1. the Phillips Curve Depicts the Relationship Between The

Chapter 27 Practice Quiz The Phillips Curve and Expectations Theory

1. The Phillips curve depicts the relationship between the a. unemployment rate and the change in GDP. b. inflation rate and the interest rate. c. level of investment spending and the interest rate. d. inflation rate and the unemployment rate.

ANS: d. The Phillips curve is a theory developed by A. W. Phillips in 1958.

2. A difficulty in using the Phillips curve as a policy menu is a. that the natural rate of unemployment does not exist. b. that the curve would not remain in one position. c. deciding between monetary and fiscal policies. d. that Democrats choose one point on the curve and Republicans choose another point.

ANS: b. The Phillips curve is a theory based on the assumption that it is stationary.

3. Since the 1970’s, the a. Phillips curve has not been stable. b. inflation rate and the unemployment rate have been about equal. c. Phillips curve has proven to be a reliable model to guide public policy. d. relationship between the inflation rate and the unemployment rate moved in a counterclockwise direction.

ANS: a. During 1960-69, the Phillips curve appeared stable. Since the 1970’s, the Phillips curve has not been stable. See Exhibit 3 in the text. 4. According to the natural rate hypothesis, a. the Phillips curve is quite flat, so that a large reduction in employment can be achieved without inflation. b. workers adapt their wage demands to inflation only after a considerable time lag. c. the Phillips curve is vertical in the long run at full employment. d. workers cannot anticipate the inflationary effects of expansionary public policies.

ANS: c. Natural rate hypothesis argues that the economy will self-correct to the full- employment unemployment rate.

5. Adaptive expectations theory a. argues that the best indicator of the future is recent information. b. underestimates inflation when it is accelerating. c. overestimates inflation when it is slowing down. d. does none of the above. e. does all of the above.

ANS: e. According to adaptive expectations theory, expansionary monetary and fiscal policies to reduce the unemployment rate are useless in the long run.

6. The conclusion of adaptive expectations theory is that expansionary monetary and fiscal policies intended to reduce the unemployment rate are a. effective in the long-run. b. effective in the short-run. c. unnecessary and cause inflation in the long run. d. necessary and reduce inflation in the long run.

ANS: c. This theory believes, after a short-run reduction in unemployment, that the economy self-corrects to the natural rate of unemployment, but at a higher inflation rate. 7. Most macroeconomic policy changes, say the rational expectations theorists, are a. unpredictable. b. predictable. c. slow to take place. d. irrational.

ANS: b. Rational expectations theory argues that people are intelligent and informed. They not only consider past changes, but also use all available information to predict the future, including future monetary and fiscal policies.

8. Rational expectations theorists advise the federal government to a. change policy often. b. pursue stable policies. c. do the opposite of what the public expects. d. ignore future economic predictions.

ANS: c. Rational expectations argue that systematic and predictable expansionary monetary and fiscal policies are not only useless, but also harmful because the only result is higher inflation.

Exhibit 10 Short-Run and Long-Run Phillips Curves

Long-run Phillips curve 12

e t 10 a ) t R E

n 9 c o r i t e 8 a p l ( f

n D I 6 4 Short-run Natural rate Phillips curve

0 4 5 6 7 8 9 10 Unemployment Rate (percent) 9. Suppose the government shown in Exhibit 10 uses contractionary monetary policy to reduce inflation from 9 to 6 percent. If people have adaptive expectations, then a. the economy will remain stuck at point E1. b. the natural rate will permanently increase to 8 percent. c. unemployment will rise to 8 percent in the short run. d. unemployment will remain at 6 percent as the inflation rate falls.

ANS: c. The unemployment rate will rise to 8 percent as people adapt their inflationary expectations to the current inflation rate. Over time, however, the economy self-corrects to the natural unemployment rate.

10. Suppose the government shown in Exhibit 10 uses contractionary monetary policy to reduce inflation from 9 to 6 percent. If people have rational expectations, then a. the economy will remain stuck at point E1. b. the natural rate will permanently increase to 8 percent. c. unemployment will rise to 8 percent in the short run. d. unemployment will remain at 6 percent as the inflation rate falls.

ANS: d. Assuming the impact of government policy is predictable, people immediately anticipate higher or lower inflation. Workers quickly change their nominal wages and businesses change prices. The price level changes, but the unemployment remains unchanged at the natural rate.

11. Voluntary wage-price restraints are known as a. wage-price controls. b. price rollbacks. c. wage-price guidelines. d. anti-inflation commitments.

ANS: c. Wage-price guidelines are voluntary standards set by government rather than wage- price controls which are legal restrictions. 12. Which of the following government policies is an incomes policy? a. A reduction in welfare expenditures. b. The publication of a list of guidelines suggesting maximum wage and price increases. c. An increase in the money supply. d. All of the above answers are correct.

ANS: b. Income policies include presidential jawboning, wage-price guidelines, and wage-price controls.

Exhibit 11 Aggregate Demand and Aggregate Supply Curves

LRAS SRAS2 120 SRAS1 115

Price level 110 E3 (CPI) 105 E2 AD2 100 E1 95 AD1 0 5.0 5.5 6.0 6.5 7.0 7.5 Real GDP (trillions of dollars per year) 15

13. As shown in Exhibit 11, if people behave according to adaptive expectations theory, an increase in the aggregate demand curve from AD1 to AD2 will cause the price level to move a. directly from 100 to 110 and then remain at 110. b. directly from 100 to 105 and then remain at 105. c. directly from 100 to 105 initially and then eventually move back to 100. d. from 100 to 105 initially and then eventually move to 110.

ANS: d. Adaptive expectations theory argues that people rely on recent information and therefore underestimate inflation when it rises. At E2, workers are not “caught off-guard” and demand higher nominal wages, which shifts SRAS1 to SRAS2. The eventual result is a shift from E2 to E3 at a price level of 110. 14. As shown in Exhibit 11, if people behave according to rational expectations theory, an increase in the aggregate demand curve from AD1 to AD2 will cause the economy to move a. directly from E1 to E3 and then remain at E3. b. directly from E1to E2 and then remain at E2. c. from E1 to E2 initially and then eventually move back to E1. d. from E1 to E2 initially and then eventually move to E3.

ANS: a. Rational expectations theory is the belief that people use future monetary and fiscal policies to anticipate the effect of these policies. Workers anticipate that expansionary policies will move the economy from E1 to E3 and so they raise nominal wage increases immediately and prices rise proportionately. Thus, there is a direct path from E1 to E3.

15. As shown in Exhibit 11, if people behave according to rational expectations theory, an increase in the aggregate demand curve from AD1 to AD2 will cause a. labor to adjust nominal wages sluggishly. b. the aggregate supply curve to remain at SRAS1. c. the price level to eventually rise from 100 to 110. d. none of the above.

ANS: d. Under rational expectations theory, wages adjust immediately causing SRAS to shift at the same time, and the price level rises immediately from 100 to 110.