DISCUSSION QUESTIONS     

1.   When unemployment and inflation were both falling in the 1990s, it was because aggregate supply was increasing at an unusually rapid rate—in response to a series of favorable supply shocks (low oil prices, advances in technology, strong U.S. dollar). This extraordinary economic performance does not contradict the basic trade-off between unemployment and inflation; favorable supply shocks should produce rapid economic growth with falling inflation.

3.   Decisions about changing aggregate demand depend partly upon objective criteria, such as the shape of the short-run Phillips curve and the time it takes the economy to self-adjust. They also depend, however, upon political and value judgments—such as whether one fears the costs of unemployment more than the costs of inflation. And of course, “fiscal and monetary policy” are not just one thing. Different policies can have the same effect on aggregate demand, but very different effects on income distribution and the composition of output; these are issues over which there are usually serious political disagreements.

4.   A Phillips curve shows the trade-off between unemployment and inflation. When one is high, the other is low. During the period 1954–1969, shifts in aggregate demand led to an inverse relationship between unemployment and inflation. But during the 1970s, reductions in aggregate supply led to the collapse of the Phillips curve, as both unemployment and inflation rose.

5.   Labor and management bargain over money wages, but one suspects that they really care more about real wages, that is, money wages corrected for changes in the price level. If workers expect rapid inflation in the future, they will demand higher money wages, to protect their purchasing power. If management expects to be able to sell output for higher prices in the future, it will be willing to grant higher wages.

6.   Rational expectations are forecasts of inflation that make optimal use of all relevant available information. If people’s expectations are rational, they will sometimes make mistakes in forecasting inflation, but they will not systematically underpredict inflation. The forecasting errors will be random, centering around the true value. The positively sloped aggregate supply curve and the negatively sloped Phillips curve are based on the assumption that when prices rise, wages and other costs lag behind. But the rational expectations school denies that they will necessarily lag; rather, any differences between wage and price increases will be random. Therefore, even the short-run aggregate supply and Phillips curves are vertical. The only events that could shift output away from its natural level are unexpected events, for example, completely unpredicted government policy. The stunning implications of the rational expectations theory are, therefore, that output and unemployment will not depart from their natural rates, and that government policy cannot change output and unemployment, even temporarily, unless they are unexpected. Believers in rational expectations do not favor fighting recessions with expanded aggregate demand because, since the aggregate supply curve is vertical, the economy is seldom below its natural level, and furthermore, increased aggregate demand will cause only inflation, not more output. They do, however, favor fighting inflation by cutting aggregate demand. Since output will not change, the full impact of the demand  cut will be on reducing inflation, and there will be no increase in unemployment at all.

7.   The president may have worried that the Fed chair would keep a tight check on the money supply, in order to squelch the inflationary potential of the economy, while the president would have preferred a more expansive monetary policy that would have brought unemployment lower.  With the growing budget deficits in the early 2000s, one would expect inflationary pressures to cause the Fed chair to implement contractionary monetary policy.  That is, to raise interest rates to slow economic growth.