Question

According to Phelps, since unemployment tends toward its natural rate the Inflation rate: Policy makers can achieve permanently higher inflation without permanently higher unemployment O Policy makers can achieve permanently lower inflation at the same level of unemployment O Policy makers can achieve permanently lower inflation without permanently lower unemployment O Policy makers can achieve permanently lower inflation without permanently higher unemployment in actual output According to the article, a negative shock to aggregate demand causes a decline in future inflation and a decline relative to its potential. Which of the following would be an appropriate policy response in order to stabilize prices? A contractionary fiscal policy to keep inflation from rising An expansionary monetary policy to keep inflation from rising An expansionary monetary policy to keep inflation from falling An expansionary fiscal policy to keep inflation from falling

Answer 1

According to the neoclassical model, policy makers cannot achieve permanently higher inflation without higher unemployment, nor can they achieve lower inflation at same level. In response to a negative shock to aggregate demand, an expansionary policy is an appropriate response to stabilize prices.

Step-by-step explanation:

According to the neoclassical model of economics, an expansionary monetary policy that shifts aggregate demand only creates inflationary increase in the price level, but does not affect GDP or unemployment. Therefore, policy makers cannot achieve permanently higher inflation without permanently higher unemployment, nor can they achieve permanently lower inflation at the same level of unemployment.

According to the article, a negative shock to aggregate demand causes a decline in future inflation and a decline relative to its potential. To stabilize prices in this scenario, an appropriate policy response would be an expansionary monetary policy to keep inflation from falling.

Answer 2

According to Phelps' neoclassical model, expansionary monetary policy does not change long-term unemployment but can temporarily increase inflation. Policymakers cannot achieve permanently lower inflation without a temporary effect on unemployment. To stabilize prices after a negative demand shock, an expansionary monetary policy should be used to prevent inflation from falling.

Explanation:

According to the neoclassical model of economics presented by Phelps, and which is generally accepted by many central bankers, expansionary monetary policy does not alter the natural rate of unemployment or real GDP in the long run. It merely leads to temporary higher inflation. Policymakers cannot achieve permanently higher or lower inflation without affecting unemployment in the short term, but in the long term, the economy tends toward its natural unemployment rate, and inflation expectations adjust accordingly. Therefore, policymakers cannot achieve permanently lower inflation without a temporary increase in unemployment.

When the economy receives a negative shock to aggregate demand, which would lead to lower future inflation and reduced output relative to potential, the appropriate policy response to stabilize prices would be an expansionary monetary policy to keep inflation from falling. This would involve measures such as reducing interest rates or increasing the money supply to shift aggregate demand to the right in the hope of moving the economy back towards its potential GDP.