The Price Level Real Output

CHAPTER 13

The Price Level, Real Output,
and Economic Policymaking

CHAPTER OVERVIEW

Chapter 13 is one of the longer chapters of the text and covers a considerable amount of material. The chapter begins by showing how the aggregate demand curve can be derived from the IS-LM-BP schedules of the previous three chapters. This is done by shifting the LM curve in the real income-nominal interest rate plane with respect to changed in the price level, which produces the downward sloping AD schedule between aggregate price and real income. The text then demonstrates how fiscal and monetary expansions and contractions translate into shifts of the AD curve. Parallels are drawn in each case between the relative effectiveness of fiscal and monetary policies in the IS-LM-BP model depending on (1) the exchange rate regime, (2) the degree of capital mobility and (3) whether or not sterilizations are implemented, and the extent to which these translate into a net shift in the position of the AD curve.

Next, the aggregate supply schedule is derived on the basis of nominal rigidities in the labor market. Specifically, firms demand labor as an input for production, which is subject to diminishing returns so that under perfect competition the value of marginal product is set equal to the nominal wage. Explicit and implicit contracts are used to justify nominal wage rigidity. The text then demonstrates how inflexible nominal wages lead to an upward sloping aggregate supply schedule, while fully flexible nominal wages lead to a vertical aggregate supply schedule. These are defined as the short run and long run aggregate supply schedules respectively.

The chapter then uses the AS-AD model to study the consequences of fiscal and monetary policies for the aggregate price level and output under both fixed and floating exchange rates. A substantial amount of discussion is also devoted to the role that rational expectations can play in mitigating or potentially eliminating the consequences of anticipated policy actions. The chapter ends with an analysis of the potential bias toward an inflationary outcome when policymakers have full discretion, and discusses the more general issue of policy credibility in the presence of time inconsistency problems.

OUTLINE

I.     Aggregate Demand
A.    Derivation
B.    Determinants of Position
1.     Monetary Policy
a.    Fixed Exchange Rate
b.    Flexible Exchange Rate

               2.     Fiscal Policy
a.    Fixed Exchange Rate
b.    Flexible Exchange Rate

II.    Aggregate Supply
A.    Output and Employment Determination
1.     Labor Demand
2.     Labor Supply
B.    Wage Flexibility
1.     Nominal Wages
2.     Aggregate Supply and Labor Market
3.     Wage Adjustment

III. Real Output, Prices, and Policymaking
A.    Fixed Exchange Rates
B.    Floating Exchange Rates

IV. Rules vs. Discretion
A.    Expectations and Nominal Wage Flexibility
1.     Rational Expectations
2.     Anticipated vs. Unanticipated Policies
B.    Discretion, Credibility, and Inflation
1.     Inflation Bias
2.     Making Policies Credible
3.     Central Bank Independence

V.    Summary    

FUNDAMENTAL ISSUES

1.     What is the aggregate demand schedule?

2.     What factors determine the extent to which changes in the quantity of money can influence aggregate demand in an open economy?

3.     What factors determine the extent to which fiscal policy actions can influence aggregate demand in an open economy?

4.     What is the aggregate supply schedule?

5.     How are a nation’s price level and volume of real output determined, and how might economic policymakers influence inflation and real output?

6.     Why does the rational expectations hypothesis indicate that economic policies may have limited real  output effects and that the credibility of policymakers is important?

CHAPTER FEATURES

1.     Policy Notebook:  “Do Labor Market Inflexibilities Contribute to Higher Unemployment?”

This policy notebook considers the impact of legal requirements that restrict the operation of labor markets and the resulting impact on business decisions. The point is made that economies with relatively inflexible labor markets typically have higher unemployment than economies with relatively flexible labor markets.

For Critical Analysis:  The benefits of labor market inflexibility seem to be the laborers who maintain employment at a relatively high wage. This comes at the expense of laborers who lose their jobs because employers must maintain high wages for the remaining employees.

2.     Management Notebook:  “Inflation, Deflation, and the Tough Choice Between Debt and Equity       Financing.”

This notebook discusses the factors firms consider when they decide to finance spending projects by either issuing debt or equity. Debt financing can be favored for tax (write-off) purposes, which is reinforced in inflationary environments in which nominal interest rates are increased. Further, inflation would serve to erode the value of debt payments. In a deflationary environment, however, a firm’s nominal earnings are smaller, as are nominal interest rates. Consequently, the tax shelter value of debt is reduced. Further, in a deflationary environment, the real value of debt repayments rise.

For Critical Analysis:  Steady deflation may reduce, but likely not eliminate, the advantages of debt issued. Factors that should be considered include the degree of deflation, how long it is likely to continue, the life of the debt instruments issued, and the tax laws in place when the debt instruments are issued.  There will clearly still be circumstances under which firms will find it to their advantage to issue debt rather than equity.

