COST AND OUTPUT : PART TWO

RELATED CONCEPTS:|ACCOUNTING PROFIT |AVERAGE VARIABLE, FIXED, AND TOTAL COSTS |CONSTANT RETURN TO SCALE |DISECONOMIES OF SCALE |ECONOMIC PROFIT |ECONOMIES OF SCALE |EXPLICIT COSTS |IMPLICIT COSTS |LAW OF DIMINISHING MARGINAL RETURNS |LONG AND SHORT RUN |LONG-RUN AVEAGE COST|MARGINAL COST |MARGINAL PHYSICAL PRODUCT |TOTAL COST |TOTAL FIXED COSTS |TOTAL VARIABLE COSTS |.

If one added worker increases output by ten units, how much labor is embodied in each unit of output? If the added worker costs $120,000, what is the marginal cost of one extra unit of output?

• One-tenth of a worker is embodied in each unit of output. So each unit costs one-tenth of $12,000, or $1,200.

Answer true or false:

a. ATC falls only when MC falls.

b. At the minimum AVC, AVC = MC

c. ATC falls when MC

d. TC increases by MC.

a. False.

b. True.

c. True.

d. True.

Mary Jones can work in a factory and earn $16,000 a year, or alternatively, be a farmer. Assume that except for monetary reward, she doesn’t care which she does. To farm, Mary has to invest her savings of $20,000. The annual cost of seed, fertilizer, etc., is $5,000. She could earn 10% annually on her best alternative investment.

a. What is the total cost of farming (including implicit costs)?

b. What is the minimum Mary must make in farming to just make it worthwhile?

c. If her farm revenues ar $30,000, what is her economic profit? Her accounting profit? Should she stay in farming?

d. Answer (c) above for revenues of $20,000

a. $23,000: Explicit costs are $5,000. Implicit costs include her forgone earnings of 416,000 plus the forgone interest of $2,000 she could have earned had she invested the $20,000 of savings at 10%.

b. $23,000

c. Economic profit = - $7,000. Accounting profit = $25,000. She should farm.

d. Economic profit = - $3,000 (i.e., a $3,000 loss). Accounting profit = $15,000. She should not farm.

Old Fud owns a jewelry store. He didn’t raise his prices on the diamonds he bought last year even though diamond prices have since doubled. He says: “I’m still making a profit at my old price.” Is Old Fud right?

• Old Fud is wrong. He is ignoring the higher opportunity costs of diamonds.

Between two towns, one can (a) fly at a cost of $100 taking one hour, or (b) take a bus at $50, which takes five hours. Why are business men and women more likely to choose (a) while relatively more students will choose (b)?

• Businessmen and women usually have a higher opportunity cost of time than students and so are more likely to find flying cheaper. For example, if the opportunity cost of time is $20 an hour, the plane’s cost is $120 while the bus’s cost is $150.

Consider the cost curves of a trucking firm.

a. Suppose there is an increase in the price of gasoline. How will each of these cost curves shift up (if they shift at all): MC, ATC, AVC, AFC?

b. Suppose the cost of incorporating and setting up a trucking business goes up. How will each of the above cost curves shift?

a. MC, AVC, and ATC will shift up. AFC will be unchanged.

b. AFC and ATC will shift up. MC and AVC will be unchanged.

Suppose a firm’s production process can be characterized as having economies of scale. If so, when output doubles, what happens to total cost? To ATC?

• Total costs will less than double, such that ATC falls.

Copyright 2008 by Sujanto Rusli
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COST AND OUTPUT : PART ONE

RELATED CONCEPTS:|ACCOUNTING PROFIT |AVERAGE VARIABLE, FIXED, AND TOTAL COSTS |CONSTANT RETURN TO SCALE |DISECONOMIES OF SCALE |ECONOMIC PROFIT |ECONOMIES OF SCALE |EXPLICIT COSTS |IMPLICIT COSTS |LAW OF DIMINISHING MARGINAL RETURNS |LONG AND SHORT RUN |LONG-RUN AVEAGE COST|MARGINAL COST |MARGINAL PHYSICAL PRODUCT |TOTAL COST |TOTAL FIXED COSTS |TOTAL VARIABLE COSTS |.

