Midterm 3

Explain what demand-pull inflation and cost-push inflation have in common?

A central bank lacks credibility. In demand-pull inflation, as the central bank raises money supply to expand output beyond the potential output, the public learns that the central bank is not committed to price stability, which shifts up SRAS curve. In cost-push inflation, as the central bank raises money supply to expand output in response to cost shock, the public again learns that the central bank is not committed to price stability, which shifts up SRAS curve. In both cases, the central bank keeps increasing money supply to increase output, but the public then feel validated and expect that inflation will rise even further, which then pushes up SRAS curve again.

How can a large balance-of-payments surplus contribute to a country's inflation rate?

A large balance-of-payments surplus may require a country to finance the surplus by selling its currency in the foreign exchange market, thereby gaining international reserves. The result is that the central bank will have supplied more of its currency to the public, and the monetary base will rise. The resulting rise in the money supply can cause the price level to rise, leading to a higher inflation rate.

For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a long - run equilibrium: consumers reduce autonomous consumption

A reduction in autonomous consumption reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity

Financial frictions decrease

A reduction in financial frictions increases aggregate demand, so monetary policymakers would pursue an autonomous tightening of monetary policy to stabilize economic activity

Using an MP curve and an AS/AD graph, show how a sufficient amount of asset purchases by the Fed can reverse the effects of the financial panic depicted in part (a).

A sufficient enough asset purchase will lower financial frictions, reversing the effects of the panic, and lower the real interest rate on investments at any given inflation rate. This moves the economy from point A, to a point such as point B, where the economy is no longer at risk of a deflationary spiral. At point B, the self-correcting mechanism can move the economy to a stable long-run equilibrium since the ZLB inflection point lies to the right of the LRAS curve along that AD curve.

Give the definition of Lucas critique.

According to Lucas, when policies change, public expectations will shift as well, and such changing expectations can have a real effect on economic behavior and outcomes.

Suppose the current administration decides to decrease government expenditures as a means of cutting the existing government budget deficit. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.

According to aggregate demand and supply analysis, the decrease in government expenditures results in a shift to the left in the aggregate demand curve, as aggregate expenditures decrease at every inflation rate. As a result, the new intersection point with the short-run aggregate supply curve determines a lower inflation rate and output level than before, as shown below. At this point, output is below potential output and inflation is below its target.

What nonconventional monetary policies shift the aggregate demand curve, and how do they work?

All nonconventional policies work by lowering the interest rate for investments and so stimulate investment spending and shift the aggregate demand curve to the right. Liquidity provision helps to heal impaired financial markets, thereby lowering financial frictions and hence the real interest rate for investments. Asset purchases of private securities raise the price of these securities, thereby lowering the credit spread and the real interest rate for investments. Asset purchases of long-term bonds raises the price of these bonds and therefore lowers long-term interest rates, which lowers the real interest rate for investments. The management of expectations by committing to keep interest rates low for a long period of time again lowers long-term interest rates, which lowers the real rate for investments.

the domestic currency appreciates

An appreciation of the domestic currency leads to lower exports and higher imports, which reduces net exports and aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity

Government spending increases

An increase in government spending increases aggregate demand, so monetary policymakers would pursue an autonomous tightening of monetary policy to stabilize economic activity

Taxes increase

An increase in taxes reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity

Why does the self - correcting mechanism stop working when the policy rate hits the zero lower bound?

Because a negative output gap, which leads to a fall in the short-run aggregate supply curve, which lowers inflation, which then causes aggregate output to fall along the lines outlined in the answer to question 3, then leads to an even more negative output gap. The result is then a downward spiral where inflation keeps falling and output does as well, so the self-correcting mechanism is not operational

If the BOK's primary objective is to keep the Korean economy at the potential GDP and keep the Korean inflation rate steady, what will it have to do in response to this political and economic development in the US? Explain why.

Clearly, if it pegs KRW to USD, its policy will be inflationary. So, the BOK needs to let KRW appreciate, which will be deflationary. To offset it, the BOK will have to lower its policy somewhat

"Inflation is not possible under the gold standard." Is this statement true, false, or uncertain? Explain your answer.