3.     Policy Notebook:  “Central Bank Independence May Not Be All It’s Cracked Up To Be.”

This notebook considers the relationship between central bank independence and various measure of macroeconomic health, including GDP growth, GDP growth variability, inflation, and inflation variability.
Studies indicate that central bank independence has no effect on GDP growth or GDP growth variability, but that independence does seem to engender lower inflation and inflation variability. Thus, researchers conclude central bank independence is a stabilizing economic force. This general result is not as binding when developing and emerging economies are included, however. In fact, there may be a positive relationship between central bank independence and inflation. The lack of well-defined property rights, bankruptcy rules, and other factors typically associated with developed economies are offered as suggestions for why this is the case.

For Critical Analysis:  If a country is already experiencing a relatively low level of inflation (as well as the accompanying relatively high unemployment rate), the cost of further reducing inflation is a significantly higher unemployment rate. Thus, if an economy faces a potentially high inflationary episode, a central bank may be inclined to lessen its focus on minimizing inflation because of the cost in terms of excessive unemployment. Whether this reduces a bank’s credibility may depend upon how clear the bank’s intentions are for the maximum unemployment rate the economy can tolerate before it accepts higher inflation rates. If it is clear that a limit to an acceptable level of unemployment is impending, the impetus for allowing inflation is understood and the bank’s credibility can be maintained.  

ANSWERS TO END OF CHAPTER QUESTIONS

1.     False. As discussed in this chapter, under a floating exchange rate the potency of monetary policy’s effect on aggregate demand and, consequently, the price level and real output, is enhanced by greater capital mobility. The reason is that a monetary expansion induces a fall in the value of the domestic currency that induces a rise in exports, which in turn reinforces the expansionary effect of the monetary expansion.

2.     Under a fixed exchange rate and relatively high capital mobility, an expansionary fiscal policy places upward pressure on the value of a nation’s currency, which requires the nation’s central bank to purchase foreign exchange reserves. If this monetary action is unsterilized, then the domestic money supply also expands, thereby reinforcing the effect of the expansionary fiscal policy on aggregate demand and the equilibrium price level. If a key goal is to limit inflation, then fiscal policy restraints may be justified.

3.     To bring about a devaluation, the nation’s central bank must increase the money stock for a time. When the value of the domestic currency falls, the BP and IS schedules shift to the right, so that equilibrium real income rises at any given price level. Thus, there is an increase in aggregate demand. If workers’ expectations are rational, and if wage adjustments are rapid, then there will be a short-run increase in equilibrium real output following this increase in aggregate demand only if the devaluation is unanticipated, so that there is no short-run shift in the position of the aggregate supply schedule. If workers are able to anticipate the devaluation, however, then they will immediately bargain for higher wages in light of their expectations of higher prices. The resulting wage increase causes the aggregate supply schedule to shirt upward and to the left at the same time that aggregate demand increases, so that real output is unchanged in equilibrium.

4.     If all other factors are unchanged, then a boost in nominal wages causes the aggregate supply schedule to shift upward and leftward along the aggregate demand schedule. As a result, the equilibrium price level rises, and equilibrium real output declines.

5.     The theory of discretionary policymaking implies that the central bank will devalue under these circumstances. Given the central bank’s low level of concern about inflation, it will devalue in an effort to raise aggregate demand (see question 3 above), thereby causing and upward movement along the economy’s aggregate supply schedule and a short-run increase in real output. Since workers realize that the required devaluation will raise inflation by 10 percent, they will bargain for a wage increase. This will cause aggregate supply to shift upward and leftward. The result will be inflation but no change in equilibrium real output.

6.     Nominal wages fully indexed to inflation will render any discretionary policy to immediately be offset by labor supply restrictions that keep equilibrium output from changing. Thus, a central bank’s incentive to produce an inflation bias is eliminated.

7.     To index a wage based on inflation when aggregate supply shocks dominate the economy would be destabilizing. This occurs because of the resulting shape of the aggregate supply curve under varying degrees of indexation. If wages are fully indexed, a vertical aggregate supply curve results. If, however, wages are only partially indexed, the aggregate supply curve is upward sloping. Consequently, if we consider the effect of an adverse supply shock under each alternative, equilibrium income will fall further with fully indexed wages. Thus, such wage indexation would not be desirable.

8.     The statement indicates that an argument in favor of central bank contracts is the balance between the benefits of central bank independence from political influence and responsibility for economy outcomes. However, the phrase, “subjecting them to societal rule” is indicative of political influence. Thus, the statement seems to be somewhat misleading. It may be more appropriate to replace that phrase with, “holding the central bank accountable for expected economic outcomes”.

