Question 1

Which of the following refers to the theory that people optimally use all available information when forecasting the future?

Accepted Answer

The theory that people optimally use all available information when forecasting the future is known as rational expectations theory.

Question 2

Suppose the Bank of Canada decreased the growth rate of the money supply. Which of the following would permanently decrease?

Accepted Answer

Decreasing the growth rate of the money supply would lead to a decrease in the inflation rate, but it would not necessarily permanently decrease the natural rate of unemployment. The natural rate of unemployment is influenced by a variety of factors, such as demographics, technology, and institutional arrangements, which are unlikely to be affected by changes in the growth rate of the money supply. However, a temporary decrease in the inflation rate might lead to a decrease in the nominal wage rate, which could reduce labor costs and stimulate employment in the short run.

Question 3

Proponents of rational expectations theory have argued that, in the most extreme case, if policymakers are credibly committed to reducing inflation, and rational people understand that commitment and quickly lower their inflation expectation, the sacrifice ratio could be as small as what?

Accepted Answer

Proponents of rational expectations theory argue that if policymakers are credible in their commitment to reducing inflation and people quickly adjust their expectations accordingly, there may not be any sacrifice ratio at all. This is because if people expect low inflation, they will act accordingly, and the need for harsh policies to reduce inflation will be minimized. Therefore, in the most extreme case, the sacrifice ratio could be 0.

Question 4

Suppose the Bank of Canada reduces inflation 2 percentage points, and this makes output fall 12 percentage points and unemployment rises 4 percentage points. What is the sacrifice ratio?

Accepted Answer

The sacrifice ratio is calculated as the loss in output divided by the reduction in inflation. Here, the output falls by 12 percentage points and inflation is reduced by 2 percentage points, so the sacrifice ratio is 12/2 = 6.

Question 5

Suppose the natural rate of unemployment is 4 percent. Then suppose that Parliament passes laws that make the labour market less flexible, so the natural rate of unemployment rises to 5 percent. If the sacrifice ratio is 3, how much higher must the inflation rate go in order to keep the unemployment rate at 4 percent in the long run?

Accepted Answer

In the long run, the unemployment rate cannot be kept below the natural rate without causing accelerating inflation. The natural rate of unemployment is determined by structural factors, and attempting to maintain a lower unemployment rate would require continuously increasing inflation.

Question 6

Which of the following best characterizes the theory of rational expectations?

Accepted Answer

The theory of rational expectations is based on the idea that people use all available information to form expectations about the future. This includes information about economic policies, market trends, and other relevant factors. The theory suggests that individuals make rational decisions based on these expectations, and that their actions can have a significant impact on the overall performance of the economy.

Question 7

Proponents of rational expectations theory have argued that the sacrifice ratio could be as small as what?

Accepted Answer

Proponents of rational expectations theory argue that the sacrifice ratio could be as small as zero because they believe that if people have rational expectations, they will adjust their behavior quickly in response to changes in policy. This means that there will be little or no output loss or unemployment in the short run, and therefore no sacrifice ratio.

Question 8

Suppose a central bank reduced inflation by 4 percentage points and that made output fall by 6 percentage points for three years, and it made the unemployment rate rise from 3 percent to 9 percent for three years. What is the sacrifice ratio?

Accepted Answer

The answer of Suppose a central bank reduced inflation by...

Question 9

If the sacrifice ratio is 3, reducing the inflation rate from 10 percent to 6 percent would require sacrificing what percent of annual output?

Accepted Answer

The sacrifice ratio is the percentage of annual output lost to reduce inflation by 1 percentage point. With a sacrifice ratio of 3, reducing inflation by 4 percentage points (from 10% to 6%) would require sacrificing 12% of annual output (3 x 4 = 12).

Question 10

Suppose that reducing inflation 3 percentage points would cost a country 12 percent of annual output. What is this country's sacrifice ratio?

Accepted Answer

Sacrifice ratio is calculated by dividing the percentage points of output sacrificed by the percentage point reduction in inflation. 
Sacrifice ratio = (Output sacrificed / % Reduction in inflation)
Here, reduction in inflation is 3 percentage points and output sacrificed is 12 percent. 
Sacrifice ratio = (12 / 3) = 4. Therefore, the sacrifice ratio of the country is 4. 
Hence, the answer is C.