False. Inflation occurred when the world was under the gold standard before World War I. The gold discoveries in the Klondike and South Africa before WWI led to a continuing increase in the quantity of gold, which caused a more rapid growth in money supplies throughout the world. The result was worldwide inflation

An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%.

If inflation rises by 1%, this alone would prompt the fed funds rate to rise by 1.5 percentage points. The decrease in the output gap alone would imply the fed funds rate would fall by .5 percentage points. Thus, the two factors together imply a net effect of increasing the fed funds rate by one percentage point according to the Taylor Rule.

Explain in words what will happen if policymakers erroneously and persistently believe that the natural rate of unemployment is 3% when it is actually 5%?

If policymakers believe that the natural rate of unemployment is 3% when it's actually 5%, then once the unemployment rate begins to rise above 3%, they are likely to pursue expansionary policy to avoid perceived recession and deflation. In actuality, this would represent a situation where policymakers are trying to stimulate the economy when inflationary pressure is already building up. The result of these policies is that this could create an upward spiral in inflation (SRAS and AD both keep shifting up).

What will happen if policymakers erroneously believe that the natural rate of unemployment is 7% when it is actually 5% and therefore pursue stabilization policy?

If policymakers believe that the natural rate of unemployment is 7% when it is actually 5%, then once the unemployment rate begins to drop below 7%, they are likely to pursue contractionary policy to avoid a perceived potential demand-pull inflation problem. In actuality, this would represent a situation where policymakers are contracting the economy when it is already in recession. The result of these policies is that this could create a downward spiral in inflation, which could lead to deflation and a severe economic downturn.

Potential output declines while actual output remains unchanged

If potential output declines, this would cause the output gap to increase, resulting in an increase in the fed funds rate according to the Taylor rule

What will be the effect on the real interest rate, the inflation rate, and the output level if the Federal Reserve decides to stabilize the inflation rate?

If the Federal Reserve decides to use its monetary policy tools to stabilize inflation, it will effectively decrease the real interest rate at every inflation rate, thereby shifting the MP curve downward. This action will shift the AD curve to the right and restore the economy to its long-run equilibrium, where the inflation rate returns to its tart inflation and output is at potential output again. The only long-run effect of this policy is to affect the real interest rate, which is now set at a lower level than the previous long-run equilibrium.

The fed revises its (implicit) inflation target downward

If the inflation target is revised downward, this would increase the inflation gap at any given inflation rate. This would result in a higher fed funds rate according to the Taylor rule.

What does the Taylor Rule imply that policymakers should do to the federal funds rate under the following scenarios: unemployment rises due to a recession

If unemployment rises, this would lower the output gap, and trigger a lower fed funds rate according to the Taylor rule

In general, how does credibility (or lack thereof) affect the aggregate supply curve?

In general, when central banks lack credibility, there is little faith by the public that the central bank will pursue policies that will result in low, stable inflation. As a result, inflation expectations are likely to be higher, leading to an upward shift in the SRAS. This results in higher actual inflation and lower output, which is obviously less desirable an outcome than if the central bank were to have full credibility.

Using a graph of aggregate demand and supply, show the effects of this fiscal initiative on the economy in the long run. Be sure to describe why the long run effects are very different from the short - run effects.

In the long run, we end up with higher inflation rate with the same output. The long run effects are very different from the short-run effects because wages are flexible in the long run (i.e., workers demand higher wages to keep up with inflation, which in turn shifts up SRAS curve)

Suppose that a new Fed chair is appointed and that his or her approach to monetary policy can be summarized by the following statement: "I care only about increasing employment. Inflation has been at very low levels for quite some time; my priority is to ease monetary policy to promote employment." How would you expect the monetary policy curve to be affected, if at all? In addition, use the aggregate demand - aggregate supply analysis to trace both the short - run and long - run impact of each shock on inflation rate and output.

In this case, the MP curve will shift down if there is an autonomous easing of monetary policy. In addition, if the Fed begins to pay less attention to the inflation rate, this would be equivalent to a reduction in lambda, which would reduce the slope of the MP curve. AD curve shifts to the right, which, in turn increases inflation rate and output in the short run. In the long run, given that output is above its potential, the expectation of inflation emerges, which, in turn, shifts up AS curve, causing further inflation and a decrease in output back to its potential.