9.     Which leader is correct will depend on the source of economic growth. If growth were assumed to come from demand management, the German leaders would be correct. However, if growth were supply side driven, lower inflation and lower unemployment would complement each other.

10. Factors other than central bank independence affect inflation in an economy. In particular, the statement focuses upon developing economies. As stated, these economies suffer from the lack of property rights, bankruptcy rules, judicial adjudication, etc. that exist in developed economies. Without these fundamentals in place, many economic policies that result in a stable economic environment will no longer have a stabilizing effect. 

MULTIPLE CHOICE QUESTIONS

1.     The aggregate demand schedule is

A.    used only in closed economy models of the macroeconomy.
B.    the set of combinations of real income and the price level that are consistent with IS-LM equilibrium.
C.    another name for the IS schedule.
D.    unaffected by an increase in autonomous expenditures.

        Answer:  B

2.     Which of the following effects best explains the slope of the aggregate demand schedule?

A.    a reduction in the price level on the real wage
B.    an increase in the price level on equilibrium income
C.    an increase in the nominal money supply on nominal income
D.    an increase in government spending on equilibrium income

        Answer:  B

3.     In a closed economy, an expansionary monetary policy leads to a

A.    rightward shift in the LM schedule.
B.    leftward shift in the LM schedule.
C.    rightward shift in the IS schedule.
D.    leftward shift in the IS schedule.

        Answer:  A

4.     In a closed economy with inflexible wages, a decrease in the nominal quantity of money leads to a

A.    higher equilibrium interest rate and higher equilibrium level of real output.
B.    lower equilibrium interest rate and higher equilibrium level of real output.
C.    higher equilibrium interest rate and lower equilibrium level of real output.
D.    lower equilibrium interest rate and lower equilibrium level of real output.

        Answer:  C

5.     In a closed economy, an increase in the nominal quantity of money induces a

A.    rightward movement along the AD schedule.
B.    leftward movement along the AD schedule.
C.    rightward shift of the ADD schedule.
D.    leftward shift of the AD schedule.

        Answer:  C

6.     In an open economy with a fixed exchange rate, expansionary monetary policy only affects output when

A.    there is a low capital mobility.
B.    there is high capital mobility.
C.    there is perfect capital mobility.
D.    the central bank sterilizes its interventions.

        Answer:  D

7.     In an economy with a flexible exchange rate, an expansion in the nominal stock of money leads to the  largest shift in aggregate demand when

A.    the economy is closed.
B.    there is low capital mobility.
C.    there is high capital mobility.
D.    there is perfect capital mobility.

        Answer:  D

8.     In an economy with a fixed exchange rate, an unexpected devaluation induces

A.    a rightward shift in the AD schedule.
B.    a leftward shift in the AD schedule.
C.    a leftward movement along the AD schedule.
D.    no change in the AD schedule.

        Answer:  A

9.    A central bank that attempts to increase output through the use of an unexpected devaluation will be most effective when

A.    capital mobility is low.
B.    capital mobility is high.
C.    capital mobility is perfect.
D.    wages are flexible.

        Answer:  C

10. In a closed economy, an increase in government spending leads to a

A.    rightward shift in the LM schedule.
B.    leftward shift in the LM schedule.
C.    rightward shift in the IS schedule.
D.    leftward shift in the IS schedule.

        Answer:  C

11. In an open economy with a fixed exchange rate, a fiscal expansion will lead to a balance of payments deficit when

A.    there is perfect capital mobility.
B.    the BP schedule is steeper than the LM schedule.
C.    the LM schedule is steeper that the BP schedule.
D.    There is no circumstance in which a fiscal expansion in an open economy with a fixed exchange rate leads to a balance of payments deficit.

        Answer:  B

12. In an open economy with a floating exchange rate, a fiscal expansion has its largest effect on aggregate demand when

A.    there is perfect capital mobility.
B.    the BP schedule is steeper than the LM schedule.
C.    the LM schedule is steeper than the BP schedule.
D.    There is no circumstance in which a fiscal expansion in an open economy has an effect on aggregate demand.

        Answer:  B

13. The production function defines the relationship between the

A.    aggregate price level and the quantity of output supplied.
B.    aggregate price level and the quantity of output demanded.
C.    marginal product of labor and the quantity of labor demanded.
D.    quantity of factors of production employed and the level of output produced with those inputs.

        Answer:  D

14. The marginal product of labor is defined as

A.    the value of the output produced when labor is employed in production.
B.    total output produced divided by the quantity of labor used in its production.
C.    the additional quantity of output that firms can produce by employing another unit of labor.
D.    the return that owners of capital earn when they rent out capital services to owners of labor.

        Answer:  C

15. As a consequence of the law of diminishing returns, the

A.    production function is bowed downward.
B.    aggregate supply curve is vertical.
C.    aggregate demand curve is downward sloping.
D.    wage rate is equal to the marginal product of labor.

