Chapter Fifteen

In the Long Run We're All Dead

The Neoclassical Synthesis

Critical Concepts

All the way back from Chapter One!

The Neoclassical Synthesis

John Maynard Keynes had not entirely refuted the Classical model of the economy. Instead, he suggested it was just an (unlikely) special case of his General Theory. A special case in which prices and wages were able to fully adjust to changes in current and planned expenditure. Economists after Keynes, most notably Paul Samuelson, John Hicks, and Franco Modigliani, attempted to synthesize Keynes' dense book into a functional mathematical model from which conclusions can be drawn. Central to this new description of Keynesian ideas was time.

In the short run, prices and wages cannot adjust and are stuck in place.

In the long run, people have adequate time to make the appropriate adjustments and respond to the economic incentives.

Thus, the neoclassical synthesis built a bridge between the Keynesian school of thought and the Classical school of thought. It was Keynesian in the short run, and Classical in the long run.

"In the long run we are all dead. Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that when the storm is long past the ocean is flat again."

- John Maynard Keynes

Aggregate Demand

Aggregate Demand represents the total amount of spending in the economy, relating the price level to the level of real GDP for that given amount of spending. For example, if you come back from the store and tell me you spent $100, there are many ways that could have gone down. Perhaps you only bought 2 things, and they cost $50 on average. Or maybe you bought 20 things and they cost $5 on average. Your aggregate demand was $100. How much stuff you got is your real GDP. And the average price of it all is the price level. Now just scale that concept up to represent the entire U.S. economy!

Open Video Transcript

In 2020, the U.S. GDP was $20,893,746,000,000. This is both the total amount of spending everyone did on goods and services made in the U.S., and the total amount of income earned by selling those goods and services. In his emphasis on the importance of the circular flow of income, John Maynard Keynes put GDP in the center stage of his theory. When people believe the future of the economy is looking bleak, they will reduce their spending, and this will reduce gross domestic product. To model this, economists who came after Keynes formalized this concept into what we call Aggregate Demand. --To make things simple for us at the start, let’s say we just have $20 worth of total spending. What can we say about the price level – the average price of final goods and services in the economy – and real GDP – the inflation-adjusted value of those final goods and services? Well, we have an equation which relates the two: the quantity theory of money. The quantity theory of money says that M (the money supply) times V (the velocity of money) is equal to P (the price level) times Y (real GDP or output). To help us see how this is going to work, I am going to rearrange this equation by dividing both sides by Y. When I do that, I get that P is equal to M times V divided by Y. This is the same equation, just rearranged. The numerator, M times V, tells us the total amount of spending in the economy. Since we know that the total spending is $20, we can replace that in the equation, and now we have just two variables left, P (the price level) and Y (real GDP). Now we can graph this equation and see what it looks like. Our graph as two axes. The vertical axis will represent the price level (P). The horizontal axis will represent real GDP (Y). Remember, each axis is just a number line, and any point on the graph represents a pair of values, one for real GDP and the other for the price level. If we knew that our real GDP was 20, we could figure out what the price level is. $20 divided by a real GDP of 20 is 1. And so, one of the points on our curve will be here, where real GDP is 20, and the price level is $1. We can plot points for a real GDP of 19, 18, 17, 16, all the way to 10. If our real GDP was 10, that would mean our price level has to be $2. And on we go. If our real GDP was 5, the price level would be $4. If real GDP was 4, the price level would be $5. A real GDP of 3 has a price level of $6.67. A real GDP of 2 has a price level of $10, again, just plugging in that value for real GDP into our Quantity Theory of Money equation and getting P, the price level. And of course, a real GDP of 1 would have a price level of $20. Every point on this line represents a different way of spending $20. It could be that our price level is high, which means $20 of spending doesn’t buy much real GDP, or it could be that our price level is low and $20 goes a long way. But this curve on the graph is what we call Aggregate Demand. --But let’s consider what happens when we increase the amount of money spent. If instead of $20 we spent $80, then a price level of $20 would go with a real GDP of 4, and that point would have to move over. So would all of the other points. This is a shift in our aggregate demand. Increasing the total spending in the economy shifts aggregate demand to the right. Because we are dealing with amounts in the trillions of dollars, and a narrower range of price levels, when we draw out a basic version of aggregate demand, we tend to just focus on the main part of the graph where the economy is likely to be. --This is how aggregate demand will look going forward, but keep in mind that this is still the same thing we just graphed out, narrowed down for practicality. Aggregate demand represents the total amount of spending in the economy. By total spending, I mean the market value of all final goods and services produced and sold, which is the same thing as nominal GDP. So, aggregate demand (AD) can be represented by the expenditure method of calculating nominal GDP. Aggregate demand is equal to consumption spending, plus investment spending, plus government spending, plus net exports, which is spending on exports minus spending on imports. Once again, for the U.S. in 2020, this total was almost $21 trillion. So, when we graph aggregate demand, the curve we draw represents a fixed amount of total spending, where every point on this line represents the same level of nominal GDP. There are many ways to increase total spending. More government spending, decreased taxes, increases in the money supply, lower interest rates, higher incomes, more consumer confidence, and positive outlooks can all have an impact on M or V, either directly by changing the money supply, or by changing the rate of spending, which is the velocity of money, V. Notice that our top two items are the Keynesian prescription for an ailing economy. If the economy is in a recession, Keynes recommended more government spending and lower taxes, both of which will spur on additional spending and increase our nominal GDP. That shifts aggregate demand to the right. Alternatively, you can decrease aggregate demand by doing the opposite of these things. Keynes believed that the cause of recessions, a negative outlook causing us to take cautious action and reduce our spending and investment, can create a shortfall of aggregate demand. Reducing total spending and shifting aggregate demand to the left.