What are the purposes of inflation targeting, and how does this monetary policy strategy achieve them?

Inflation targeting has two basic purposes, to keep inflation under control and to increase the credibility of monetary policymakers' commitment to price stability. These are achieved by announcing a numerical target for inflation and a commitment to price stability as the primary long-run goal of monetary policy, increasing communications with the public and financial market participants about the goals and processes of monetary policy making, and holding policymakers accountable for achieving the inflation target that has been set.

If net exports were not sensitive to changes in the real interest rate, would monetary policy be more or less effective in changing output?

Monetary policy would be less effective in changing output, since net exports represent a reinforcing channel, in addition to investment, through which interest rate changes can affect output

How does a credible nominal anchor help improve the economic outcomes that result from a negative aggregate demand shock? How does a credible nominal anchor help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.

Positive aggregate demand shocks shift the aggregate demand curve to the right causing both inflation and output to rise, which shifts the short-run aggregate supply curve upward and causes the inflation rate to increase further. With a credible nominal anchor, however, expected inflation does not change, so there is no upward shift in the SRAS curve. Thus, with a credible nominal anchor, inflation is more stable following the demand shock. The outcome is similar when a negative aggregate supply shock occurs. Inflation increases and output falls as the SRAS curve shifts upward, but with a credible nominal anchor, expected inflation does not increase. As a result, no further upward shifts of the SRAS curve occur and the increase in inflation and decrease in output are not as great as they otherwise would be. Thus the credible nominal anchor brings about better outcomes for both inflation and output when a negative supply shock occurs.

The economy experiences prolonged increases in productivity growth while actual output growth is unchanged

Prolonged increases in productivity growth would increase potential output, and with the same rate of actual output growth this would cause the output gap to decline, resulting in a decline in the fed funds rate according to the Taylor rule

Suppose the current administration substantially increases military spending in response to the heightened risk of terrorist attack, which, in turn, leads to a substantial increase in budget deficit. Answer the following questions, assuming that MP curve does not shift in response to fluctuations in aggregate demand: Using a graph of aggregate demand and supply, show the effects of this fiscal initiative on the economy in the short run. Assume that the expected inflation of the public remains unchanged.

The AD curve shifts upward

If the Bank of Korea (BOK)'s primary objective is to keep the KRW pegged to the US dollar, will the BOK have to increase or reduce its policy rate in response to this political and economic development in the US? Predict what will happen to the Korean GDP, and Korean inflation rate? Explain why.

The BOK will have to reduce its policy rate; otherwise, KRW will appreciate. The Korean GDP and Korean inflation rate will rise as the BOK's expansionary policy will stimulate aggregate demand.

Explain how the Fed ought to react to this fiscal initiative. Does the Divine Coincidence hold? Explain why or why not. Illustrate your answer, using a graph of aggregate demand and supply as well.

The Fed's dual mandates are price and output stability; hence, it ought to react to this fiscal initiative by implementing contractionary monetary policy (i.e., raising the federal funds rate) and effectively shifting back AD curve to the original location (or in the ideal world, keeping AD curve from shifting out to begin with). The Fed's policy stabilizes both inflation rate and output so Divine Coincidence holds in this case.

If large budget deficits cause the public to think there will be higher inflation in the future, what is likely to happen to the SRAS curve when budget deficits rise?

The SRAS curve will shift upward because wages and production costs rise, since workers and firms expect prices to be higher

In what ways was the Volcker disinflation considered a success? In what ways was it considered a failure?

The Volcker disinflation is considered a success in that the Chair of the Federal Reserve, Paul Volcker, was finally able to bring inflation down to a permanently lower, stable level after a decade of high and volatile inflation through most of the 1970s. Unfortunately, the policies to get the economy on a path of low, stable long-term inflation required significantly contractionary policies. These policies resulted in two recessions in the early 1980s, with unemployment rising above 12% at its peak. So although the policies to reduce inflation from the high levels of the 1970s achieved their purpose, they did not come without some costs.