        Answer:  A

16. In a competitive labor market, the nominal wage is equal to the

A.    price of the output.
B.    value of the average product of labor.
C.    value of the marginal product of labor.
D.    minimum wage.

        Answer:  C

17. When wages are inflexible, an increase in the price level leads to

A.    no change in the aggregate quantity of output supplied.
B.    an increase in the quantity of output supplied.
C.    a decrease in the quantity of output supplied.
D.    a rightward shift in the entire aggregate supply schedule.

        Answer:  B

18. The aggregate supply schedule relates

A.    the aggregate price level and the nominal interest rate.
B.    aggregate expenditures and the price level.
C.    the quantity of real output supplied and the price level.
D.    the quantity of real output supplied and the nominal interest rate.

        Answer:  C

19. When wages are perfectly flexible, an increase in the aggregate price level leads to

A.    no change in the aggregate quantity of output supplied.
B.    an increase in the quantity of output supplied.
C.    a decrease in the quantity of output supplied.
D.    a rightward shift in the entire aggregate supply schedule.

Answer:  A

20. Because most nations have only partial nominal wage adjustment in the short run, the standard model of aggregate supply includes

A.    both an upward sloping short run aggregate supply schedule and a horizontal long run aggregate supply schedule.
B.    a long run aggregate supply schedule that is upward sloping.
C.    a vertical short run aggregate supply schedule.
D.    both a vertical long run aggregate supply schedule and an upward sloping short run aggregate supply schedule.

        Answer:  D

21. Which of the following is consistent with rational expectations?

A.    individual actors using past information in forming expectations
B.    individual actors using current information in forming expectations
C.    individual actors using a proper understanding of economic theory in forming expectations
D.    all of the above

        Answer:  D

22. The equilibrium price and real output levels are determined by the intersection of

A.    money supply and money demand schedules.
B.    the IS and BP schedules.
C.    the aggregate supply and aggregate demand schedules.
D.    the aggregate supply and IS schedules.

        Answer:  C

23. In the short run, an expansionary monetary policy leads to a

A.    higher level of real output and a higher aggregate price level.
B.    higher level of real output and a lower aggregate price level.
C.    lower level of output and a higher aggregate price level.
D.    lower level of output and a lower aggregate price level.

Answer:  A

24. The view that workers and firms can anticipate the effects of particular policy actions is known as the

A.    locomotive effect.
B.    beggar-thy-neighbor effect.
C.    sterilization effect.
D.    rational expectations hypothesis.

        Answer:  D

25. A monetary policy expansion that is fully anticipated by workers and firms leads to

A.    a higher level of equilibrium real output and a higher aggregate price level.
B.    a higher aggregate price level, but no change in the level of equilibrium real output.
C.    a higher level of equilibrium real output, but no change in the aggregate price level.
D.    no change in either the level of equilibrium real output or the price level.

        Answer:  B

26. If workers and firms have rational expectations, the short run impact of an unexpected monetary policy expansion is

A.    a higher level of equilibrium real output and a higher aggregate price level.
B.    a higher aggregate price level, but no change in the level of equilibrium real output.
C.    a higher level of equilibrium real output, but no change in the aggregate price level.
D.    no change in either the level of equilibrium real output or the price level.

        Answer:  A

27. The capacity output level is defined as the

A.    level of real GDP that occurs at the intersection of the short run aggregate supply and demand schedules.
B.    level of real GDP that occurs at the intersection of the IS and LM schedules.
C.    value of total sales of final goods ad services, adjusted for changes in the price level.
D.    level of real GDP that could be produce if all factors of production were fully employed.

        Answer:  D

28. An example of a time inconsistency problem occurs when

A.    an economy with a fixed exchange rate is experiencing a balance of payments deficit.
B.    a central banker fully sterilizes all monetary interventions.
C.    a policymaker can better achieve his or her objectives by violating a prior policy stance.
D.    the nominal interest rate exceeds the rate of inflation.

        Answer:  C

29. The absence of policy credibility can lead to

A.    the beggar-thy-neighbor effect.
B.    the locomotive effect.
C.    inflation bias.
D.    rational expectations.

        Answer:  C

30. Which of the following is not an example of a strategy that is used to enhance a monetary authority’s policy credibility?

A.    constitutional limitations
B.    establishing a reputation
C.    sterilization
D.    appointing a conservative policymaker

        Answer:  C

31. Cross-country comparisons tend to show that central bank independence is correlated with

A.    low levels of average inflation and low inflation variability.
B.    a low level of average inflation and a high level of inflation variability.
C.    a high level of average inflation and a low level of inflation variability.
D.    high levels of average inflation and high inflation variability.

        Answer:  A