Why are average costs lowest in the long run?

• Because the firm can then select the scale of plant and the amount of equipment that is most efficient for each level of output.

What is happening to the marginal productivity of workers as marginal costs fall?

• MPP is increasing, meaning it takes less labor units to produce each unit of output.

Why do marginal costs rise?

• Because MPP increases due to the law of diminishing marginal returns, each added unit of output requires more labor units to produce and so, a higher marginal cost.

Is the law of diminishing marginal returns true when all inputs are increased together?

• No. It holds true only when some inputs are not increased.

How is the total variable cost curve derived from the marginal cost curve?

• TVC is the sum of the MCs.

How is the total cost curve derived from the total variable cost curve?

• TC is derived by adding fixed costs to TVC.

When MC less than AVC, how will AVC change when output is increased?

• AVC will fall.

How is MC related to AVC and ATC at their respective minimum values?

• MC = AVC at AVC’s minimum. MC = ATC at ATC’s minimum.

Why does the ATC fall when the firm is experiencing economies of scale?

• ATC falls since each added unit of output costs less since less added inputs are needed to produce it.

Why would a firm be better off not producing when its economics profits are negative?

• Because then it would be better off investing its time and capital elsewhere. Total costs equal the opportunity cost (i.e., the forgone revenues) of the best alternative. If the firm earns less, it’s better off with the alternative.

Copyright 2008 by Sujanto Rusli
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THE THEORY OF DEMAND: PART TWO

RELATED CONCEPTS:|CONSUMER SURPLUS |GIFFEN PARADOX |INCOME EFFECT |LAW OF DIMINISHING MARGINAL UTILITY |LAW OF EQUAL MARGINAL UTILITY |PER DOLLAR |MARGINAL UTILITY |SUBSTITUTION EFFECT |TOTAL UTILITY |.

For Bill, clothing has marginal utility of 20 utils and food has a marginal utility of 20 utils. If clothing costs $4 and food $8, is Bill doing the best he can? If not, what can he do to increase his utility?

• MU/P for clothing is 5, for food 2.5. Bill should buy more clothing and less food.

Suppose food costs $12 and clothing costs $2, and at the highest level of utility, clothing has a marginal utility of 6 utils. What is the marginal utility of food?

• From the equality of MU/P, MUf/$12 = 6 utils/$2. MUf = 36 utils

If you are taking a test that has several questions, how should you allocate your time among the questions in order to get the highest score?

• You should allocate your time so that the last minute spent on each question adds the same number of points to your total score.

Mary buys a Cadillac instead of a Chevrolet. The Cadillac costs exactly twice as much as the Chevrolet. What can we conclude about Mary’s marginal utility of owning a Cadillac relative to owning a Chevrolet?

• For Mary, the marginal utility of owning a Cadillac must be twice as high, or higher, as the marginal utility of owning a Chevrolet.

What is wrong with the following statement: “According to the law of diminishing marginal utility, if you consume less food, the marginal utility you receive from the last unit of food goes up. So you will have greater total utility from consuming less food.”

• As one less unit of food is consumed, total utility decreases by the unit’s marginal utility. As less food is consumed, the law of diminishing marginal utility states that this loss in total utility becomes bigger.

Bill is maximizing his utility. He is consuming (among other goods) beer, which costs $1 a can, and pretzels, which cost $50 a bag. Which good has the higher marginal utility? What is the ratio of his marginal utilities?

• The MU of a can of beer will be twice the MU of a bag of pretzels (the ratio of marginal utilities equaling the ratio of prices).

Suppose the government taxed food and either (1) gave the tax revenues back to Americans in the form of reduced income taxes or (2) gave the tax revenues to a foreign government. In which case (1) or (2) will the demand for food go down more? (Food is a normal good).

• In case (2), because the loss in real U.S. income is greater, so the income effect reduces food demand more.

Mary has $12 to spend. She buys two beers (which cost $3 each) and three bowls of chili (which cost $2 each). Then the price of beer falls to $2 and chili’s price goes up $3. How will Mary change her consumption of beer and chili? Does this event reflect a substitution effect, an income effect, or both?