Describe the specific nature of this problem for the central banker and also for the diplomat, highlighting their commonality.

The optimal long-run policy for the diplomat is not to negotiate; otherwise, terrorists will likely take hostages, knowing that the diplomat will negotiate. The optimal long-run policy for the central banker is not to expand money supply to create jobs; otherwise, the public will expect higher inflation, and SRAS shifts up, thereby not only adding inflationary pressure but also negating the effects of monetary expansion on job creation. In both cases, the incentive of the policymaker to deviate from the optimal long-run policy is strong in the short-run, and the expectation that the policy-maker is likely to deviate from the optimal long-run policy leads to a sub-optimal outcome. The diplomat will be tempted to negotiate to rescue hostages. Knowing this, the terrorists take hostages. The central bank will be tempted to increase money supply to create jobs. Knowing this, the public expects higher inflation rate, which, in turn, creates inflationary pressure.

If the federal reserve buys dollars in the open exchange market but does not sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?

The purchase of dollars involves a sale of foreign assets, which means that international reserves fall and the monetary base decreases. The resulting fall in the money supply causes interest rates to rise and lowers the future price level, thereby raising the future expected exchange rate. Both of these effects raise the expected return on dollar assets at any given exchange rate, shifting the demand curve to the right and raising the equilibrium exchange rate.

If the Federal Reserve buys dollars in the foreign exchange market but conducts an offsetting open market operation to sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?

The purchases of dollars involves a sale of foreign assets, which means that international reserves fall. However, the offsetting open market purchase means that the monetary base and the money supply will remain unchanged. There is thus no change in the expected return on dollar assets, so the demand curve does not shift, and the exchange rate also remains unchanged.

If, in a surprise victory, a new administration that the public believes will pursue inflationary policy is elected to office, predict what might happen to t he level of output and inflation even before the new administration comes into power.

The rise in expected inflation as a result of the election would shift the short-run aggregate supply curve downward, which would leave to a rise in inflation and a fall in output

Why does the MP curve necessarily have an upward slope?

The upward sloping MP curve implies that real interest rates rise, rather than fall, when inflation increases. This is necessary because otherwise a rise in inflation would lead to a fall in real interest rates, which would lead to an increase in output, a further increase in inflation, and a further fall in real interest rates which would lead to even higher inflation. In other words, the MP curve must be upward sloping in order to keep inflation from spinning out of control

Describe each of the parameters in the Taylor equation. Explain why is it that h must be positive? How did h change over the course of the US monetary history?

This equation holds that short-term interest rates (r or the fed funds rate) should equal the equilibrium interest rate (rf) plus the inflation rate (pi) plus a positive function of output gap inflation. When inflation is above its target or when output is above its potential (holding other factors constant), then the policy response should be to raise interest rates to slow the economy down. If inflation and output are both at their target amounts, the nominal interest rate to target for the fed will simply be the target inflation rate plus the equilibrium real interest rate. For the equation to work, h must be positive. If it were negative, when inflation is above target inflation, this increase in inflation above target would call for a reduction in real interest rates. This would cause an increase in aggregate demand, further widening the gap between inflation and the inflation target.

Based on the concept of Lucas critique, describe how this fiscal initiative could have negative effects on output using a graph of aggregate demand and supply.

This fiscal initiative could have negative effects on output since it can lead to a spike in the expected rate of inflation, which shifts out the aggregate supply curve such that the economy ends up with a higher inflation rate and lower output.

determine whether the IS curve shifts to the right or left, does not shift, or is indeterminate in the direction of shift. In addition, use the aggregate demand - aggregate supply analysis to trace both the short - run and long - run impact of each shock on inflation rate and output: the real interest rate rises

This is a movement along the IS curve, and so does not shift the IS curve

Autonomous consumption decreases

This results in a decrease in equilibrium output at any given interest rate, which shifts the IS curve to the left. AD curve shifts to the left, which, in turn reduces inflation rate and output in the short run. In the long run, given that output is below its potential, the expectation of disinflation/deflation emerges, which, in turn, shifts down AS curve, causing further disinflation/deflation and an increase in output back to its potential.

