Sample Final Exam Questions

1) The fed announces target inflation is 2%, and economists estimate that
structural and frictional unemployment account for 5.5% of unemployment.
This week a report is released saying inflation is 2.1% and unemployment if
4.5% (These are roughly the present economic circumstances).
a. Use the model of aggregate demand/ supply to demonstrate
graphically, our economic circumstances. What changed to move us
from the long-run equilibrium?
AS

AD
AD
Y*

The AD curve shifted rightwards, perhaps because people are confident

about future economic prospects. This results in a short-run
equilibrium with inflation slightly higher than the target level of
inflation, and output slightly higher than potential output.
b. How would the economy self-correct? What would be the inflation in
the long-run?
Prices would adjust. With Y>Y*, this would put upward pressure on
price, causing some initial inflation. Then, since inflation is above
target (

> ) people would no longer believe the target level, and

come to expect higher inflation, causing AS to shift to the left. Long-run

inflation will be greater than 2.1%.
c. How could the government use macro-economic stabilization policy to
shorten the business cycle?
The government could pursue tighter monetary or fiscal policy, by
increasing interest rates, reducing government spending, of increasing
taxes. This would shift aggregate demand back leftwards, towards its
original level.
d. In this case, what sorts of policies are likely to be most effective?
Here the output and inflation gaps are relatively small. If the
government did anything, raising interest rates is probably the best
measure. Fiscal policy would be too slow, and too imprecise.

2) Target inflation is 2%, non-cyclical unemployment is 5.5%. Suppose realized

unemployment is 25%, inflation is -4% (this situation is analogous to the
Great Depression).
a. Use the model of aggregate demand/ supply to demonstrate
graphically the economic circumstances. What changed to move us
from the long-run equilibrium?

(Axes and curves are labeled as above)

This short-run equilibrium can be characterized by a large leftward shift
in aggregate demand, perhaps caused by the financial panic and bank
failures. This results in low inflation and low output (high
unemployment)
b. How would the economy self-correct? What would be the inflation in
the long-run?
Prices and expectations adjust. Because output is below potential, this
causes an initial decrease in prices, when people see inflation lower
than target, they will come to expect lower inflation, shifting the AS
curve rightward until we reach a new equilibrium level of inflation,
which will be less than -4%.
c. How could the government use macro-economic stabilization policy to
shorten the business cycle?
The government could use monetary policy (reducing interest rates to
low levels), or fiscal policy (increasing G, reducing T). This would have
the effect of stimulating aggregate demand, shifting the aggregate
demand curve back to the right. In the long-run inflation would stay at
the target level.
d. In this case, what sorts of policies are likely to be most effective?
Here fiscal policy makes sense because the output gap is so large.
Monetary policy may be constrained by the 0-lower bound. That is,
because inflation has gone negative, the fed may not be able to cut
nominal interest rates low enough (cant go below 0) to be effective.

3) Target inflation is 2%, non-cyclical unemployment is 5.5%. Realized

unemployment is 12%, inflation is 15% (an example of 1970s stagflation).
a. Use the model of aggregate demand/ supply to demonstrate
graphically the economic circumstances. What changed to move us
from the long-run equilibrium?

A price shock in the economy may cause AS to shift to the left. In the
1970s, this was the result of a sharp increase in oil prices. Short-run
equilibrium output is below potential output (Y<Y*), and inflation is
above target.
b. How would the economy self-correct? What would be the inflation in
the long-run?
The inflation shock causes inflation to be above target inflation.
Because output is below potential output, firms will want to lower
prices. However, because inflation is above target, people may expect
inflation to be higher. Which way prices move depends on what
ultimately happens with expectations. If people believe the central
bank will maintain their target, people expect low inflation, prices fall
and AS shifts right restoring equilibrium. Inflation would be 2%.
c. How could the government use macro-economic stabilization policy to
shorten the business cycle?
The government could use fiscal policy (increase G or decrease T) to
stimulate aggregate demand. It could also use monetary policy
(reducing interest rates) for the same purpose. AS would stay at the
new level, AD would shift to the right, and long-run inflation would be
greater than 15%.

d. In this case, what sorts of policies are likely to be most effective?

Inflation is further away from the target than unemployment is from its
target, so it is best to fight the inflation. The central bank would do
nothing, and may even raise interest rates to fight inflation and deepen
the recession. This would signal to the world that the central bank is
serious about fighting inflation. If the central bank was credible, then
expectations would adjust quickly, AS would rapidly shift right, prices
would fall, inflation would abate, and the recession would be short.

4) Target inflation is 2%, non-cyclical unemployment is 5.5%. Realized

unemployment is 4%, inflation is 1.5% (1990s Great Moderation).
a. Use the model of aggregate demand to demonstrate graphically, the
economic circumstances. What changed to move us from the long-run
equilibrium?

Here the economy is benefiting from some beneficial price shocks,

shifting AS rightward, resulting in low unemployment and inflation.
This may happen because new technologies are reducing costs
economy-wide (this may shift the long-run aggregate supply to the
right as well).
b. How would the economy self-correct? What would be the inflation in
the long-run?
Eventually, if Y>Y*, prices will rise, causing AS to shift leftwards back
to the original equilibrium, at 2% inflation.
c. How could the government use macro-economic stabilization policy to
shorten the business cycle?
The government could increasing interest rates, reducing G or increase
T to reduce aggregate demand, resulting in long-run inflation below

1.5%.
d. In this case, what sorts of policies are likely to be most effective?
Since the output gap is small, it may be best to do nothing. In the
1990s the government exploited this beneficial shock to balance its
budget without adverse economic consequences.