• Mary will buy more beer and less chili. Since she could have bought her old quantities at the new prices, her real income has not changed. So this event reflects the substitution effect onl

Copyright 2008 by Sujanto Rusli
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THE THEORY OF DEMAND: PART ONE

RELATED CONCEPTS:|CONSUMER SURPLUS |GIFFEN PARADOX |INCOME EFFECT |LAW OF DIMINISHING MARGINAL UTILITY |LAW OF EQUAL MARGINAL UTILITY |PER DOLLAR |MARGINAL UTILITY |SUBSTITUTION EFFECT |TOTAL UTILITY |.

Why do we add consumers’ demand curves together horizontally to get the market demand curve?

• Because economists want to sum the amounts consumers will buy at each price.

How are total utility and marginal utility related?

• Marginal utility is the addition to total utility when one more unit of a good is consumed.

Does a good with a higher total utility also have a higher marginal utility?

• The total utility and marginal utility of differing goods need not be related. Water, for example, has a high total utility but a small marginal utility.

What happens to total utility as marginal utility diminishes (as one consumes more of a good)?

• As long as marginal utility is positive, when more of a good is consumed, total utility increases.

If the marginal utilities per dollar of two goods are not the same, why will consumers change their consumption pattern?

• Because consumers will be better off by consuming more of the good that has the higher marginal utility per dollar. By doing this, they will be gaining more utils per dollar than they are giving up.

What is the substitution effect of a price increase?

• The substitution effect is the decrease in the quantity demanded of a good that results when the good’s relative price goes up (holding the consumer’s real income constant).

What is the income effect of a price increase? How does it differ for normal and inferior goods?

• The income effect of a price increase is the change in the quantity demanded due to the decrease in real income caused by the price increase. For a normal good, the quantity demanded falls; for an inferior good, it rises.

Is the marginal utility of a candy bar greater to a poor person or a rich person?

• Since utility between persons cannot be objectively compared, it is impossible to say.

Bill has spent $300 for a video recorder. He would have been willing to pay $500. What is his consumer surplus?

• $200 ($500 - $300) is Bill’s consumer surplus.

Even if consumers could still consume the same goods they have been consuming, why will a change in relative prices cause them to change their consumption pattern?

• Those goods whose price fell will now have a higher marginal utility per dollar: Consumers will demand more of these goods.

Copyright 2008 by Sujanto Rusli
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ELASTICITY : PART TWO

RELATED CONCEPTS :|PRICE ELASTICITY OF DEMAND |ELASTIC, INELASTIC, UNIT ELASTIC |TOTAL REVENUE |INCOME ELASTICITY OF DEMAND |NORMAL GOODS, INFERIOR GOODS |CROSS ELASTICITY OF DEMAND |SUBSTITUTES |COMPLEMENTS |PRICE ELASTICITY OF SUPPLY |

a. Compare the effect of a $1,000 tax on cars with the effect of a 10% tax on cars. Which tax is likely to have the same impact on the demand for cars (in percentage terms) no matter which year it was imposed?
b. What does your answer imply about the relative advantages of using slopes or elasticities to predict the impact of a price change?

• a. Due to inflation, the $1,000 represents a smaller percentage of car prices over time. When cars were sold for $2,000, the $1,000 in added price meant car prices would go up 50%: we’d expect a huge decrease in demand. When cars sell for $10,000, this is only a 10% increase in price: we expect a smaller decrease in demand. On the other hand, the 10% tax would probably have a similar impact if imposed today or 30 years ago.

• b. Inflation does not harm the usefulness of elasticities; this is one reason why economists use them.

a. When the wheat harvest falls by 10% due to bad weather, wheat prices go up 40%. What is the price elasticity of demand for wheat?
b. Using this number, what will happen to the wheat bought by consumers if the government raises the price of wheat by 20%? What happens to the total revenue of wheat farmers?
c. Still using the elasticity from (a) above, what will happen to the price of wheat if the government destroys 10% of the crop? To the total revenues of wheat farmers?

• a. o.25 (10%/40%).

