Question 1

-In the above figure, if we start at AD1 and SRAS1, and the money supply increases unexpectedly, what would be the long-run equilibrium?

Accepted Answer

An unexpected increase in the money supply would initially shift the AD curve to the right (from AD1 to AD2), leading to a higher price level and output in the short run (moving from E1 to E2). However, in the long run, as prices and wages adjust, the SRAS curve would shift left (from SRAS1 to SRAS2), moving the economy to a new equilibrium at E3 with a higher price level but the same level of output as initially.

Question 2

One implication of coupling the rational expectations hypothesis with the assumption of flexible wages and prices is that

Accepted Answer

Under rational expectations and flexible wages/prices, individuals anticipate policy actions, so only unexpected (unpredictable) actions can affect the real economy.

Question 3

The rational expectations hypothesis is based on all the following assumptions EXCEPT

Accepted Answer

The rational expectations hypothesis assumes that individuals have an understanding of how the economy operates, use knowledge of the effects of past policy actions, and use their judgment to predict the effects of future policy actions. However, it does not assume that prices are sticky. In fact, one of the key implications of the rational expectations hypothesis is that prices adjust quickly and efficiently to changes in supply and demand.

Question 4

-In the above figure, if we start at AD1 and SRAS1, and the money supply increases unexpectedly, what causes the economy to get to the long-run equilibrium?

Accepted Answer

An unexpected increase in the money supply initially moves the economy to a point where output is above its natural rate, leading to higher demand for labor and thus higher wages. Over time, as people adjust their expectations, the short-run aggregate supply (SRAS) shifts leftward to return the economy to its natural rate of output, but at a higher price level.

Question 5

The rational expectations hypothesis suggests that if wages and prices are flexible

Accepted Answer

The rational expectations hypothesis posits that individuals form expectations about the future based on all available information, including anticipated policy changes. Therefore, anticipated monetary policy actions are already factored into decision-making, affecting nominal variables like the price level or inflation rate, but not real variables such as output or employment, which adjust based on new, unanticipated information.

Question 6

When "stagflation" occurs

Accepted Answer

Stagflation is characterized by a stagnant economy with high inflation and high unemployment rates, which contradicts the typical economic theory that inflation and unemployment have an inverse relationship.

Question 7

-Refer to the above figure. The rational expectations hypothesis implies that an anticipated increase in aggregate demand from AD1 to AD2 will

Accepted Answer

The rational expectations hypothesis suggests that if an increase in aggregate demand (from AD1 to AD2) is fully anticipated, producers will adjust their prices in advance. Therefore, the economy moves directly from point a to point b, with an increase in the price level but no change in output, as the economy is already at its full employment output.

Question 8

The proposition that policy actions have no real effects in the short run if the policy actions are anticipated is known as

Accepted Answer

The policy irrelevance proposition states that policy actions have no real effects in the short run if the policy actions are anticipated. This is because individuals and businesses will adjust their behavior in advance of the policy action, thus negating any impact it would have had.

Question 9

-Refer to the above figure. The rational expectations hypothesis implies that an anticipated decrease in aggregate demand from AD2 to AD1 will

Accepted Answer

The rational expectations hypothesis suggests that people will anticipate the effects of economic policies and adjust their behavior accordingly. Therefore, an anticipated decrease in aggregate demand will lead to immediate adjustments, moving the economy from point b to point a without a transition through point c.

Question 10

The idea that policy actions have no real effects in the short run if they are anticipated and no real effects in the long run is called the

Accepted Answer

The policy irrelevance proposition states that policy actions have no real effects in the short run if they are anticipated and no real effects in the long run. This proposition is often associated with the rational expectations hypothesis, which suggests that economic agents will form expectations about future policy actions and adjust their behavior accordingly. Therefore, policymakers cannot achieve their desired outcomes by simply changing policy, as their actions will be offset by the adaptive behavior of economic agents.