Long Run Aggregate Supply

The proponents of the Neoclassical Synthesis argued that the Classical school of thought, which had fared poorly in the face of the Great Depression, still made sense. If people are doing their best when making economic choices, the "Invisible Hand" should make markets self-correcting. But the history of recessions showed that sometimes it takes people a fair bit of time to figure out what is best. In this framework, the Classical model still holds, but only in the long run.

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The Classical school models the economy with the assumption that markets are always at equilibrium. The market for loanable funds finds the interest rate which balances savings with investment. At the equilibrium interest rate, all savings becomes investment spending, and all that isn’t saved is either spent on consumption or by the government from what it collects in taxes. This market for loanable funds is the critical market which keeps the circular flow of income flowing. Then there is the labor market, which finds the wage which balances the supply of labor with the demand for labor. At the equilibrium wage, all those who want a job can get one, and those who do not wish to work for the market wage turn to whatever alternatives afford them that option. When this market is at equilibrium, there is no involuntary unemployment. The amount of investment replaces the capital that is lost to depreciation until we reach a steady state that also sets our level of output, or real GDP, based on the economy’s production function, or its technological capacity. In other words, left to their own devices, people will drive resources to the most efficient uses desired by society by following the incentives of consumer demand and the opportunity for profits. Adam Smith’s Invisible Hand at work.The amount any society can produce – which determines our standard of living – depends on the resources and technology we have. And the classical model assumes that people are making the best use of those resources and technology already. And so, our aggregate supply of goods and services does not depend at all on the price level. The price level doesn’t come into this process at all. Which means it translates to our graph with the price level and real GDP on each axis like this…--The Long Run Aggregate Supply, or LRAS as we will call it, is a vertical line, because in the Classical model it is based on, there is no relationship between the price level and the amount of real GDP the economy produces. The price level can be high, and it will produce the same output as when the price level is low. And due to Say’s Law of Markets, this will be the most efficient level of output. You can think if it like an arrow pointing at the horizontal axis saying, “Here, this is the amount of real GDP the economy can sustainably produce with the resources and technology we have.” It doesn’t matter what numbers we write on our dollar bills. We can count them in the hundreds or in the millions. How much we can produce doesn’t change just because we print off some more green pieces of paper. And since this level of output represents the efficient level of production, an economy that is not underproducing and leaving people unemployed, and an economy that is not overproducing and burning through resources too quickly, LRAS is like the flag on the golf course marking the hole. It is the outcome we should be aiming for, whether or not the markets self-correct fast enough to get us there. This makes Long Run Aggregate Supply synonymous with full employment – where there are enough jobs available for everyone who wants a job – and with what we call ‘Potential GDP’, or the level of GDP we will get when the economy is operating efficiently. --When we add aggregate demand, we are able to find the long run equilibrium for the economy. Remember, aggregate demand represents the total amount of spending in the economy. If the economy produces at the level of long run aggregate supply, then the point where these two lines cross is where the economy is at, setting the price level. For example, if we spend $20 total, if that’s our Aggregate Demand, and