Question 11

Which of the following best describes the sacrifice ratio for Canada?

Accepted Answer

The sacrifice ratio for Canada falls over a range of 2 to 5.

Question 12

The long-run response to a decrease in the growth rate of the money supply is shown by shifting which of the Phillips curves and in what direction?

Accepted Answer

The answer of The long-run response to a decrease in...

Question 13

Which of the following best defines the sacrifice ratio?

Accepted Answer

The sacrifice ratio is defined as the number of percentage points of annual output that a country must sacrifice (i.e. forego) for each percentage point reduction in inflation. It provides an estimate of the cost of reducing inflation to policymakers.

Question 14

Which of the following best defines disinflation?

Accepted Answer

Disinflation refers to a reduction in the rate of inflation, i.e., when the rate of price increases is decreasing over time. It is not a zero rate of inflation (A), a constant rate of inflation (B), or a negative rate of inflation (D), as it specifically refers to a slowing down of the rate of price increases.

Question 15

If the Bank of Canada announced a policy to reduce inflation and people found it credible, what would happen to the short-run Phillips curve and the sacrifice ratio?

Accepted Answer

If the Bank of Canada's policy to reduce inflation is credible, people will adjust their inflation expectations downward. This leads to a leftward shift in the short-run Phillips curve, as lower inflation expectations reduce wage and price pressures. The sacrifice ratio, which measures the cost of reducing inflation in terms of lost output, would fall because the credible policy reduces the need for high unemployment to fight inflation.

Question 16

Ultimately, what causes the short-run reduction in unemployment associated with an increase in inflation?

Accepted Answer

Unanticipated inflation can temporarily lower unemployment by providing an illusion of higher real wages to workers, leading to increased labor supply and lower unemployment in the short run. However, this effect is only temporary and the long-run Phillips curve is not affected by changes in the rate of inflation. The other options (A, C, D) do not explain the short-run reduction in unemployment associated with an increase in inflation.

Question 17

Suppose an economy with high inflation decides to decrease the money supply growth rate. Which of the following best describes the results?

Accepted Answer

When an economy with high inflation decides to decrease the money supply growth rate, it typically leads to higher interest rates and reduced spending in the short term. This can cause an increase in unemployment as businesses adjust to the decreased demand. Over time, as inflation expectations adjust downward, the short-run Phillips curve, which illustrates the trade-off between inflation and unemployment, shifts to the left, indicating lower inflation at each level of unemployment.

Question 18

If the sacrifice ratio is 3, reducing the inflation rate from 10 percent to 8 percent would require sacrificing how much annual output?

Accepted Answer

The sacrifice ratio is the percentage of short-run output lost when inflation decreases by one percentage point. In this case, the sacrifice ratio is 3. Therefore, to reduce inflation from 10 percent to 8 percent, we need to sacrifice 2 percentage points of inflation. Since the sacrifice ratio is 3, the sacrifice in terms of annual output would be 2 times the sacrifice ratio, which is 6 percent of annual output. Therefore, the best choice is B, which is 6 percent of annual output.

Question 19

Suppose that monetary policymakers announced that they were going to make a serious effort to fight inflation. A few years later the inflation rate has been reduced, but there had also been a serious recession. Which of the following could we conclude with certainty?

Accepted Answer

While we can conclude that the monetary policymakers were successful in reducing inflation, the occurrence of a serious recession alongside this outcome makes it difficult to draw any conclusions about the rational expectations theory or the credibility of the policymakers with certainty. Moreover, it is possible that other factors, such as external economic shocks, may have contributed to the recession, making it challenging to isolate the effects of the policymakers' actions on the economy. Therefore, no conclusive statement can be made without further analysis.

Question 20

What did proponents of rational expectations argue about the sacrifice ratio and why?

Accepted Answer

Proponents of rational expectations argued that the sacrifice ratio could be low because people might adjust their expectations quickly if they found anti-inflation policy credible. According to them, if people believed that the government was committed to reducing inflation, they would adjust their expectations accordingly, leading to lower sacrifice ratio.

Quiz 16: The Short-Run Tradeoff Between Inflation and Unemployment