• b. It will decrease by 5% (-.25x 20%). Total revenues will rise 15% [(1-.25)x 20%]

• c. Price will go up 40%. (105/.25); total expenditures on wheat will go up 30%.

Why will tourists likely have a more inelastic demand curve for restaurant food than will “locals”?

• Tourists have little time to price shop among substitute restaurants, so their demand curve for any one restaurant is likely to be more inelastic. Tourists also lack the substitute of home-cooked meals.

Why do merchants often have sales (and cut their prices) on air-conditioners in spring and early summer when demand is highest?

• In spring and early summer, more people are seeking to buy air-conditioners. This makes the advertising cost per customer lower. With more merchants advertising, customers can more easily price shop. So merchants face a more elastic demand curve for their air-conditioners. This leads them to cut prices (to increase their total revenues), causing sales to occur at these times.

Select from each of these groups the good that is likely to have the highest price elasticity of demand :
Group A : Energy, oil, gasoline, Shell Gasoline, Bill’s Shell Station gas.
Group B : The gasoline bought by truckers, the gasoline bought by week-end drivers.
Group C : Gas bought from Joe, who has no competitors, gas bought from Bill, who has many competitors.
Group D : Eyeglasses from Sid’s Glass Emporium in a state that does not permit advertising, eyeglasses from the same store in a state that does permit advertising.

• a. Bill’s Shell Station gas.

• b. The gasoline bought by truckers (they have more incentive to price-shop).

• c. Bill.

• d. The store in the state that permits advertising.

When Titantown Bus Company raised its bus fare, its local revenues fell. When Petrogard Bus Company raised its bus fare, its total revenues went up. When can we conclude about the elasticity of demand for each company?

• Tintantown’s demand is elastic; Petrogard’s is inelastic.

Which of these groups do you expect to be complements and which do you expect to be substitutes? What is the likely sign of the cross elasticity of demand?
Group A : Tires and cars.
Group B : Buses and airplanes.
Group C : Coal and oil.
Group D : Hot dogs and hamburgers.

• Group A : Complements (negative).

• Group B : Substitutes (positive).

• Group C : Substitutes (positive).

• Group D : Substitutes (positive).

You are president of the American Bicycle Federation and you have been asked to predict how the

sale of American bicycles will do next year (giving the percent change from this year’s sales). Give

your answer using the following facts:

1. The price elasticity of demand for American bicycles is 2.5

2. Their income elasticity is 3.0

3. The cross elasticity of demand with foreign bikes is 4.0

4. American bikes will go up 5% in price, foreign bikes will go up 7% in price, and American income will go up 3%

What will happen to the total expenditures of Americans on American bicycles (which equals the total revenues of the American bicycle makers)?

• We sum the effect of price, foreign bike prices, and income: (-2.5x5)+(4x7)+(3x3)= 24.9%. With 24.9% more bikes sold at a 5% higher price, total expenditures will be up (by approximately the percent change) in quantity plus the percent change in price, or 29.9%).

As people earn more income, their food purchases go up but their share of income spent on food goes down. What can we conclude about the income elasticity of food demand?

• The income elasticity is positive (since food purchases went up) but less than unity (since food’s share of income went down).

Copyright 2008 by Sujanto Rusli
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ELASTICITY : PART ONE

RELATED CONCEPTS :|PRICE ELASTICITY OF DEMAND |ELASTIC, INELASTIC, UNIT ELASTIC |TOTAL REVENUE |INCOME ELASTICITY OF DEMAND |NORMAL GOODS, INFERIOR GOODS |CROSS ELASTICITY OF DEMAND |SUBSTITUTES |COMPLEMENTS |PRICE ELASTICITY OF SUPPLY |

When economists say that the price elasticity of demand for bananas is 2.0, what do they mean?

• They mean that the quantity demanded will increase 2% for every 1% decrease in price.

If consumers of a good are very sensitive to its price, is the good’s demand elastic or inelastic?

• Elastic.

If the output demanded is the same regardless of the price, what is the price elasticity of demand?

• It is perfectly inelastic.

If one demand curve has a steeper slope than another, is the steeper demand curve more inelastic?

