Homework 6 Economics 101 Chapter 13 1. Suppose that in elections President Push wanted to help out Congressional candidates in his party by making the economy look strong: high GDP figures and low inflation. Suppose he increased government spending, hoping to make GDP statistics rise in the period prior to the election. He knows this can lead to higher inflation, but he hopes this policy will affect inflation statistics (CPI) mainly after the election is over. a) Discuss the short-run and long run implications of the president’s fiscal policy on output, the price level and real interest rate. Use IS-LM & AS-AD graphs, where the short-run aggregate supply assumes that output is some positive function of price surprises. b) How does the success of the president’s strategy depend on how flat or steep the short-run aggregate supply curve is? Thinking of our stories of aggregated supply, what are some things that determine the steepness of this curve? P LRAS Answer) a)The president’s fiscal policy will shift the SRAS2 aggregate demand curve to the right, from 3 AD1 to AD2. In the short run, this will raise P3 SRAS1 2 output and price some, as equilibrium moves P2 from point 1 to point 2. Output goes up because people are surprised by the rise P1 1 AD2 in price, so they can be tricked into producing AD1 more output than they were intending to. Ybar Y2 Y In the long run, price expectations will adjust to the new policy, and shift the short run aggregate supply curve left (from SRAS1 to SRAS2). So equilibrium moves from point 2 to point 3, where price level rises much and output returns to Ybar. So the president could be successful in getting a rise in output prior to the election, and getting most of the inflation after the election. b) If the SRAS were steeper, then price would rise more in the short run. A steep SRAS means it takes a bigger price rise to induce people into producing more. Perhaps a smaller fraction of prices or wages are set ahead of time in contracts, or perhaps workers or suppliers are harder to surprise (expectations are closer to the assumption of rational expectations). 2. Answer the following questions about the short-run aggregate supply equation: a. Let = 0.5. Draw the aggregate supply curve. b. As the term increases, how does this change the supply curve? c. If the expected price level increases, how does this change the supply curve? Answers: 2. a. The aggregate supply curve should be graphed from the following equation: where the first group of terms are the intercept and the slope is 1/. b. As increases, the aggregate supply curve becomes flatter and the intercept with the y-axis increases c. An increase in the expected price level will shift up the supply curve. 3. What is the difference between cost-push and demand-pull inflation? Which was the primary cause of inflation in the early 1970's? What type of inflation had the Federal Reserve been trying to prevent in 1998 and 1999? What about in 2005 and 2006? Answer: Cost-push inflation is caused by supply shocks that alter the cost of production. Demand-pull inflation is caused by upward pressure on prices from high aggregate demand. In the early 1970's, the OPEC oil price shock was a primary cause of the high inflation. This is an example of cost-push inflation. In 1998 and 1999 the Federal Reserve was worried about demand- pull inflation caused by high demand in the current economic boom. In 2005 and 2006, rising oil prices had again made the Federal Reserve relatively more concerned about cost-pull inflation. 4. a. Explain the link between the aggregate supply curve and the Phillip's curve. b. If the natural rate of unemployment falls, how will this affect the Phillip's curve? c. If the sacrifice ratio was 5 and the central bank wanted to lower inflation by 8 percentage points, how much GDP would have to be sacrificed? Would you recommend reducing the inflation all at once, or spreading it out over several years? What would a proponent of rational expectations theory recommend? Answers: a. The aggregate supply curve provides the link between output and prices, which can be modified to link output and inflation. By incorporating Okun's law, which links output and unemployment, we then have the Phillip's curve relationship between inflation and unemployment. b. The Phillip's curve is graphed from the following equation: where the first group of terms is the y-axis intercept and the slope is -. A decrease in the natural rate will shift down the Phillip's curve. c. The sacrifice ratio is the percentage of a year's GDP that must be forgone to reduce inflation by 1 percentage point. With a sacrifice ratio of 5, lowering inflation by 8 percentage points would require 40 percent of GDP to be sacrificed. This would be a lot of GDP to lose in a one-year period, so it may be best to spread it out over several years in order to avoid mass unemployment. On the other hand, a proponent of rational expectation would argue that committing to the policy with a quick reduction would be the best solution. They argue that this quick-reduction policy will alter people's expectations and allow prices to fall quickly without the large loss in GDP. Chapter 15 1. According to the Lucas critique, why should policy makers not rely upon the Phillips curve relationship between inflation and unemployment as the formula for monetary policy. Answer: If policy makers consistently used the Phillips curve to determine how much inflation was needed to lower unemployment, people would react to this policy by expecting higher inflation every time unemployment was high. This change in inflation expectations would cause an outward shift in the Phillips curve, and an even higher rate of inflation would now be needed to lower unemployment. 