the economy produces and sells five things, that’s our long run aggregate supply, then we know the average price of those five things, the price level, must be $4 for us to get $20 spending total. When all prices and wages are able to fully adjust, and markets immediately reach their equilibrium, then production will remain where it is set by long run aggregate supply. If there is an increase in aggregate demand – as a result of some extra money being printed, or additional government spending, or any other reason – then the equilibrium just moves up along LRAS pushing up the price level but leaving real GDP the same. The result is inflation, but since production stays steady, there no change in unemployment or output. If aggregate demand decreases – say because a bank run has reduced the amount of credit and the money supply shrinks – then just the opposite happens. We get deflation, but output stays the same, so no recession occurs. Since this is based on the Classical model, it is no surprise that long run aggregate supply suggests money neutrality, that changes in the money supply do not lead to changes in real GDP. But remember, this observation does not seem to match reality. This is why the neoclassical synthesis refers to this as “long run” aggregate supply. If prices and wages do not fully adjust, if they are sticky and get stuck in place, then deviations away from long run aggregate supply are possible. The theory now is that, given enough time, eventually those prices and wages will adjust, in the long run. We might not always be on LRAS, but the economy will always be headed there. --Just like the Classical school, long run aggregate supply is not useful in understanding why recessions occur or how to get out of them. But it does offer us a target to aim for. The target can move though, and for good reasons. Long run aggregate supply shows us the capacity of our economy given the resources and technology we have. But the quantity of resources we have, and the productive power of our technology can change. If there is an increase in the quantity of resources available to us – such as an increase in the labor supply, or an increase in the capital stock, or perhaps even just the discovery of a new resource like plastics or solar energy – or if there is an improvement in the productivity of our technology – such as new and better machines, increased human capital, or smarter production processes – then LRAS will shift to the right. Notice that the result is economic growth, and this should not be surprising. We saw how LRAS is built by the same mechanics as the Solow model of economic growth, and that model would agree with this insight. But we have learned something new here. Economic growth – when paired with the same amount of total spending – results in deflation. The price level goes down. Since, in many ways, deflation was the great villain of the Great Depression, this is an important finding and is why modern economists are in strong agreement that the money supply should be managed so that it grows along with the economy. That is, if we have a growing economy, we should always be printing more money to keep the price level steady. Of course, sometimes there are setbacks our in our economy. Natural disasters can destroy resources, and some technologies (*cough* Facebook *cough*) might actually reduce our productivity. In those cases, LRAS shifts to the left, resulting in a decline in output and an increase in the price level. This combination is very painful for an economy. Declining output means a lower standard of living, which is combined with inflation that raises prices and makes it harder for people to afford what they need. Avoid if at all possible.

Short Run Aggregate Supply

While the Classical model is said to explain the long run, in the short run the Neoclassical Synthesis is decidedly Keynesian. Imperfect competition and human nature make input price, such as wages, resistant to downward pressure from deflation. Or, as we have said before, these prices and wages are sticky. If that is the case, then changes in the price level could create distortions in the economy which lead to overproduction or underproduction.