• You cannot tell unless the two curves cross. At the crossing point, the steeper curve is the more inelastic.

What is the main factor that increases the elasticity of demand for a good?

• The greater availability of substitutes.

When will total revenue go up in the price is reduced?

• When the good’s demand is elastic.

If the income elasticity of demand for a good is greater than 1, what will happen to the demand for the good and to the good’s share of people’s income when income goes up?

• As income goes up, the quantity demanded will go up and the good’s share in income will go up.

How can one tell if two goods are substitutes? Complements?

• Two goods are substitutes if when the price of one goes up, the demand for the other also goes up. Two goods are complements if when the price of one goes up, the demand for the other goes down.

Will firms produce where total revenues are highest?

• No. Firms will produce where profits are highest.

If the demand for a good goes up, what will be the immediate supply response? The longer-term supply response?

• The immediate supply response will be a small increase in supply (or perhaps no increase). But given time, suppliers will increase the quantity supplied.

Copyright 2008 by Sujanto Rusli
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THE RATIONAL EXPECTATION THEORY : PART TWO

RELATED CONCEPTS :|RANDOM ERRORS |RATIONAL EXPECTATIONS |REAL BUSINESS CYCLE THEORY |SYTEMATIC ERRORS |

If a baseball player has a 300 batting average, why is it unbiased to predict that for every ten times at bat, he or she should have three hits? Why is predicting four hits (out of ten) a biased prediction?

• The forecast of three hits out of ten times at bat is unbiased in the sense that on average it will be right. Sometimes, the baseball player will hit more, sometimes less. Predicting four hits will be right some of the time, but more often it will be too high. So it is biased.

Suppose the Fed announces: “We are not going to increase the money supply” and then surprises everyone by increasing it by 20%. What will happen? If the Fed does this ten times in a row, what will happen the eleventh time?

• The first time this occurs, people will not anticipate the increase in the money supply; Output will increase in the short run. But by the eleventh time, people will anticipate the increase in the money supply, so in the short and long run, only prices will increases. Real output will be unaffected.

Continuing the above question, what will happen the twelfth time the Fed announces: “ We are not going to increase the money supply” if it actually does not increase the money supply that time?

• People will expect prices to rise, so the AS curve will shift up. But the AD curve will be unchanged. So output will fall and prices will rise (there will be a cost-push stagflation). In the long run, output and prices will return to their original levels.

What is wrong with the following theory: “To get elected, the party in power stimulates the economy just before the election. So we can expect an economic expansion during an election year.”

• Over time, people will come to expect this event, and any attempted expansion before an election will just raise prices.

When will an unanticipated decrease in the money-supply growth to 2% likely cause a bigger reduction in output:

a. After a long period of a steady monetary growth of 10%, or

b. After period when money supply on average grew 10% but grew faster and slower at various times.

After (a). After (b), prices will be more flexible, so a decrease in price will have less effect. The Great Depression followed a decade of stable prices, which may explain why it took such a long time for the economy to return to full employment.

When can the government reduce inflation without causing a recession?

• If the public expects inflation to fall, the government can reduce inflation without reducing output (both the AD and AS curve will shift down the long-run aggregate supply curve together). For example, after World War I, Germany was able to go from a 100% inflation rate per day to stable prices without a recession mainly because the public had confidence in the promises of the German leaders to stop inflation.

Does everybody have to have “rational expectations” for the rational expectations model to work?

• No. For example, suppose there is an increase in the growth rate of the money supply that good economic models have anticipated. If enough people hiring workers and making investment decisions have this good forecast, their competition will raise wages and nominal interest rates to reflect the higher rate of inflation. So even if workers and savers don’t know what is going on, the economy will have the rational-expectations results.

Copyright 2008 by Sujanto Rusli
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THE RATIONAL EXPECTATION THEORY : PART ONE

RELATED CONCEPTS:|RANDOM ERRORS |RATIONAL EXPECTATIONS | REAL BUSINESS CYCLE THEORY |SYSTEMATIC ERRORS |

Suppose you have the price level forecasts that business leaders have made in the past. How can you tell whether their forecasts are unbiased and without systematic error?

