3 - Macro Policy In The 3-Equation Model Flashcards
Why is monetary policy chosen over fiscal policy as the preferred tool for stabilisation policy?
- fiscal policy cannot be adjusted at MONTHLY intervals.
- FLEXIBILITY - fiscal policy cannot respond quickly to shocks because of time lags in setting fiscal policy.
- INHERENTLY POLITICAL - fiscal policy has direct redistributive consequences, whilst monetary policy does not create obvious winners and losers.
What does the government gain from controlling monetary policy?
The government can use it for electoral advantage.
The electorate values low inflation.
Why would governments choose to delegate responsibility for monetary policy to an independent CB?
To avoid the temptation to manipulate interest rates to achieve short-term favour with the voters/electorate.
When inflation is high…
People want to hold less money.
Shoe leather coats: people spend more time managing their financial assets.
Menu costs: firms incur costs and the need for frequent price changes.
Governments seeking to reduce inflation
-from rising inflation
Can be very costly and there is a period of high unemployment, this is wasteful:
- resources
- skills
- social costs
Rising inflation in the WS-PS model
Rising inflation leads to the persistent frustration of workers real wage expectations.
Volatile (slow-moving) inflation which often accompanies high inflation
Volatile inflation can distort resource allocation to the extent that it masks relative price changes.
Advantages and disadvantages of a target inflation rate of 0%
Advantages
•closer to the optimal rate of inflation
•return on holding notes and coins is zero
Disadvantages
•makes changes in relative prices and wages more difficult
-downward nominal rigidity
Advantages and disadvantages of a target inflation rate of 4%
Advantages
•retain policy effectiveness for the CB in the event of a serious negative demand shock
•avoid the danger of a deflation trap
-reduce interest rates when demand is very weak to stimulate interest-sensitive spending (investment), but this can push the nominal interest rate close to it’s lower bound of zero.
•a positive interest rate allows for changes in relative wages.
What is the Central Bank’s loss function?
A CB’s loss function captures the costs it incurs of being away from the inflation target and from equilibrium output.
Inflation-averse loss circle
Wide
Will accept a large increase in unemployment in order to reduce inflation sharply.
Unemployment-averse loss function
Tall and thin
Will favour a gradualist strategy in which the peak of unemployment associated with adjustment to the shock is lower.
Adjustment takes longer because smaller reductions in inflation are achieved each period.
Inflation averse CB
Initially entails a larger negative output gap and more disruption to the economy as firms lay off workers.
Higher unemployment but for a shorter time.
Inflation shock
-unemployment goes up before the economy returns to equilibrium
Inflation is above target. The CB will need to reduce output below equilibrium to squeeze inflation out of the system.
To do so, reduce aggregate demand by increasing the real interest rate to get the eve only back on the MR curve.
Permanent negative aggregate demand shock
•shift IS curve left
•negative output gap implies a decrease in bargaining power for workers
-inflation falls due to lower wages and markup prices
•CB changes Phillip’s curve and cuts the interest rate to get economy back on MR curve.