Open Video Transcript

Inflation is supposed to be a tide that lifts all boats. Prices at the store go up, but those higher revenues get passed on to the factors of production, and so you also see an equivalent increase in your paycheck. That’s how it’s supposed to work. But in practice, prices go up at the store well before you get a cost-of-living raise at work. The prices of the factors of production tend to adjust slowly, whereas the prices of goods and services tend to adjust quickly. This unevenness can distort economic incentives, and lead to the overuse of resources. Likewise, deflation follows the same pattern, shrinking revenues but not the costs of production, leading to an underuse of resources. When we say, “the short run”, we mean the time it takes for inflation or deflation to make its way through the entire economy. The short run is essentially the time it takes for changes in the price level to go from showing up at the store to showing up in your paycheck. --Let’s translate our example with an economy only producing burgers into our model for aggregate supply. According to the classical school, aggregate supply is a vertical line, because when the price level changes, it results in immediate changes in the prices of inputs. I’m using our technical jargon here, so let me clarify that real quick. The factors of production are broad categories of resources: labor, land and natural resources, capital (meaning tools and machines), and entrepreneurship. The “price” of each factor of production is the income that is paid to each one. The price of labor is wages. The price of land and natural resources is what economists call rent, even though that word means something different to regular people. The price of capital – which again is not financial capital, but rather the tools we use to make things – is interest. And the price of entrepreneurship is profits. In the classical model, when the price level falls, it corresponds to the price of the burger falling. And since each burger is fetching a lower price now, each factor of production has to adjust their share of the proceeds. The deflation here immediately translates into falling wages, rent, interest, and profits. And we saw in a previous video why that’s ok, because everyone is still able to afford the same things they could afford before. No one is worse off and no one is better off. When prices and wages are flexible, the economy responds well to a bout of deflation or inflation. --But what Keynes noted is that even though the incentives people face are to adjust these prices and wages quickly, people don’t seem keen on following those incentives. No one likes getting a pay cut, and most bosses don’t want to give one, not just for fear of lowered morale but because telling someone you are cutting their salary isn’t a very fun thing to do. And the same goes for these other factors of production. If a decrease in the price level lowers the price a business can charge for a burger, but it doesn’t lower their costs, then the burden of deflation falls on profits. In order to stay in business, production will have to be reduced, producing only what is profitable, which means unemployment and lower real GDP. And so, on our graph, we can’t stay on our aggregate supply line. As prices fall, real GDP falls too in the fallout, and so to connect these dots, aggregate supply can no longer be vertical. The amount we can produce depends on the price level so long as we experience sticky prices and wages. --It’s easier to raise wages than it is to lower them, and so Short Run Aggregate Supply is often drawn like this, which gets more resistant to price changes as you move down it, and less resistant as you move up. But it is important to note that this is still aggregate supply. It is still describing the amount of real GDP the economy can produce with the resources and technology we have. For this reason, SRAS will always tag along when there is a change in long run aggregate supply. That is, if LRAS shifts, SRAS will shift too and in the same direction. But SRAS has another assumption added to it. Imperfect competition makes input prices (for example, wages) sticky, particularly with respect to deflation. This means that if those input prices get unstuck, SRAS will shift to accommodate the change. --When we add aggregate demand to our graph, we are able to determine the price level and real GDP for the economy. SRAS will shift when there are changes to the cost of production which change input prices. For example, if the economy sees increasing costs due to higher average wages or higher costs for capital, then SRAS will shift to the left. Higher costs decrease supply. You can see that the result is a higher price level and a lower level of real GDP. --Resetting, we can also see an example of what happens when there are decreasing costs. Lower costs are a boon for business, and they increase SRAS, shifting it to the right, and the result is a lower price level and a higher real GDP. Without LRAS though, we can’t tell whether this is a good thing or not. We don’t know if the economy is still falling short of its potential and experiencing high unemployment, or if the economy is overheating and gobbling up resources too quickly, inviting rapid inflation. But at least now we have all the tools we need to figure it out.

The AS/AD Model

The Neoclassical model is focused on aggregate demand and aggregate supply. In the short run, aggregate supply is upward sloping due to sticky prices and wages. In the long run, aggregate supply is a vertical line, with no relationship between the price level and real GDP. With these pieces put together, we can use the AS/AD model to better understand the state of the economy, and make predictions about how it will respond to different events.

