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?
The economy will experience deflation and a severe slump, causing inflation to spiral lower.
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Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and an estimate of the natural rate of unemployment (NROU). For the price index, adjust the units setting to “Percent Change From Year Ago.” For the unemployment rate, adjust the frequency setting to “Quarterly.” Select the data from through the most current data available, download the data, and plot all three variables on the same graph. Using your graph, identify periods of demand-pull or costpush movements in the inflation rate. Briefly explain your reasoning.
Assume that aggregate output is below the natural rate level. What would an activist policy recommend that the government do? Explain your answer.
In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a “soft patch” in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.
Why does the self-correcting mechanism stop working when the policy rate hits the zero lower bound?
Many developing countries suffer from endemic corruption. How does this help explain why these countries’ economies typically have high inflation and economic stagnation? Use a graph of aggregate demand and supply to demonstrate.
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