2. Describe how automatic stabilizers can help to "cool off" an economic boom. Answer: Automatic stabilizers are policies that help stimulate or slow the economy when needed without requiring any specific policy change. One stabilizer that helps slow a booming economy is the income tax. As people earn more in a boom, the amount of taxes they pay increases. This prevents consumers from spending a higher fraction of their additional income, which would further boost the economy. 3. Describe two benefits and two costs of an inflation-targeting rule for monetary authorities. Answer: The benefits of inflation targeting include the increased accountability of the central bank because people are able to easily judge its performance. Another benefit is added credibility caused by providing clear guidelines for the goals of monetary policy. Costs of inflation targeting include a lack of discretion to address other economic problems that may occur. Also, the targeting may require extreme policy adjustments to keep inflation within the required bands, which may lead to higher volatility in other areas such as GDP and unemployment. 4. Why do you think the level central-bank independence is not correlated with a country's average growth rate of real GDP? Answer: From our study of money neutrality in previous chapters, we know that monetary policy does not affect real GDP in the long run. Thus, we should expect that the degree of central-bank independence is not correlated with the country's average (long run) growth rate. Chapter 5 and 12 1. Neoclassical Model of Open Macro Economy: Consider an economy described by the following equations: Y = C + I + G + NX, Y = 5,000, G= 1,000, T = 1,000, C = 250 + 0.75(Y – T), I = 1,000 – 50r, NX = 500 – 500 r= r* = 5. a. In this economy, solve for national savings, investment, the trade balance, and the equilibrium exchange rate. b. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. c. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000). Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. Answer) a) National saving is the amount of output that is not purchased for current consumption by households or the government. We know output and government spending, and the consumption function allows us to solve for consumption. Hence, national saving is given by: S=Y–C–G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750. Investment depends negatively on the interest rate, which equals the world rate r* of 5. Thus, I = 1,000 – 50x5 = 750. Net export equals the difference between saving and investment. Thus, NX = S – I = 750 – 750 = 0. Having solved for net exports, we can now find the exchange rate that clears the foreign- exchange market: NX = 500 -500 x 0 = 500 -500 x => = 1. b) Doing the same analysis with new value of government spending we find: S=Y–C–G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250 = 500. I = 1,000 – 50 x 5 = 750. NX = S – I = 500 – 750 = -250. NX = 500 -500 x -250 = 500 -500 x = 1.5. The increase in government spending reduces national saving, but with an unchanged world real interest rate, investment remains the same. Therefore, domestic investment now exceeds domestic saving, so some of this investment must be financed by borrowing from abroad. This capital inflow is accomplished by reducing net exports, which requires that the currency appreciates. c) Repeating the same steps with new interest rate, S=Y–C–G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750. I = 1,000 – 50 x 10 = 500. NX = S – I = 750 – 500 = 250. NX = 500 - 500 x 250 = 500 - 500 x => = 0.5. Saving is unchanged from part (a), but the higher world interest rate lowers investment. This capital outflow is accomplished by running a trade surplus, which requires that the currency depreciates. 2. What will happen to the trade balance and the real exchange rate of a small open economy when government purchases increase, such as during a war? Answer) The increase in government spending decreases government saving and national saving; this shifts the saving schedule to the left. Given the world interest rate r*, the decrease in domestic saving puts an upward pressure on real exchange rate and reduces net export. (The effect on the trade balance depends on our starting point. If we start from a trade balance i.e., NX=0an increase in government expenditure makes it deficit i.e., NX<0). 3. Mundell-Fleming Model Use the Mundell-Fleming Model to predict what happens to aggregate income y, the exchange rate e, and the trade balance NX, under both floating and fixed exchange rates in response to each of the following shocks: a. A fall in consumer confidence about the future induces consumers to spend less and save more. b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars. c. The introduction of automatic teller machines reduces the demand for money. Answer) a. A fall in consumer confidence shifts planned expenditure line and the IS* curve to the left. Under floating exchange rate the fall in IS* curve is completely absorbed by rising NX following a reduction in exchange rate. Therefore aggregate output does not change. But when exchange rate is fixed a fall in IS* curve induces a fall in money supply (LM* curve shifts left ward) so that exchange rate remains unchanged. As a result aggregate output falls. b. A shift toward foreign cars increases imports and shifts NX cure left ward. This shifts IS* curve to the left. Under floating exchange rate this reduces exchange rate such that the level of NX goes up to its original level. But Aggregate output demanded does not change. Under fixed exchange rate a leftward shift in LM* follows the fall in IS*. Foreign exchange rate stays the same but both NX and aggregate output fall. c. Reduction in demand for money shifts LM and hence LM* curves to the right, leading to a rise in equilibrium aggregate output demand. Under floating exchange rate this will reduce exchange rate and increase NX. Under fixed exchange rate LM curve shifts back to its original level to keep exchange rate constant.
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