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The Aggregate Supply / Aggregate Demand model is a sort of compromise between the Keynesian and Classical views of the economy. Aggregate demand represents the total amount of spending in the economy. Long run aggregate supply represents the capacity of the economy and is the destination for the economy if it’s given enough time to fully adjust to changes in the price level. Short run aggregate supply represents the path deviations from the efficient level of production will take when prices and wages are sticky. We can use the AS/AD model to both diagnose the state of the economy, and to identify the effects of a treatment, or an intervention we might make to try and heal the economy. Let’s take a look. --During the Great Depression, and common to most recessions before it, bank runs reduced the money supply, and fear slowed consumer spending and investment spending too. For both of these reasons, total spending in the economy fell, causing aggregate demand to shift to the left.The economy is always where aggregate demand and short run aggregate supply cross. Long run aggregate supply is the goal, but it’s like a weak magnet. It pulls the economy towards it, but not strongly enough to prevent this deviation. We can see that the price level fell, meaning deflation, and so did real GDP, meaning high unemployment. I know you are probably watching this a little perplexed, maybe a little bored, but this is very exciting. This model for the economy is built on reasonable assumptions about how the macroeconomy works, and for the first time, it is making a prediction which matches the experience of economic recessions. On this bit of evidence, the model checks out! This is where we can use the model to diagnose the economy. Because our equilibrium is to the left of our potential GDP, represented by LRAS, we know that this economy is in a recession. And by virtue of it being at the equilibrium, we know that for the short run, this economy will stay in a recession. If fears grow, and spending slows more, it might even turn into a deep recession, or a depression.--The response classical economists would recommend is doing nothing. Deviations from full employment should not last long because wages and input prices will fall to match the drop in spending and bring the economy back to normal. When wages and other input prices fall, it reduces the costs of production, and short run aggregate supply shifts to the right. It will keep shifting until the economy is brought back to full employment, and there is no more downward pressure on wages. In the end, the economy experiences some deflation, but gets back to normal. But that is what we are waiting for. If we leave the economy to its own devices, we just have to wait for wages and input prices to fall. We have to wait for everyone to accept a pay cut so that businesses can adjust to the deflated price level. Depending on just how sticky they are, that could take a while. And as Keynes said, in the long run we’re all dead. --His solution was countercyclical fiscal policy. The government was large enough that if it had the will to act, increasing government spending and lowering taxes would kick off a chain reaction of consumer and investment spending that would boost aggregate demand, shifting it to the right and reinflating the economy to its previous levels, allowing for a return to full employment without the pain of further deflation. Pretty snazzy! --Of course, if the government is running big deficits to help the economy, but consumer and investor confidence in the economy returns, restoring old spending habits, then aggregate demand might push well beyond potential GDP. Now our economy is experiencing inflation and boosted real GDP. Diagnosis: An Economic Boom. The equilibrium – which is always where AD and SRAS cross – is off to the right of potential GDP or LRAS. Some people might not like the inflation, but few are complaining about the economy. Its running on overdrive, with more jobs available than people to take them. But this level of production is unsustainable. This economy is overproducing given the resources and technology it has, burning through those resources too quickly and threatening much higher inflation and economic catastrophe. Best to slow it down than to have to deal with the impending economic hangover. --The Keynesian solution is – rather than letting rapid inflation force a solution to the problem – decrease government spending and raise taxes. Either or both will hit the brakes on spending, shifting aggregate demand to the left and bringing the economy back to the manageable, sustainable level of output. Keynes himself proposed a more permanent intervention in the economy, with the government directing the lion’s share of investment spending in the economy at all times. But this was not a view that many economists found acceptable, fearing that the government would do worse than the market in directing investment. Instead, this Neoclassical Synthesis recommended demand management via countercyclical fiscal policy. Using budget deficits and surpluses, the government could steady aggregate demand and maintain stable economic growth. Governments around the world were ready to give it a whirl.

The AS/AD Flow Chart

Now it is time to practice using the AS/AD model. This flow chart helps guide your thinking to match the workings of the model. Here are the steps for using it:

Determine if the scenario impacts Aggregate Demand or Aggregate Supply. There are keywords under each to help make this determination.
Proceed to the next decision. If AD, decided if the scenario results in less spending or more spending. If AD, determine if the scenario will impact long run aggregate supply, or just short run aggregate supply. Then determine the direction of the shift.

Take the time to master this!

Try the AS/AD Quizlet Exercise!

It will be worth it!

The Phillips Curve

The AS/AD model was an important breakthrough for macroeconomics because it could be used to make predictions about how certain events would impact the economy. Economists could use it to forecast GDP like meteorologists use models to forecast the weather. Unlike the weather though, economic policy could then be used to change the forecast, and turn a rainy day into a day of sunshine!

