Topic&7(&Introduction&to&Economic&Fluctuations&&

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1. Explain*the*following*components*of*LEI*index:*
a. Average*workweek*in*manufacturing*
b. Index*of*stock*prices*
c. Index*of*consumer*expectations*
d. M2*
*
See#page#279#in#Mankiw.#
*
2. Explain* the* slope* of* the* aggregate* demand* (AD)* curve* using* the* quantity*
theory*equation.*
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Quantity#theory#says#M#x#V=#P#x#Y.#In#the#short#run,#both#M#and#V#are#constant.#
So# if# P# increases,# Y# has# to# decrease# to# make# the# equation# hold.# That# means# P#
and#Y#are#negatively#related.#Hence,#the#AD#curve#is#downward#sloping.##
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3. Suppose*that*the*government*reduces*the*money*supply*to*reduce*inflation.*
Using*graphs,*illustrate*the*impact*of*this*policy*on*output*and*inflation*both*
in* the* shortJrun* and* in* the* long* run.* State* what* would* happen* to*
unemployment.**
*

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If#the#government#reduces#the#money#supply,#AD#curve#would#shift#left#and#the#
shortKrun#equilibrium#is#given#by#point#B.#So#in#the#short#run#output#falls#to#Y2,#
but#price#level#remains#stuck#at# P .##In#the#long#run,#however,#price#level#adjusts#
in# response# to# a# fall# in# demand.# Therefore# over# time# the# economy# moves# to#
point# C# where# the# equilibrium# output# is# back# to# its# natural# level# (or# full#
employment# level)# and# price# level# is# lower# which# implies# there# is# deflation# in#
the#long#run.#
*
4. Read* the* case* study* titled* A* Monetary* Lesson* from* French* History* from*
Chapter* 10* (Mankiw).* Was* the* government* successful* in* its* goal* to* reduce*
inflation?*Why*was*the*government*successful/unsuccessful?**

*
In#1724,#the#French#government#sought#to#reduce#the#price#level#in#the#economy#
to#what#the#government#considered#an#appropriate#level.#Therefore#it#reduced#
the# nominal# value# of# the# money# stock# by# 45%.# This# has# the# same# effect# as#
decreasing#the#money#supply.#It#turned#out#that#the#prices#and#wages#did#fall,#
but# not# by# the# full# 45# percent.# However,# the# fall# in# the# price# level# was# not#
instantaneous,#rather#it#took#some#time.#The#government#was#successful#in#its#
plan#to#reduce#inflation#but#that#happened#at#the#cost#of#a#severe#recession.#The#
lesson# you# should# take# from# this# caseKstudy# is,# reducing# inflation# is# a# painful#
process#as#it#often#is#associated#with#a#fall#in#output#(i.e.#recession)#too.*
5. Suppose* there* is* an* exogenous* increase* in* the* velocity* of* money.* Show*
graphically*what*would*happen*to*output*and*inflation*in*the*shortJrun*and*
in*the*long*run.*Also*mention*what*would*happen*to*unemployment.*
*
If# the# money# supply# is# held# constant,# an# increase# in# V# means# people# will# be#
using#their#money#in#more#transactions.#In#other#words,#demand#for#real#money#
balances# (M/P)# will# decrease.# But# if# the# Fed# holds# M# constant,# then# P# has# to#
increase#to#make#sure#that#M/P#falls.#Thus,#the#decrease#in#real#money#demand#
causes# an# increase# in# the# value# of# P# associated# with# each# Y# and# the# AD# curve#
shifts#upward.#Therefore,#the#resultant#graph#should#look#like#the#one#drawn#in#
question#9.#There#you#can#see#that#because#equilibrium#output#falls#in#the#shortK
run,#according#to#Okuns#law#unemployment#increases.#*
6. Suppose* workers* have* unionized* and* have* bid* up* their* wages.* Explain*
graphically* the* impact* of* this* event* on* output* and* inflation.* What* sort* of*
stabilization*policy*would*you*suggest*to*restore*the*economy?*
*
This# event# is# an# example# of# a# negative# supply# shock.# A# negative# supply# shock#
shifts#the#aggregate#supply#curve#upward,#decreases#output#and#raises#the#price#
level#in#the#shortKrun#(refer#to#point#B).#However,#in#the#long#run#the#economy#
can# automatically# come# back# to# the# initial# equilibrium# point# A# without# any#
government#intervention.#Refer#to#the#following#figure:#
*

*
If#the#government#does#not#want#to#wait#until#the#output#automatically#comes#
back#to#the#natural#level,#it#can#institute#a#stabilization#policy#by#increasing#the#
aggregate# demand# through# expansionary# monetary# policy# i.e.# increasing#
money#supply.#Refer#to#the#following#graph.#An#increase#in#money#supply#would#
shift# the# AD# curve# upward# so# that# the# economy# comes# to# point# C.# Hence# the#
output#is#back#to#its#natural#level#at#the#expense#of#higher#price#level# P2 .##
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