answerkey ch11 3ed - Answers to Text Questions and Problems...

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Answers to Text Questions and Problems in Chapter 11 Answers to Review Questions 1. The aggregate demand curve relates aggregate demand (equal to short-run equilibrium output) to inflation. As inflation rises, the Bank of Canada tightens monetary policy by raising the real interest rate, which reduces aggregate demand and short-run equilibrium output. Thus the aggregate demand curve is downward sloping. 2a. For given levels of inflation and the real interest rate, an increase in government purchases raises aggregate demand and short-run equilibrium output. Thus an increase in government purchases shifts the ADI curve to the right. b. Because it leads consumers to spend more, a cut in taxes stimulates aggregate demand at each level of inflation, shifting the ADI curve to the right. c. A decline in planned investment spending by firms reduces aggregate demand at each level of inflation, shifting the ADI curve to the left. d. For each level of inflation, a lower real interest rate stimulates consumption and investment spending, raising aggregate demand and output. Thus, an easier policy by the Bank of Canada shifts the ADI curve to the right. 3. Prices of commodities are set continuously in auction markets and therefore can adjust quickly to changes in supply or demand. However, most prices are not determined in auction markets but are set only periodically. In setting prices or wages for a longer period, individuals’ expectations of future inflation are important; the higher is expected inflation, the higher the future wage or price must be set in order to maintain the desired level of purchasing power. But expectations of inflation in turn depend in part on recent experience with inflation. So we have a vicious (or virtuous) circle, as high inflation leads to high expectations of inflation, which in turn leads to high actual inflation (and the reverse if inflation is low). Together with long-term contracts that “lock in” prices and wages for a period of time, expectations of inflation contribute to inflation inertia, or “stickiness”. 4. Expansionary gaps tend to raise inflation, and recessionary gaps tend to reduce it. If an expansionary gap exists, for example, firms are producing above normal capacity. Eventually they will respond by attempting to raise their relative price (that is, raising their own price faster than the rate of inflation). As all firms try to do this, inflation will tend to speed up. Likewise, a recessionary gap implies that firms are producing below normal capacity. To stimulate demand for their products, firms will try to reduce their relative prices, leading to an overall slowdown in inflation. Graphically, the link between output gaps and inflation is captured by movements of the short-run aggregate supply ( IA ) line. If an expansionary gap exists at the current intersection of the IA line and the ADI curve (which determines short-run equilibrium output), inflation rises and the IA line moves upward. If a recessionary gap exists in short-run equilibrium,
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This note was uploaded on 06/11/2011 for the course ECON 102 taught by Professor Lemche during the Winter '08 term at The University of British Columbia.

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answerkey ch11 3ed - Answers to Text Questions and Problems...

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