Open Video Transcript

The Neoclassical view of the economy opened the door for a new era of economic policy. Where once governments merely made decisions about taxes to fund government programs, now decisions about spending and taxes had broader implications. Government could use fiscal policy to impact the overall health of the economy, and they had two targets in their sights. They were the same targets as given to the Federal Reserve: keeping both unemployment and inflation in check. Ideally, governments would try to set their economic policies to keep unemployment low and prices stable. But our AS/AD model has some bad news on that front. --On the left I have the AS/AD model, set to start with low aggregate demand. On the right, I have a new graph, which will chart the relationship between the inflation rate on the vertical axis and the unemployment rate on the horizontal one. So, each point plotted corresponds to some possible pairing of inflation and unemployment. Our hope is to find a point which is close to the origin, with low inflation and low unemployment. But when we move aggregate demand with government policies, it increases both the price level and real GDP. The further we go, the faster the price level rises, meaning higher and higher inflation. But the corresponding increases in real GDP mean more production, which means more people will be employed to carry out that production. The points plotted on the right show the predicted relationship between the inflation rate and the unemployment rate. It is downward sloping, meaning that there is a trade-off, at least in the short run, between inflation and unemployment. The lower we push unemployment, the higher we push up inflation. This inverse relationship is called the Phillips Curve, named after the New Zealand economist William Phillips, who first studied it. --Phillips actually didn’t use the AS/AD model to spot this relationship, he just gathered data on it. Each point here shows the inflation and unemployment rates experienced in the United States during the 1960s. For example, this point here shows that in 1961, the unemployment rate in the U.S. was around 6.7%, while inflation was low at under 1%. Alternatively, at the end of the decade in 1969, unemployment had fallen to just under 3.5%, but inflation was up to nearly 6%. The inverse relationship between inflation and unemployment is plain to see from the data, and similar patterns were found in other industrialized economies. This finding was another mark in favor of the Keynesian framework. --But the question remained as to whether or not the relationship could be sustained for long periods of time. In the long run, the economy should return to the full employment level of GDP. But this doesn’t mean it should get unemployment down to zero. Remember, we have three kinds of unemployment. Frictional unemployment is common and mostly harmless. At any given time, there will be some people in the process of finding a job. That process takes time, but this kind of unemployment isn’t a problem so long as there is a job available for every job seeker. Structural unemployment is more pernicious and is unemployment that arises due to economic growth an innovation. We want our economy to continuously grow, and the innovations required to make that happen will necessarily mean that people employed in obsolete jobs will become unemployed. If the economy is healthy, other jobs in different industries or roles are available, but they might require difficult adjustments like retraining or lower pay for a time. Then there is cyclical unemployment, which arises due to a recession brought on by insufficient aggregate demand. Cyclical unemployment happens only when there aren’t enough jobs available for everyone seeking a job. In a healthy economy, we would still expect to see frictional and structural unemployment, but we would also expect there to be enough job openings to employ everyone once they get things sorted out. These two types of unemployment form what we call the natural rate of unemployment. It is the unemployment rate we would see when the economy is at full employment, meaning there is a job for everyone who wants one, and cyclical unemployment is at zero. Our AS/AD model says that the economy will move to potential GDP and full employment in the long run. That means in the long run the economy will see its natural rate of unemployment. --This implies that the Phillips curve will only hold in the short run. Over the long run unemployment will revert to the natural rate. This means the short run Phillips curve might move around with changes in aggregate supply, and we cannot rely on the data from the 1960s form the basis of future policy, but with the AS/AD model policymakers might be able to anticipate those changes and adjust accordingly. What is the long run if not a series of short runs? --The Phillips Curve took center stage in macroeconomics because it offered a sort of policy menu that the policymakers could choose from. Economic advisors could simply present the latest data, and the President and Congress could just choose the combination of inflation and unemployment they thought was best. The theory was behind it. The data was behind it. By managing aggregate demand, we could manage the tradeoff between the two, keeping the American economy healthy and growing. At least, that’s how it seemed to people at the time.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Example Question
Using estimates from economic data, economists believe the Phillips curve is best modeled by the equation:

Inflation Rate = 47/(Unemployment Rate)

Where both the inflation rate and the unemployment rate are entered in percentage form (e.g. 30.57 not 0.3057).

The economy is also in a recession, with real GDP currently at $13,390. Economists estimate potential GDP to be $18,066.

In response to the recession, the Federal Reserve has increased the money supply by 57%. Luckily, the velocity of money held steady at v = 1 and the economy recovered to full employment.

What is the natural rate of unemployment for this economy?

Put your answer in percentage form and round to two decimal places.

Hints: This question is super difficult! I hope it will be all the more satisfying to you when you figure it out. Here are some clues:

(1) Remember that M*V = P*Y, and we know V stays at 1, so it reduces to M = P*Y

(2) Inflation is the rate of change in the price level (P). So, Inflation = (P₂ - P₁)/P₁

(3) You can rearrange the equation from (1) and note that P1 = M1/Y1 and P2 = M2/Y2

(4) You have Y₁ and Y₂ in the question. Think about it. And math tells us that M₂/M₁ has to equal 1+(growth in the money supply).

(5) You can use these clues to help you find the rate of inflation that brought the economy to full employment. Then use the Phillips Curve to find out what the rate of unemployment is.

Video Solution

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