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Chapter 24: Q. 20 (page 655)

What will happen if policymakers erroneously believe that the natural rate of unemployment is 7% when it is actually 5% and therefore pursue stabilization policy?

Short Answer

Expert verified

The economy will experience deflation and a severe slump, causing inflation to spiral lower.

Step by step solution

01

Step 1. Introduction

The framework established by the central bank in order to accomplish economic growth and stabilise the country's economy is known as monetary policy.

02

Step 2. Explanation

When a stabilisation policy is adopted and the unemployment rate begins to decline, falling below 7%, policymakers choose a contractionary economic policy to avoid demand-pull inflation in the economy. As a result of policymakers' actions, the economy will contract, now in the midst of a recession. As a result, the economy will experience deflation and a severe slump, causing inflation to spiral lower.

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Most popular questions from this chapter

How can monetary authorities target any inflation rate they wish?

Suppose that welfare gains derived from eliminating output (and unemployment) fluctuations in the economy can be measured. Assuming these gains are relatively small for the average individual, how do you think this measurement would affect the activist/ nonactivist debate?

Assume that aggregate output is below the natural rate level. What would an activist policy recommend that the government do? Explain your answer.

The Problems update with real-time data in MyLab Economics and are available for practice or instructor assignment. 1. On January 19, 2017, the Federal Reserve released its amended statement on longer-run goals and monetary policy strategy. It stated: “The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate” and that “the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent.” Assume this statement implies that the natural rate of unemployment is believed to be 4.8%. Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), real GDP (GDPC1), and real potential gross domestic product (GDPPOT), an estimate of potential GDP. For the price index, adjust the units setting to “Percent Change From Year Ago.” Download the data into a spreadsheet.

  1. For the most recent four quarters of data available, calculate the average inflation gap using the 2% target referenced by the Fed. Calculate this value as the average of the inflation gaps over the four quarters.
  2. For the most recent four quarters of data available, calculate the average output gap using the GDP measure and the potential GDP estimate. Calculate the gap as the percentage deviation of output from the potential level of output. Calculate the average value over the most recent four quarters of data available.
  3. For the most recent 12 months of data available, calculate the average unemployment gap, using 5.6% as the presumed natural rate of unemployment. Based on your answers to parts (a) through (c), does the divine coincidence apply to the current economic situation? Why or why not? What does your answer imply about the sources of shocks that have impacted the current economy? Briefly explain.

How does the policy rate hitting a floor of zero lead to an upward-sloping aggregate demand curve?
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