve of  = 3 - .5(u - 5) would be consistent with the _____ model(s).
a. Keynesian.*
b. monetarist.
c. monetarist and classical.
d. classical.
e. None of the above

35. Friedman's theory of the natural rate of unemployment and output

a. indicates the power of the central bank to target levels of unemployment.
b. demonstrates the limits to the trade-off between inflation and unemployment.
c. is the theoretical foundation for the monetarist belief that, in the long run, the influence of the
money stock is primarily on the price level and other nominal variables.
d. both b and c.*
e. all of the above.

36. According to Monetarists, the natural rate of unemployment in each country will be determined
by the structural characteristics of the
a. the productive efficiency of that country.*
 b. relationship between the actual price level and the expected price level.
c. the monetary policy of that country.
d. Both a and b
e. All of the above

37. In response to an increase in technology, we would expect

a. both the short run and long run Phillips curve to shift to the right.*
b. both the short run and long run Phillips curve to shift to the left.
c. the long run Phillips curve remains unchanged while the short run Phillips curve shifts to the right.
d. the short run Phillips curve remains unchanged while the long run Phillips curve shifts to the right.
e. none of the above.

38. The natural rate of employment

a. will change with changes in the long run aggregate supply curve.
b. will be a level such that the expected real wage equals the actual real wage.
c. will be at a level where the actual and expected price levels are equal.
d. both a and c.
e. all of the above.*

39. Labor market regulations in European Union countries

a. do not contain limitations on plant closing but do have provisions for mandatory severance pay
that may discourage firms from expanding employment.
b. include limitations on plant closing but have no provisions for mandatory severance pay that may
discourage firms from expanding employment.
c. neither entail limitations on plant closing nor provisions for mandatory severance pay that
may discourage firms from expanding employment.
d. include limitations on plant closing and provisions for mandatory severance pay that may
discourage firms from expanding employment.*

40. The divergent behavior of unemployment in the United States and Europe, especially in the 1990s,
a. has been ascribed to different structural characteristics of money markets in the two regions.
b. has been attributed to different structural characteristics of labor markets in the two regions.*
c. cannot be explained for these two regions.
d. has been explained with different demographic factors in the two regions.

41. According to the Keynesian model, a decline in the expected price level
a. will increase the inflation rate a central bank must generate to achieve a target level of
unemployment.
b. will decrease the inflation rate a central bank must generate to achieve a target level of
unemployment.*
c. will not affect the inflation rate a central bank must generate to achieve a target level of
unemployment.
d. will not impact the effectiveness of monetary policy.

42. Which of the following is correct? The natural rate of unemployment

a. is a zero unemployment rate.
b. has been steady at 3 percent over the past decade.
c. is defined by Friedman as that rate of unemployment "in which everyone who wants a job can
have a job."
d. is the unemployment rate that exists in the long-run.*
 e. None of the above

43. One would expect a shift down in the Phillips curve if there was a(n)
a. a decrease in aggregate demand.
b. decrease in government spending.
c. decrease in the money supply.
d. a shift in aggregate supply to the left.*
e. Any of the above

44. The idea that hysteresis plays a role in macroeconomics implies that
a. monetary policy can have an effect on the natural rate of unemployment.*
b. workers can overreact to changes in monetary policy.
c. stabilization policy is ineffective and counterproductive.
d. fiscal policy is ineffective and counterproductive.

45. The tradeoff for monetary policy represented by the Phillips curve is
a. lower inflation for lower output.
b. lower inflation for higher unemployment.*
c. lower inflation for higher employment.
d. higher expected inflation for higher output.
e. none of the above.

46. The natural rate of unemployment

a. is not the same as the full employment rate of unemployment.
b. is achieved at a zero level of unemployment.
c. is a constant.
d. is that unemployment rate to which the economy tends at the end of every period.
e. none of the above.*
The natural rate of unemployment
a. is not the same as the full employment rate of unemployment.
b. is achieved at a zero level of unemployment.
c. is a constant.
d. is that unemployment rate to which the economy tends at the end of every period.
e. none of the above.*

47. The natural rate of unemployment

a. exists only when labor supply equals labor demand.*
b. exists only if labor supply is greater than labor demand.
c. is known and constant.
d. exists when everyone who wants a job has a job.
e. none of the above.

48. Policies aimed at reducing the natural rate of unemployment are referred to as
a. stabilization policies.
b. structural policies.*
c. macroeconomic policies.
d. labor policies.

49. Which of the following statements is correct?

 a. Milton Friedman’s theory of the natural rates of unemployment and output has been highly
influential since it describes the limits to the trade-off between inflation and unemployment.
b. Milton Friedman’s main concern in advancing the concept of the natural rates of output and
unemployment was to illustrate a limitation on monetary policy.
c. Milton Friedman’s main concern in advancing the concept of natural rates of output and
unemployment was to define a limitation on fiscal policy.
d. Both a and b*
e. Both a and c

50. The rate of adjustment between the long run and short run Phillips curve will be determined by
a. the rate of adjustment of price expectations.
b. the rate of money growth.
c. the level of wage flexibility in labor markets.
d. both a and c.*
e. all of the above.