Inflation and Total Factor Productivity Essay

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The Aggregate Demand and Supply Model, Part 2

A) Multiple Choice Questions

1. Suppose that the economy begins in general equilibrium. If there is now an increase in total factor productivity that raises the expected future marginal product of capital, then in the long-run, this would cause:
a. A decrease in the real interest rate.
b. An increase in the real interest rate.
c. No change in the real interest rate.
d. An indeterminate change in the real interest rate.

Answer: Increase in total factor productivity has two effects, both long-run and short-run effects. First, increase in total factor productivity will shift the LRAS curve to the right. Second, increase in total factor productivity implies a positive (favorable) supply shock for the present period and thus an immediate downward shift of the SRAS curve. Increase in expected future marginal product of capital means increase in autonomous planned investment, thus a right shift in the IS curve resulting in a right shift in AD curve. All these shifts will result in a higher potential level of output and a higher actual output level (but below new potential output) and an indeterminate change in inflation. If shift in aggregate demand is larger in magnitude we will have an increase in inflation, otherwise a decrease. Since change in inflation rate is indeterminate, so is the change in the real interest rate.

2. Suppose that there is a decline in both the unemployment rate and inflation. This could be caused by:
a. A positive aggregate demand shock and a positive short-run aggregate supply shock.
b. A positive aggregate demand shock and a negative short-run aggregate supply shock.
c. A negative aggregate demand shock and a negative short-run aggregate supply shock.
d. A negative aggregate demand shock and a negative long-run aggregate supply shock.

Answer: Decline in unemployment rate means increase in actual output. Make graphs for explanation. a) is a possible answer, if the magnitude of the shift of the SRAS curve is larger than the magnitude of the shift of the AD curve, we will see a short-run equilibrium where inflation is smaller and actual output is larger than in the initial economic situation.
Problem with other scenarios:
b) Inflation will increase independent of the magnitude of the shifts
c) Actual output will decrease independent of the magnitude of the shifts
d) Actual (and potential) output will decrease independent of the magnitude of the shifts

3. Suppose that a new technology provides faster and better matching between people seeking jobs and business firms seeking qualified workers. This would:
a. Shift both the short-run and long-run Phillips Curves to the left.
b. Shift both the short-run and long-run Phillips Curves to the right.
c. Shift the short-run Phillips Curve to the left and the long-run Phillips Curve to the right.
d. Shift the short-run Phillips Curve to the right and the long-run Phillips Curve to the left.

Answer: The better and faster matching means that the natural rate of unemployment declines. This will have two effects in the economy. Decrease in natural rate of unemployment implies that the labor market became more efficient as a result when decreases in period t, the LRPC curve will shift to the left and the LRAS curve will shift to the right. But this is not all what happens in the present period. In addition, the labor market became efficient not just in the long run but also already in period t and thus SRAS and SRPC curves will shift too. You can think of it the following way, this change in the natural rate of unemployment and increased efficiency in the labor market result in a positive supply shock in period t and thus the SRPC curve will shift down and to the left and the SRAS curve will shift down and to the right.

4. Suppose the central bank surprisingly and substantially reduces the real interest rate and that this drastic action leads to increased worries among households and
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