Hwk10_sol

Hwk10_sol - Economics 345 Prof. Irina Telyukova Fall 2008...

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Economics 345 Prof. Irina Telyukova Fall 2008 Homework Assignment 10 SOLUTIONS 1. Mishkin and Serletis, p. 664 (ch 26). (1) It is true that in the data we sometimes observe inflation without significant monetary growth, but it is short-run/temporary inflation. As we have discussed, this type of short-run increase in inflation can be caused by any number of factors, including cost shocks, or fiscal policy moves and other aggregate demand shocks. This alone does not contradict the statement that inflation is a monetary phenomenon, so long as by “inflation” we mean “sustained inflation”. This was the view we took all along in linking inflation to high monetary growth. We can draw the graph to show a one-time increase in inflation that does not result from an increase in money supply. Suppose, for example, that there is an increase in oil prices. Then the SRAS curve shifts left, which results in an increase in prices, and a fall in output. This increase in prices is not sustained for long, however, because the economy’s long-run adjustment mechanism will kick in to bring prices back to initial equilibrium level. Mark the graph appropriately and make sure you understand these stories. Try also with an aggregate demand shock, other than that associated with money supply growth! LRAS Y P Y n SRAS’ SRAS AD (3) False. Fiscal policy can produce rightward shifts in the aggregate demand curve, which lead to a one-shot increase in the price level. However, fiscal policy cannot produce continuing rightward shifts in the aggregate demand curve because there are limits to how high government spending can be raised (in the extreme, it cannot go above 100 percent of GDP, and will in practice stop long before that for political and fiscal reasons) and how much taxes can be cut (in the extreme, they cannot go below zero). Therefore, since a continuing rightward shift
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of the aggregate demand curve is required in order for inflation to occur (a continuing increase in the price level), fiscal policy cannot be the source of the inflation. (4) Answer in the book. Go through graphical analysis to develop how cost-push inflation happens, and make sure you understand the intuition. (5) False. Even though policymakers do not want inflation, there are many situations in which other priorities push their policies in inflationary directions. For example, if policymakers face a financial crisis like the one in the U.S. today, accompanied by a credit crunch, or if they pursue goals such as high employment or choose to run high budget deficits, inflationary monetary policy and inflation can result through the mechanisms that we described. Make sure you know how these mechanisms work. (6)
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Hwk10_sol - Economics 345 Prof. Irina Telyukova Fall 2008...

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