7. Policy

Question 1

What is debt owed by the government equal to?

Answer 1

The stock of bonds

Question 2

When do we have explosive debt?

Answer 2

When real interest rate is greater than growth of GDP

Question 3

Explain the vicious cycle of having a high debt/GDP ratio

Answer 3

To increase the primary surplus the gov raises taxes and cuts spending. This causes more political uncertainty, further increasing the risk premium and therefore interest rates. This generates a deeper recession, further reducing the rate of growth, causing r-g to increase making it even more difficult to stabilise the debt/GDP ratio

Question 4

Ways to reduce debt

Answer 4

Generate sufficient primary surpluses
Resort to monetary financing
Repudiate the debt (file for bankruptcy)

Question 5

What does the Lucas critique state?

Answer 5

That it is unrealistic to assume wage setters wouldn’t consider changes in policy when forming their expectations (they would consider their expectations of the future)

Question 6

What is the essential component of disinflation?

Answer 6

The credibility of monetary policy- the belief by wage setters that the central bank is truly committed to reducing inflation

Question 7

What is the Ricardian equivalence?

Answer 7

The argument that once the government budget constraint is taken into account, neither deficit nor debt has an effect on economic activity

Question 8

What is time inconsistency?

Answer 8

The differing in objective functions between firms/ households and government/ politicians

Question 9

Ways to deal with time inconsistency

Answer 9

• make central bank independent
• give incentives to central bankers to take long term view
• choose a “conservative” banker who dislikes inflation

Question 10

Ways to minimise budget deficits

Answer 10

Put limits on deficits

Put mechanisms in place if large deficits are to arise

Question 11

Taylor rules

Answer 11

The fact most central banks set an inflation target and then adjust nominal interest rates accordingly