• First, find out whether the forecasts were correct on average. Then find out whether the errors were systematic (i.e., whether mistakes were repeated).

Why don’t rational-expectations economists expect people to make systematic errors in their forecasts?

• A person making systematic errors is making the same costly mistake again and again. If people are rational, they will avoid past errors.

If forecast errors are random, can one predict when a recession is going to occur?

• Only recessions that are due to real causes (such as an OPEC oil price increase) can be predicted. Those that are due to unanticipated shifts in the AD curve cannot, by definition, be anticipated.

Why do workers supply more labor in response to an unanticipated increase in inflation?

• When firms offer workers higher money wages and ask them to work more, workers accept since they think they are getting higher real wages (but in fact inflation will reduce their real wages).

Why will workers supply no more labor in response to an anticipated increase in inflation?

• When workers correctly anticipate inflation, they adjust their wages such that they supply the labor they want and no more.

Why can’t the government stimulate the economy when it is in a recession?

• According to rational-expectations theory, government cannot systematically trick workers and suppliers into producing more, and in particular, it cannot systematically do this whenever the economy is in a recession (since its actions can then be anticipated).

How will an unanticipated expansionary fiscal and monetary policy affect the economy?

• It will increase output in the short run, because aggregate demand will shift right and the aggregate supply curve will not shift.

If firms know the price of their output is going up because people have changed their tastes and increased their demand for firms’ output (this being a real shock), how will firms change their output?

• A change in taste that increases the demand for a good means first, that people are willing to pay more in real terms for the good, and second, that the factors that produced the goods now out of favor are now available to be hired. So the firms will produce more, knowing costs won’t rise to offset their profits from producing more.

If firms know the price increase is due to a nominal shock, how will they change output?

• If the increase in price is only nominal, there are no new available factors from out-of-favor goods. So costs will rise to offset the output’s higher price. Firms will raise their price, not their output.

How can an active discretionary ppgovernmental policy that is designed to increase output actually reduce output in the long run?

• An active discretionary policy adds uncertainty to the economy and reduces the responsiveness of firms to all price changes, whether they are due to real or nominal shocks.

Copyright 2008 by Sujanto Rusli
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INFLATION AND UNEMPLOYMENT : PART TWO

RELATED CONCEPTS:|ACCELATIONIST THEORY | COLD TURKEY AND GRADUALISM |DEMAND-PULL AND COST-PUSH INFLATION |EXPECTED RATE OF INFLATION |LONG-RUN PHILLIPS CURVE |NATURAL RATE OF UNEMPLOYMENT |PHILLIPS CURVE |TAX-BASED INCOME POLICY (TIP) |

Use the following Phillips Curve schedule and answer the following questions.

Inflation Rate : 20 14 10 8 7 6.5
Unemployment Rate : 3 4 5 6 7 8
a. If natural rate of unemployment is 6%, what is the expected rate of inflation?
b. If inflation falls from 8% to 7%, what will happen to unemployment (if expectations about inflation don’t change).

a. 8%.
b. Unemployment will rise to 7%.

Workers expect inflation to be 20% and the economy is fully employed. Then the Fed acts to reduce the inflation rate to 10%. What will happen in the short run? In the long run?

• Workers will contract for 20% higher wages, but when prices only go up 10%, employers will find they are paying higher real wage and so will cut back employment. The economy will go into a recession (as AD shifts left). In the long run, both unemployment and lower prices will cause workers to adjust their wages down, so the economy will return to full employment (shifting the AS curve right).

What phase of the business cycle (the demand push or the cost pull phase of an
expansion or recession0 is economy in when these statements are made?
a. “Unions have negotiated for lower wages so as to retain their jobs.”
b. “Unemployment has fallen dramatically as inflation has accelerated.”
c. “Firms have been forced by recent wage hikes to raise their prices and produce less.”

a. Cost-push phase of a recession.
b. Demand-pull phase of an expansion.
c. Cost-push phase of an expansion.

Wage inflation is related to expected inflation by the following equation:
Percent change in Wages = Expected rate of Inflation + Percent change in Productivity
If expected inflation is 10% and productivity increases by 2%, how much will wages change?

