1. The short-run aggregate supply curve will move_________ if the economy s actual output is below full-employment output.

2. If the adjustment process works slowly, then economic policy is less necessary. _________ (True/False)

3. A political business cycle may occur because policymakers are willing to trade off a current reduction in unemployment for future increases in inflation. _________ (True/False)

4. Supply Shocks and Policy Choices. In Chapter 9, we discussed supply shocks, sudden increases in the prices of commodities such as oil or food. These shocks shift the short-run aggregate supply curve. For example, the increase in oil prices in 2006 will shift the short-run aggregate supply curve upward, because firms costs have risen and firms must charge higher prices to avoid losing money.

a. Suppose the economy is operating at full employment and foreign countries raise the world price of oil. Assuming policymakers do not take any action, describe what will happen to prices and output in the short run and in the long run. Show these situations graphically.

b. Suppose the Federal Reserve decided it wanted to offset any adverse effects on output due to a supply shock. What actions could it take? What would happen to the price level if the Fed used monetary policy to fight unemployment in this situation?

c. Economists say supply shocks create a dilemma for the Federal Reserve that shocks to demand (for example, from sudden increases in investment spending by optimistic firms) do not create. Using your answer to part (b) and the aggregate demand and aggregate supply graph, explain why economists say this.

5. Foreign Firms Opening Their Markets in the Long Run. Suppose the economy is at full employment and foreign firms open their markets and U.S. firms start to produce more for export. Everything else remains the same.

a. In the short run, what happens to GDP?

b. Assuming that exchange rates do not change, what happens to U.S. prices in the long run? How might this affect the export market?

6. Stabilization Policy and the Speed of Adjustment. Economists who believe the transition from the short run to the long run occurs rapidly do not generally favor using active stabilization policy. Use the aggregate demand and aggregate supply graphs to illustrate how active policy, with a rapid adjustment process, could destabilize the economy.

7. Understanding the Liquidity Trap. The adjustment process can run into problems during a liquidity trap when interest rates are driven close to zero and the economy remains below full employment. Both Japan in the 1990s and the United States during the Great Depression in the 1930s are possible examples of liquidity traps.

a. Draw a money-demand curve and an investment schedule to illustrate this possibility.

b. During the Great Depression in the United States, some interest rates dropped close to zero. Search the historical database at the Web site of the National Bureau of Economic Research (www.nber.org) to find out how low interest rates actually dropped and when they were at their lowest.

c. Use the Web to find data on a variety of Japanese interest rates from 1985 through 2006. Over what period do you think low interest rates may have become a policy problem? You might wish to start with the Economagic Web site (www.economagic.com/bjap.html ).

8. Analyzing a Bernanke Speech on Deflation and Liquidity Traps. While he was a member of the Board of Governors of the Federal Reserve but before he became its chairman, Ben S. Bernanke delivered a speech to the National Economists Club in Washington, D.C., on the risks of deflation, liquidity traps, and how to prevent them. Read Bernanke s speech and discuss how he recommends preventing deflation and combating liquidity traps. The speech from November 21, 2002, is available at

www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm (accessed April 21, 2010).

9. Investigating Political Business Cycles. Use the Web site for the Federal Reserve Bank of St. Louis (www.research.stlouisfed.org/fred2) to find historical data on unemployment rates. Use these data to explore whether unemployment behaves differently in the first two years of a presidential term than in the final two years. Are there any systematic differences in unemployment between Democratic and Republican presidencies?