EXAM 2 PRACTICE PROBLEMS

Business cycle

short-run fluctuations around potential GDP that are driven by changes to aggregate demand

Capacity utilization

the percentage of business’ capacity that is being used for production

Countercyclical (stabilization) monetary policy

monetary policy that pushes against the current direction of a business cycle

Consider an economic shock that results in an increase in aggregate demand for the economy

In the short run, what are the expected changes to firm production levels, the price level

in the economy, and the unemployment rate?

▪ Firms would be expected to increase production levels.

▪ Firms would be expected to keep prices unchanged.

▪ Higher production would result in lower unemployment.

Consider an economic shock that results in an increase in aggregate demand for the economy

In the long run, what is the expected outcome for GDP, unemployment, and inflation if

monetary policy is successful?

▪ GDP will return to its long-run trend (potential GDP).

▪ Unemployment will return to the level associated with potential GDP.

▪ Inflation will remain stable

Consider an economic shock that results in an increase in aggregate demand for the economy

In the medium run, what happens to capacity utilization? How do changes in capacity

and unemployment cause pressure for higher inflation? What is the expected response

from the Federal Reserve?

▪ Capacity utilization will increase as firms continue to increase production. Firms

will run out of excess capacity, and this will force them into raising prices.

▪ Lower unemployment means that firms need to compete more for labor, forcing

them to pay higher wages.

▪ Both of these will pressure inflation to increase in the economy.