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TUTORIAL 9: Stabilization Policy
- What is the inside lag and the outside lag? What has longer inside lag – monetary or
fiscal policy? Which has the longer outside lag? Why?
The inside lag is the time it takes for policymakers to recognize that a shock has hit the economy and to put the appropriate policies into effect. Once a policy is in place, the outside lag is the amount of time it takes for the policy action to influence the economy. This lag arises because it takes time for spending, income, and employment to respond to the change in policy.
Fiscal policy has a long inside lag—for example, it can take years from the time a tax change is proposed until it becomes law. Monetary policy has a relatively short inside lag. Once the Fed decides a policy change is needed, it can make the change in days or weeks.
Monetary policy, however, has a long outside lag. An increase in the money supply affects the economy by lowering interest rates, which, in turn, increases investment. But many firms make investment plans far in advance. Thus, from the time the Fed acts, it takes about six months before the effects show up in real GDP.
a) Describe adaptive expectations and rational expectations
b) Explain why are expectations so important in macroeconomic theory? [Hint: Use your knowledge from the previous Mankiw’s chapter dealing with “SRAS & Inflation Unemployment Trade-off”]
c) Describe the Lucas critique. What is its relevance to macroeconomic policymaking?the assumption is that people form their expectations of inflation based on recently observed inflation. This assumption is called adaptive expectations.
- a) What is meant by the “time inconsistency” of economic policy?
The problem of time inconsistency arises because expectations of future policies affect how people act today. As a result, policymakers may want to announce today the policy they intend to follow in the future, in order to influence the expectations held by private decision makers.
b) Why might policymakers be tempted to renege on an announcement they made earlier? In this situation, what is the advantage of a policy rule?
Once these private decision makers have acted on their expectations, the policymakers may be tempted to renege on their announcement. For example, your professor has an incentive to announce that there will be a final exam in your course, so that you study and learn the material. On the morning of the exam, when you have already studied and learned all the material, the professor might be tempted to cancel the exam so that he or she does not have to grade it.
In monetary policy, suppose the Fed announces a policy of low inflation, and everyone believes the announcement. The Fed then has an incentive to raise inflation, because it faces a favorable tradeoff between inflation and unemployment.
Understanding that policymakers may be inconsistent over time, private decisionbmakers are led to distrust policy announcements.. In these situations, a rule that commits the policymaker to a
particular policy can sometimes help the policymaker achieve his or her goals—students study, terrorists do not take hostages, and inflation remains low. In this situation, to make their announcements credible, policymakers may want to make a commitment to a fixed policy rule.
c) List three policy rules that the Fed might follow. Which of these would you advocate and why
One policy rule that the Fed might follow is to allow the money supply to grow at a constant rate. Monetarist economists believe that most large fluctuations in the economy result from fluctuations in the money supply; hence, a rule of steady money growth would prevent these large fluctuations.
A second policy rule is a nominal GDP target. Under this rule, the Fed would announce a planned path for nominal GDP. If nominal GDP were below this target, for example, the Fed would increase money growth to stimulate aggregate demand. An advantage of this policy rule is that it would allow monetary policy to adjust to changes in the velocity of money.
A third policy rule is a target for the price level. The Fed would announce a planned path for the price level and adjust the money supply when the actual price level deviated from its target. This rule makes sense if one believes that price stability is the primary goal of monetary policy.
- Discuss the arguments for policymakers to pursue active policies and arguments for pursuing passive policies?
A person’s view of macroeconomic history affects his or her view of whether macroeconomic policy should play an active role or a passive role. If one believes that the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy is clear. Conversely, if one believes that the economy has experienced few large shocks, and if the fluctuations we observe can be traced to incompetent economic policy, then the case for passive policy is clear.
TUTORIAL 7: Mundell-Fleming Model
- Venus Island is a small open economy with perfect capital mobility. The goods market, exchange rate market and money market is in equilibrium when aggregate income/output is Y1, exchange rate is e1 and interest rate r1. Then the government implemented a contractionary fiscal policy.
a. Use Mundell-Fleming model to show and explain, by referring to the events in the each of the markets, the predicted effects of the income tax increase. Assume that Venus Island uses a floating exchange rate.
Contractionary fiscal policy is either when government decrease spending or increase taxes [ mark]. Below I will demonstrate with an increase in taxes but it has similar effects with decrease in government spending.
b. If the country used a fixed exchange rate, explain how the equilibrium on IS-LM market will change.
c. If Venus country was in a recession and wanted to use a combination of (discretionary) fiscal policy and monetary policy to stimulate GDP, which exchange rate type will this be feasible and why?
- Mars Island is a small open economy with a fixed exchange rate and perfect capital mobility. The country bans imports with an objective to increase net exports and GDP.
Use the Mundell-Fleming model to show and explain, by referring to the events in the goods market, the money market and the exchange rate market, the predicted effect of import ban on the country’s output, employment, trade balance and the exchange rate. Comment whether the country’s objective was met.
- The government of Alpha nation wants to make domestic industries more competitive (i.e. improve trade balance), but does not want to alter aggregate income. According to the Mundell- Fleming model, show and explain the combinations of monetary and fiscal policy they should pursue as well as the appropriate exchange rate?
[Note: There is no need to refer to the goods and money market; just the IS-LM graph(s) are adequate]
Do not to refer to the goods and money/exchange rate market since you are not asked to; just the IS- LM graph and explanation are adequate.
This is an application question, which has the same solution as question 1 above.
Thus, the same question can be asked differently and this one started from the result you would like to achieve.
