Answers to the questions in Quiz 13:

1. Use the AD curve and long-run AS curve to explain the classical analysis of economic growth
and inflation.

Answer: There are two important forces that govern the economy in the long-run. These forces
are technological progress and expansionary monetary policies.

 Technological progress shifts the long-run aggregate supply curve to the right.

 The central bank increases the money supply over time, which shifts the aggregate
demand curve to the right.

The result, as shown in the above figure, is growth in output and continuing inflation (increases
in the price level over time.)

2. Use the AD-AS model to explain how a recession happens. How do policymakers eliminate a
recession?

Answer: A recession is caused by a decline in the aggregate demand.

 That is, the aggregate demand curve shifts to the left, causing a short-run decline in
output (with a rise in unemployment) and a decline in the price level (see Figure a
below).

 This situation is consistent with a downward movement along the Phillips curve from
point A to point B (see Figure b below).

 To eliminate a recession, policymakers can implement an expansionary monetary policy

and/or an expansionary fiscal policy.

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3. Use the AD-AS model to explain how a boom happens. How do policymakers ease a boom?

Answer: A boom is caused by an increase in the aggregate demand.

 That is, the aggregate demand curve shifts to the right, causing a short-run increase in
output (with a decline in unemployment) and a rise in the price level (see Figure a
below).

 This situation is consistent with an upward movement along the Phillips curve from point
A to point C (see Figure b below).

 To ease a boom, policymakers can implement a contractionary monetary policy and/or a

contractionary fiscal policy.

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4. Use the AD-AS model to explain how a stagflation happens.

Answer: A stagflation is caused by a decline in the short-run aggregate supply.

 The short-run aggregate supply curve shifts to the left, causing a short-run decline in
output (with a rise in unemployment) and an increase in the price level (see Figure c
below).

 This situation is consistent with a shift to the right in the Phillips curve. An increase in
unemployment is associated with an increase in inflation (see Figure d below).

 Definition of stagflation: a period of declining output (or real incomes), rising

unemployment and rising prices.

5. Explain what causes movements along the Phillips curve. Explain what causes the Phillips
curve to shift.

Answer:

 Any factor that causes a change in aggregate demand (and therefore shifts the AD curve)
results in a movement along the Phillips curve.

 Any factor that causes a change in aggregate supply (and therefore shifts the SRAS
curve) results in a shift in the Phillips curve.

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6. Explain why the Phillips curve is vertical in the long-run.

Answer:
 In the long run, a change in money supply has no real effects.

 This means that a change in money supply cannot affect the factors that determine the
natural unemployment rate.

 Thus, in the long run, we would not expect a relationship between unemployment and
inflation.

 This must mean that, in the long run, the Phillips curve is vertical at the natural rate of
unemployment.

The vertical Phillips curve occurs because, in the long run, the aggregate supply curve is vertical
as well.

 Thus, increases in aggregate demand lead only to changes in the price level and have no
effect on the economy’s level of output.

 Thus, in the long run, unemployment will not change when aggregate demand changes,
but inflation will.

 Note that the long-run aggregate-supply curve occurs at the economy’s potential output;
thus, the long-run Phillips curve occurs at the natural rate of unemployment.

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7&8. What are the LR government policies? What are the SR government policies? Explain how
these policies help promote economic growth.

Answer: From Unit 8, the long-run government policies include:

i. encouraging saving and investment;
ii. taking advantage of the Catch-up effect;
iii. encouraging investment from abroad;
iv. providing free education;
v. promoting property right and political stability;
vi. encouraging free trade;
vii. the control of population growth, and
viii. encouraging research and development.

 These policies are intended to make the long-run trend in real GDP steeper.

 A steeper long-run trend in real GDP means shorter time to double real GDP and thus
faster economic growth.

From Unit 12, the short-run government policies include both monetary and fiscal policies.

 Using these policies, policymakers are able to promote economic growth by stabilizing
short-run economic fluctuations (or the actual real GDP) around the long-run trend in real
GDP.

9&10. Explain how an expansionary monetary policy works. Explain how an expansionary fiscal
policy works. Explain which policy is more effective in stabilizing economic fluctuations.

Answer:
 An expansionary monetary policy (or an increase in money supply) works through
reducing the interest rate which encourages investment resulting in higher aggregate
demand. Firms respond to higher aggregate demand by increasing output and
employment.

 An expansionary fiscal policy (or an increase in government spending) works through

increasing aggregate demand. Firms respond to higher aggregate demand by increasing
output and employment.

o The interest rate increases, when the government finances spending through
borrowing from the public. The increase in the interest rate crowds out part of the
increase in aggregate demand (through reducing investment). Because of this
crowding-out effect, an expansionary fiscal policy is less effective than an
expansionary monetary policy in stabilizing the economy.