• Wages will go up 12%.

“Changes in employment and output are caused by how wages and prices change relative to each other.” Explain.

• When wages (W) rise more quickly than prices (P), real wages (W/P) are increasing and employment will fall (holding technology) and capital constant). When wages rise more slowly than prices, real wages are decreasing, and employment will rise.

Suppose you own International Widget Works. How could you evade wage and price controls before and after they are enacted?

• The trick is to increase your widget price before controls are imposed (since you would not be permitted to increase them after) but also to not lose customers because of your higher price. So you raise your price but offer “special” discounts to your customers (such as coupons, special credit terms, and special volume discounts). Once controls are imposed you can raise your effective price by cutting back on these discounts. If this is not enough, have your customers pay for some of your costs by picking up the product themselves. Have very strict credit terms or even demand cash in advance for widgets. Have many grades of quality, each with its own price, so you can push up your effective price by reducing the quality in each grade. If your product is in high demand, insist that your customers buy something else from you (at an inflated price) before they can get widget.

How could wage and price controls appear to be holding down inflation when in fact they are not?

• If many firms employ the tactics described in the above question, reported prices will not rise. But the effective price of goods will. So inflation will not be stopped. Note that by evading wage and price controls, firms are actually serving the customers, for otherwise there would be shortages of goods and less output.

Copyright 2008 Sujanto Rusli
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INFLATION AND UNEMPLOYMENT : PART ONE

RELATED CONCEPTS:|ACCELERATIONIST THEORY | COLD TURKEY AND GRADUALISM |DEMAND-PULL AND COST-PUSH INFLATION |EXPECTED RATE OF INFLATION | LONG-RUN PHILLIPS CURVE | NATURAL RATE OF UNEMPLOYMENT |PHILLIPS CURVE | TAX-BASED INCOME POLICY (TIP) |

How can you tell what the expected price level is by looking at the AD/AS diagram?

• The expected price level is where the AS curve intersects the long-run aggregate supply curve (i.e., at full employment).

How can you tell what the expected rate of inflation is by looking at the Phillips Curve?

• The expected inflation rate is where the Phillips Curve intersects the long-run Phillips Curve (at the natural rate of unemployment).

Along a Phillips Curve, how are inflation, unemployment, and output related? What is being held constant?

• More inflation means less unemployment and so more output. The AS curve and the expected rate of inflation are held constant along the Phillips Curve.

In what sense are workers “fooled” by inflation?

• Workers set their wages based upon what they think the price level will be. But if inflation is greater than they expected, they will have been “fooled” into accepting a lower real wage than they wanted.

How will the economy eventually get to the price level where the AD curve intersects the long-run aggregate supply curve?

• If output differs from the full-employment level of output, workers will adjust their expectations and wages so the AS curve shifts the economy along the AD curve towards full employment.

Will a higher rate of inflation always reduce unemployment?

• No. Inflation reduces unemployment only if inflation is higher than expected. If it’s lower than expected, unemployment will go up.

What happens to the Phillips Curve when people expect higher rates of inflation?

• If people expect higher rates of inflation, they will demand higher wages and raise other factor costs. The Phillips Curve and the AS curve will shift up.

Why must inflation accelerate in order to reduce unemployment below its natural rate?

• Because if inflation doesn’t accelerate, the expected rate of inflation will catch up with the actual rate, returning unemployment to its natural level.

What rate of unemployment and what output level can be sustained in the long run?

• Only the natural rate of unemployment and the full-employment level of output can be sustained in the long run.

If wage and price controls worked, how could they help speed the recovery of an economy?

• Wage and price controls could speed the recovery of an economy if they corrected the mistaken judgment of people as to how high prices and inflation will be. This would cause the AS curve to shift more quickly towards full employment.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

MONEY AND AGGREGATE DEMAND - THE MONETARIST MODEL : PART TWO

Using the quantity theory, how will the following events affect the money supply, V, and nominal income (or $GNP)?

Event A: Because of widespread bank failures, the public increases its cash holdings.
Event B: Credit cards become widely used.
Event C: The money supply is reduced.
Event D: The nominal interest rate rises.