[Maximum: 15 marks]
Making domestic industries more competitive i.e. make the nation improve its trade balance meaning by either decreasing its imports [1 mark] or increasing its exports [1mark]. In order for net exports to increase [1 mark], the exchange rate has to decrease [1 mark] i.e. depreciate [ mark]. Hence, we need to adjust the IS* and/or the LM* curves such that we obtain a decrease in the exchange rate while keeping income unchanged. As shown in the graph below, we can achieve this by shifting the IS curve to the left [1 mark]. Thus, the government has to engage in contractionary fiscal policy [2 marks] i.e. either an increase TAXES [1 mark] or decrease GOVT SPEND [1 mark]. Both have the effect of reducing the exchange rate [1 mark], i.e. making our goods cheaper relative to the world [1 mark]. In other words they depreciate our currency [ mark]. No monetary policy action is required [1 mark] since LM* curve did not shift [1 mark]. Clearly, Alpha nation is a small open economy, with perfect capital mobility, and with floating exchange rates [2 marks].
- Beta Island has a floating exchange rate system and perfect capital mobility. Use the Mundell- Flemming model to explain the macroeconomic effects of a monetary contraction while referring to the effects on the goods market, the money market and the exchange rate market.
Contractionary monetary policy is when the central bank reduces money supply [1 mark]
Money & exchange rate market: ↓ M ↑ r ↑ e [Draw liquidity pref. graph]
(temporary) 3 marks for Liquidity preference graph 5 marks for explanation
Goods market: ↑ e ↓ NX ↓ PE ↓ Y [Draw Keynes cross & IS-LM graphs]
3 marks for Keynesian cross graph 4 marks for explanation T
he IS-LM graph [4 marks] depicts the outcomes highlighted in red i.e. ↑ e and ↓ Y [1 mark]
TUTORIAL 8: SRAS & Inflation Unemployment Trade-off
- Explain the two theories of short-run aggregate supply model. Mention the market imperfections that each of the two theories for short-run aggregate supply rely?
In this chapter we looked at three models of the short-run aggregate supply curve. All three models attempt to explain why, in the short run, output might deviate from its long-run “natural rate”— the level of output that is consistent with the full employment of labor and capital. All three models result in an aggregate supply function in which output deviates from its natural rate Y when the price level deviates from the expected price level:
c. An aggregate demand shock (in the form of increased police force to control drug trafficking), raised Beta’s expected inflation to 14% percent (the natural unemployment rate is unaffected). Graph the new Phillips curve and compare with the one you drew in part (ii). What happens to the unemployment rate if the central bank holds actual inflation at 9 percent? What happens to the Phillips curve and the unemployment rate if the central bank announces that it will hold inflation at 9% after the aggregate demand shock and this announcement is fully believed by the public?
d. Define Okun’s law and define sacrifice ratio. How much cyclical unemployment is necessary to reduce inflation by 3 percent? Using Okun’s law, compute the sacrifice ratio.
To reduce inflation, the Phillips curve tells us that unemployment must be above its natural rate of 6 percent for some period of time. We can write the Phillips curve in the form
π – π –1 = 0.5(u – 0.06).
Since we want inflation to fall by 5 percentage points, we want π – π –1 = –0.05.
Plugging this into the left-hand side of the above equation, we find
–0.05 = –0.5(u – 0.06).
We can now solve this for u:
u = 0.16.
Hence, we need 10 percentage point-years of cyclical unemployment above thenatural rate of 6 percent.
Okun’s law says that a change of 1 percentage point in unemployment translates
into a change of 2 percentage points in GDP. Hence, an increase in unemployment
of 10 percentage points corresponds to a fall in output of 20 percentage
points. The sacrifice ratio is the percentage of a year’s GDP that must be forgone
to reduce inflation by 1 percentage point. Dividing the 20 percentage-point
decrease in GDP by the 5 percentage-point decrease in inflation, we find that the
sacrifice ratio is 20/5 = 4.
- Refer to Mankiw’s FYI box titled “How precise are estimates of the natural rate of unemployment”
a. Why is the natural unemployment rate an important economic variable?
b. Describe any two factors that explain the change in the natural unemployment rate over time?
c. Describe two government policies, if any, might be used to reduce the natural unemployment rate?
Tutorial 2 – Classical Macroeconomic Model of a Closed Economy: Read Ch. 3 - Mankiw
- Jewel Island, is a small open economy. The Island’s economy is described by the
following long-run classical equations where represent domestic interest rates:
Y=
G=
b. Investment depends negatively on the world interest rates:
S = Y − C − G
= 5,000 − [250 + 0.75(5,000 − 1,000)] − 1,
S = 500
National savings, S remains the same as in part (a): I = 750
S − I = NX
500 − 750 = NX
NX = − 250
NX = 500 − 500 ∈
− 250 = 500 − 500 ∈
∈ = 1.
In part (a), national savings was equal to investment so there was no borrowing from abroad since there
was a trade balance. The increase in government spending reduced national saving, but with an
unchanged world interest rate, investment remained the same. Therefore Jewel/domestic investment
now exceeds its/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
appreciate (i.e. exchange rate to rise).s
c. National savings, S remains the same as in part (a): 𝑆 = 750
In part (a), national savings was equal to investment so there was no borrowing from abroad since there
was a trade balance. Savings is unchanged from part (a), but the higher world interest rate lowers
investment causing a capital outflow. This capital outflow is accomplished by running a trade surplus
, which requires the currency to depreciate.
Use EITHER the S-I vs NX graph OR the S vs I graph as below