Question 11

Adding the assumption of pure competition and complete flexibility of all prices and wages to the rational expectations hypothesis yields a theory that provides support for

Accepted Answer

Pure competition and complete flexibility of prices and wages imply that the market will always adjust to eliminate any distortions, and any attempts by policymakers to intervene and correct them will only lead to inefficiencies. Therefore, passive policy making is the most appropriate approach to maintain economic stability.

Question 12

According to a theory that relies on the rational expectations hypothesis and the assumption that wages and prices are flexible, why do anticipated expansionary monetary actions NOT boost real GDP?

Accepted Answer

According to the rational expectations hypothesis, if economic agents anticipate expansionary monetary policy, they will adjust their expectations accordingly. This leads to an immediate upward shift in the short-run aggregate supply curve, offsetting the increase in aggregate demand and leaving real GDP unchanged.

Question 13

The policy irrelevance proposition states that

Accepted Answer

The policy irrelevance proposition, associated with the rational expectations theory, suggests that anticipated changes in monetary policy do not affect real GDP because individuals and businesses adjust their behaviors in anticipation of these changes, rendering the policy ineffective in altering real economic outcomes.

Question 14

-In the above figure, if we start at AD1 and SRAS1, and the money supply increases unexpectedly, what would be the short-run equilibrium even with rational expectations?

Accepted Answer

In the short run, an unexpected increase in the money supply shifts the aggregate demand curve to the right, moving the economy from AD1 to a new equilibrium at E2, even with rational expectations.

Question 15

Those who accept both the rational expectations hypothesis and the assumption of flexibility of wages and price would likely argue that

Accepted Answer

The rational expectations hypothesis combined with the assumption of wage and price flexibility suggests that individuals will adjust their expectations and actions in response to anticipated policy changes, rendering active policy interventions ineffective in stabilizing the economy. This is because people anticipate the effects of policy changes and adjust their behavior accordingly, neutralizing the intended effects of such policies.

Question 16

Real business cycle theory emphasizes the effect of ________ on real GDP.

Accepted Answer

Real business cycle theory emphasizes the effect of aggregate supply shocks, such as changes in technology or natural disasters, on real GDP. This theory suggests that fluctuations in real GDP are primarily driven by changes in productivity and production possibilities, rather than changes in aggregate demand or government policy.

Question 17

According to the theory based on rational expectations and flexible wages and prices,

Accepted Answer

The theory based on rational expectations and flexible wages and prices suggests that neither fiscal nor monetary policy can influence real GDP in the long run. This is because individuals and businesses adjust their expectations and actions in response to policy changes, neutralizing the effects of these policies on real output.

Question 18

The policy irrelevance proposition suggests that the policy effects on the economy primarily occur as a result of

Accepted Answer

The policy irrelevance proposition argues that, in the long run, economic outcomes are determined by factors such as technology, preferences, and endowments, rather than by government policies. However, policy mistakes or misjudgment of policies can lead to short-term effects on the economy.

Question 19

The rational expectations hypothesis is based on the assumption that

Accepted Answer

The rational expectations hypothesis is based on the idea that individuals form expectations about future economic conditions based on a combination of past policy actions and their own judgment about future changes in policy. This means that individuals take into account both the past and the future when forming their expectations, and they do so in a rational and consistent manner. Option B is incorrect as it suggests that individuals only adapt in response to past policy actions without considering future changes. The other two options, C and D, are unrelated to the rational expectations hypothesis.

Question 20

The hypothesis suggesting that people combine the effects of past policy changes on economic variables with their own judgment about the future effects of current and future economic policy is referred to as the

Accepted Answer

The hypothesis described in the question is known as the rational expectations hypothesis. It suggests that individuals combine their knowledge of past policy changes with their own judgment about current and future policy changes to form their expectations of future economic conditions. This hypothesis is based on the idea that individuals are rational and use all available information to form their expectations.

Quiz 17: Stabilization in an Integrated World Economy