Event A: MS down, V down, $GNP down. (This happened in the Great Depression). Note that the change in $GNP is also the change in aggregate demand.
Event B: MS unchanged, V up, $GNP up.
Event C: MS down, V unchanged, $GNP down.
Event D: MS unchanged, V up, $GNP up.

If the money demand equals 5% of income, the money supply is $60, and real GNP is 1,000 units of output, what will the price level be? What will the price level be if the money supply is $120? What happens to nominal income? To real money holdings?

• P = MS/kQ. K is 0.05 and V= 20. In the first case, P equals $1.20. In the second case, $2.40. $GNP equals V times MS, increasing from $1,200 to $2,400. Note that P also equals $GNP/Q. The real money supply (MS/P) equals 5% of real income or $50 (in real dollars). In the first case, it’s $60/1.20, in the second, $120/2.40.

An economic forecaster predicts that output will grow by 4% next year, the money supply will grow at 10%, and V will follow its historical pattern of growing at 3% per year. What will be the predicted rate of inflation?

• 9% (10% + 3% - 4%).

A small country produces 5,000 units of output and has a money supply of $2,000. Its citizens want to hold 10% of their income in money (k = 0.10).
a. What are V, $GNP, P, and the real money supply (MS/P).
b. If the money supply doubles to $4,000 but real output and V stay the same, what will $GNP, P, and the real money supply be?

a. V= 10. $GNP = $20,000. P=$4.00 MS/P =500.
b. $GNP = $40,000. P= $ 8.00. MS/P = 500.

Suppose you believe that over the next thirty years V will increase by 2% annually, output will grow at 3% per year, and the money supply will grow at 9% per year. Would you invest in a thirty-year bond paying 10% if you want a real return of 6%?

• You should believe that inflation will be 8%. The real rate of interest on the bond will only be 2%. You should not buy the bond.

Show with and AD and AS diagram how a decrease in the money supply can cause a recession and how the economy can recover on its own.

• A fall in the money supply reduces $GNP and shifts the AD curve left. In the short run, the short-run AS curve remains unchanged, so prices and output will fall as the economy sinks into a recession. In the long run, the AS curve will shift down as wages fall. This will reduce prices further and shift the economy to the right along the new AD curve to full employment.

Assume that V is constant. Assume the money supply is growing at 10% and output at 3%. The real rate of interest is 5%. What is the nominal rate of interest?
What will happen to interest rates, real and nominal, if the money-supply growth rate drops to 4% and the public has fully anticipated this event?

• Inflation will be 7%. The nominal interest rate will be 12% (5%+7%). If money supply growth falls to 4%, inflation will fall to 1%. The nominal interest rates will fall to 6% (5%+1%). The real interest rate will still be 5%.

In a small country, MS = $300, V= 10, and Q= 1,500.
a. What is P?
b. If MS falls to $250 and the price level does not change, what will happen to Q?
c. If 1,500 is the full-employment level of output, what will P be in the long run?

a. P= $2.00
b. Q= $1,250 (i.e., the economy is in recession).
c. P=$1.67 (when prices fall, the economy returns to full employment).

In terms of the quantity theory, how could unions raise the rate of inflation? Could a 10% inflation rate be explained by union activity?

• Unions do not affect the money supply or V. So they can affect inflation only by reducing output growth. To increase inflation by 1%, they must reduce output growth by 1%. To cause a 10% rate of inflation, they would have to reduce national output by 10%. Unions have never been observed causing output to fall this drastically; They cannot be a major cause of inflation.

Can higher oil prices cause inflation?

• Higher oil prices will not affect the money supply or V. So they affect inflation only by reducing output growth. Some economists estimated that output grew about 1% to 2% slower for several years because of the oil price increases in the ‘70s. Thus, higher oil prices added only 1% to 2% to the inflation rate. So why did our economy have such a high inflation rate (12%) when oil prices went up? Because the Fed dramatically increased the growth rate of the money supply. In Germany and Japan, the inflation rates were low and almost unaffected by the higher oil prices, because the money growth rate was kept low.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com