The economy begins in long-run equilibrium. Then one day, the president appoints

Question

The economy begins in long-run equilibrium. Then one day, the president appoints a new chairman of the Federal Reserve. This new chairman is well-known for his view that inflation is not a major problem for an economy.

a. How would this news affect the price level that people would expect to prevail?

b. How would this change in the expected price level affect the nominal wage that workers and firms agree to in their new labor contracts?

c. How would this change in the nominal wage affect the profitability of producing goods and services at any given price level?

d. How does this change in profitability affect the short-run aggregate-supply curve?

e. If aggregate demand is held constant, how does this shift in the aggregate-supply curve affect the price level and the quantity of output produced?

f. Do you think this Fed chairman was a good appointment?

Explanation / Answer

(1) The news itself would cause an increase in inflationary expectations; these expectations would, in the short run, cause the “velocity” (turn-over frequency) of money to increase, which would itself cause an increase in the price level. That would induce further increases in expectations, but these would not feed on themselves indefinitely, because the costs of moving one's money faster will eventually outgrow those of lost purchasing power. (If all else remained constant, then the price level would stabilize, inflationary expectations would receed, velocity would decrease towards its previous level, and the price level would drop towards its original level.) (2) Higher expected inflation would incline all contracts (including labor contracts) towards higher prices. Employees would typically insist on higher compensation, expecting to pay higher prices; employers would typically be more willing to offer higher compensation, expecting to receive more (nominal) money for the product. (3) There will be an increase in the nominal wage due to adjustments for inflation. (Though, understand that wage adjustments are typically very slow.) Anyways, this means that there will be less profitability of producing goods and services at any given price level (4) This will cause the short run aggregate supply curve to shift leftwards (5) It will increase the price level and decrease the quantity of output (6) No. The quality of economic calculation in an advanced economy is determined by the stability of the monetary unit, so it should be no surprise that the costs of inflation and of deflation have been enormous; the alleged benefits have proved for the most part to be illusory. The President should be stripped naked and pushed across the border into Canada. The Fed appointee should be hosed-down with warm, cheap beer, and made to share living quarters with Paul Krugman, for the rest of his life

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