Financial frictions increase

This results in a decrease in equilibrium output at any given interest rate, which shifts the IS curve to the left. AD curve shifts to the left, which, in turn reduces inflation rate and output in the short run. In the long run, given that output is below its potential, the expectation of disinflation/deflation emerges, which, in turn, shifts down AS curve, causing further disinflation/deflation and an increase in output back to its potential.

The government provides tax incentives for research and development programs for firms

This results in an increase in equilibrium output at any given rate, which shifts the IS curve to the right. AD curve shifts to the right, which, in turn, increases inflation rate and output in the short run. In the long run, given that output is above its potential, the expectation of inflation emerges which in turn, shifts up the AS curve, causing further inflation and a decrease in output back to its potential.

A central banker who is contemplating on lowering the interest rate in order to reduce unemployment rate confronts the same problem as a diplomat who is contemplating on negotiating with terrorists in order to have them release hostages. What is the technical term of this problem?

Time-inconsistency problem

Why can balance-of-payments deficits force some countries to implement contractionary monetary policies?

To finance the deficits, the central banks in these countries might intervene in the foreign exchange market and buy domestic currency, thereby implementing a contractionary monetary policy. The result is that they sell off international reserves and their monetary base falls, leading to a decline in the money supply.

"If a country wants to keep its exchange rate from changing, it must give up some control over its money supply." Is this statement true, false, or uncertain? Explain your answer.

True, because when the exchange rate is falling, the central bank must buy its currency, which lowers its holdings of international reserves and its monetary base. Similarly, when the exchange rate is rising, it must sell its currency, which raises its holdings of international reserves and its monetary base. The necessary central bank intervention to keep its exchange rate fixed thus affects the monetary base and hence the money supply.

Suppose that both the Korean and the US economies start out at the potential GDP with the stable inflation rate of 2%. Suppose that the Fed caves into political pressure from the US President and lowers the fed funds rate. Predict what will happen to the US GDP, and US inflation rate, and the value of USD in terms of KRW as a result of this political and economic development in the US. Explain why.

US GDP and US inflation will rise as the Fed's expansionary policy will stimulate aggregate demand. USD will depreciate visa PPP and UIP

How can persistent U.S. balance-of-payments deficits stimulate world inflation?

When other countries buy US dollars to keep their exchange rates from changing vis-a-vis the dollar because of the US deficits, they gain international reserves and their monetary base increases. The outcome is that the money supply in these countries grows faster and leads to higher inflation throughout the world.

If the unemployment rate is above the natural rate of unemployment, holding other factors constant, what will happen to inflation and output?

When the unemployment rate is above the natural rate of unemployment, there is slack in the labor market and output is below potential. This causes the SRAS curve to shift downward, leading to lower inflation and higher output over time, until the economy reaches a long-run equilibrium.

How does the policy rate hitting a floor of zero lead to an upward - sloping aggregate demand curve?

When the zero lower bound is hit, a lower inflation rate leads to a higher real interest rate because the nominal interest rate is fixed at zero, and this higher real interest rate then causes planned expenditure and therefore aggregate output to decline. The fall in aggregate output as inflation falls, then results in an upward sloping aggregate demand curve.

Using an MP curve and an AS/AD graph, show how a sufficiently large financial panic can pull the economy below the zero lower bound and into a destabilizing deflationary spiral.

a financial panic will increase financial frictions, thus raising the real interest rate on investments at any given inflation rate. A sufficiently large panic will push the economy to point B, where the self-correcting mechanism will lower inflation, and real rates will rise since the economy is beyond the ZLB. This results in a deflationary spiral in which the economy will move toward (and past) a point such as point C.

How can exchange-rate targets lead to a speculative attack on a currency?

with a pegged exchange rate, speculators are sometimes presented with a one-way bet in which the only direction for a currency to go is down in value when a country's central bank is unable or unwilling to defend the currency's value. In this case, selling the currency before the likely depreciation gives speculators an attractive profit opportunity with potentially high expected returns. As a result, they jump on board and attack the currency.