13 U.S. INFLATION, Chapter

UNEMPLOYMENT,

AND BUSINESS

CYCLES* *

Solutions to the Odd-Numbered Problems

1. a. Argentina experienced inflation in 1994, 1995, 2000, 2002, 2003, and 2004. Argentina

experienced deflation in 1997, 1998, 1999, and 2001.

b. Argentina had recessions in 1995, 2000, 2001, and 2002. Argentina had expansions in 1994,

1996, 1997, 1998, 2003, and 2004.

c. The unemployment rate was probably high in all of the recessionary years. It was probably

the highest in 2000 and 2002 when the recessions were the most severe.

d. There is not a strong relationship between unemployment and inflation in the data. The

unemployment rate would likely have been high in 1995, 2000, 2001, and 2002. In 1995,

2000, and 2002 Argentina experienced inflation while in 2001 Argentina experienced

deflation. So there is no consistent relationship between either inflation and high

unemployment or deflation and high unemployment. There also is a similar lack of

relationship between inflation and low unemployment or deflation and low unemployment.

3. a. Anything that decreases short-run aggregate supply can set off a cost-push inflation. For

instance, an increase in the money wage rate, an increase in the money price of raw materials

could all be the start of a cost-push inflation. But to sustain such an inflation, the quantity of

money must keep increasing.

b. Starting out on AD and SAS , the price level is 120 and real GDP is at potential GDP of $10 0 0

trillion. Short-run aggregate supply decreases and the SAS curve shifts leftward to SAS . The 1

price level rises and real GDP decreases to the intersection of AD and SAS . There is now a 0 1

recessionary gap.

c. Starting out on AD and SAS with a recessionary gap, real GDP is below potential GDP and 0 1

unemployment is above the natural rate. In an attempt to restore full employment, the central

bank increases the quantity of money. The aggregate demand curve shifts rightward to AD . 1

Real GDP returns to $10 trillion and the price level rises to 160. A further cost increase

occurs, which shifts the short-run aggregate supply curve to SAS and a recessionary gap 2

opens up again. The economy is again below potential GDP. In an attempt to restore full

employment, the central bank increases the quantity of money. The aggregate demand curve

shifts rightward to AD . Real GDP returns to $10 trillion and the price level rises to 200. 2

5. a. People expect that the price level will fall. The money wage rate falls in expectation of the

lower price level. The short-run aggregate supply curve shifts rightward. There is no change

in potential GDP. The long-run aggregate supply curve does not shift.

b. Starting out on AD and SAS , the price level is 120 and real GDP is at potential GDP of $10 0 0

trillion. Short-run aggregate supply increases, and the SAS curve shifts rightward . The

aggregate demand curve does not shift. The price level falls, but by less than people

expected. Real wages fall because money wages have fallen by more than the price level.

Real GDP increases. Real GDP is greater than potential GDP and an inflationary gap opens.

* This is Chapter 29 in Economics . *

1

c. The money wage rate rises to reflect the higher expected price level. The rise in money

wages decreases the short-run aggregate supply and the SAS curve shift leftward to SAS . 0

The price level rises to 120 and the economy returns to its potential GDP.

7. a. First the inflation rate increases from 5 percent to 15 percent and the unemployment rate

does not change. Then the unemployment rate increases from 4 percent to 8 percent and the

inflation rate does not change. Next the inflation rate falls from 15 percent to 5 percent and

the unemployment rate does not change. Finally the unemployment rate falls from 8 percent

to 4 percent and the inflation rate does not change. This set of changes could be the result of

an expected increase in the inflation rate from 5 percent to 15 percent, followed by an

increase in the natural unemployment rate from 4 percent to 8 percent, followed by an

expected fall in the inflation rate from 15 percent to 5 percent, finally followed by a decrease

in the natural unemployment rate from 8 percent to 4 percent.

b. The initial increase in the expected inflation rate moves the economy up its (stationary) long-

run Phillips curve from point A to point B . The short-run Phillips curve shifts upward to

intersect the long-run Phillips curve at point B . Then the increase in the natural

unemployment rate shifts both the long-run and short-run Phillips curves rightward so that

they both reach point D . Next the fall in the expected inflation rate moves the economy

along its (stationary) new long-run Phillips curve from point D to point C . The short-run

Phillips curve shifts downward to intersect the long-run Phillips curve at point C . Finally, the

fall in the natural unemployment rate shifts both the long-run and short-run Phillips curves

rightward so that they both reach point A .

c. The economy has experienced expected inflation, the movement from point A to point B , and

expected deflation, the movement from D to point C .

2