Question 1 Distinguish between the short run and the long run as they relate to

Question

Question 1

Distinguish between the short run and the long run as they relate to macroeconomics. Why is the distinction important?

Question 2

Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is, and thus undertakes expansionary fiscal and monetary policy to try to achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these policies might at first succeed. Use the concept of the long-run Phillips Curve to explain the long-run outcome of these policies.

Question 3

According to mainstream economists what is the usual cause of macroeconomic instability? What role does the spending-income multiplier play in creating instability? How might adverse aggregate supply factors cause instability, according to mainstream economists?

Question 4

State and explain the basic equation of monetarism. What is the major cause of macroeconomic instability, as viewed by monetarists?

Explanation / Answer

1. The long run and the short run do not refer to a specific period of time such as 3 months or 5 years. The difference between the short run and the long run is the flexibility decision makers have.

"The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. Thelong run is a period of time in which the quantities of all inputs can be varied.

There is no fixed time that can be marked on the calendar to separate the short run from the long run. The short run and long run distinction varies from one industry to another."

Short Run: Some inputs variable, some fixed. New firms do not enter the industry, and existing firms do not exit.

Long Run: All inputs variable, firms can enter and exit the market place.

2. In the short run, unemployment and inflation are inversely related. That is, decreases in the unemployment rate will tend to see increases in the inflation rate. Why is that: more money circulating in the economy. As the labor market improves and more people become employed, they have income which they spend which will eventually exert an upward pressure on prices. If demand is depressed enough however, inflation will be anemic and increases in it will be quite small.

In the long run, inflation does not affect unemployment. Higher inflation leads to demands for higher wages, which will push up inflation, which will in turn lead to a demand for higher wage. There is essentially a wage/price spiral and unemployment is not really affected.

3. Two Sources of Economic Instability

The Monetarists' view of instability focuses on:

4. Monetarism is a school of economic thought that holds that the money supply is the main determinant of economic activity. In other words, if the money supply is growing, the economy will grow, and if money-supply growth is accelerating, so will economic growth. Monetarism's leading advocate is the economist Milton Friedman.

Central to monetarism is the equation MV = PQ. M is the money supply; V is velocity -- the number of times per year the average dollar is spent; P is prices of goods and services; and Q is quantity of goods and services. The equation suggests that if V is constant and M is increasing, there must be an increase in either Q or P. Accordingly, monetary policymakers can control inflation by allowing the money supply (M) to grow no faster than the desired rate of economic growth (Q).

From 1979 to 1982, U.S. monetary policy focused on achieving a certain rate of M1 money supply growth. If money supply growth outpaced the target rate, the Fed would raise the fed funds rate to curb it.

The Fed stopped targeting money supply growth and reverted to targeting the fed funds rate because the development of new types of financial products complicated measurement of the money supply.

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