Policy

Question 1

How do macroeconomists deal with uncertainty?

Answer 1

• They do not have all the knowledge required for solving economic problems
• Rely on econometric models which give answers for how to solve a particular problem

Question 2

Should uncertainty lead policy makers to do less?

Answer 2

• Uncertainty leads policy makers to be cautious
• Policies should be broadly aimed at avoiding prolonged recessions and inflationary pressure whilst slowing down booms
• The higher the unemployment rate the more active the policies should be
• Should stop short of fine tuning - trying to achieve constant unemployment or constant output growth

Question 3

If α = 1, by accepting inflation of 1% - what effect does that have on the unemployment rate?

Answer 3

Unemployment rate will be 1% below natural rate.

Question 4

What happens when wage setters expect positive inflation?

Answer 4

Economy returns to the natural rate of unemployment but with higher inflation

Question 5

What is Ricardian Equivalence?

Answer 5

The proposition that neither deficits nor debts have any effect on economic activity

Question 6

Does how extra government spending is financed matter for economic activity?

Answer 6

• Consumers do not change their consumption in response to a tax cut if the PV of after tax labour income is unaffected
• The effect of lower taxes is cancelled out by higher taxes tomorrow

Question 7

Does the timing of taxes matter?

Answer 7

• No, the present value of tax liabilities matters

Question 8

Does Ricardian Equivalence apply in practice?

Answer 8

• Evidence suggests we should take it seriously
• Not enough to suggest debts and deficits don’t matter

Question 9

What does budget deficits having adverse effects imply?

Answer 9

Deficits during recessions must be offset by surpluses during booms to avoid a steady increase in debt

Question 10

What is a full employment deficit?

Answer 10

The deficit there would be under existing tax and spending rules if output were at its natural level

Question 11

What happens if actual deficit is large but cyclically adjusted deficit is zero?

Answer 11

• Fiscal policy is consistent with no systematic increase in debt over time
• Debt increases as long as output is below the natural level but as it returns to natural level the deficit disappears and debt will stabilise

Question 12

Discuss the goals of fiscal policy.

Answer 12

• Not necassarily to maintain cyclically adjusted deficit equal to zero at all times
• In a recession government may want to run a deficit large enough that CAD is positive

Question 13

How is the practice of cyclically adjusted deficit tricky?

Answer 13

• Not easy to establish how much lower deficit would be if output were higher
• Very difficult to assess how far output is from its natural level

Question 14

Describe automatic stabilisers?

Answer 14

A recession naturally generates a deficit and therefore a fiscal expansion - counteracting the recession

Question 15

What are two good reasons to run deficits during war?

Answer 15

• Distributional - deficit finance is a way to pass some of the burden of those alive after the war
• Economic - deficit spending helps reduce tax distortions

Question 16

How do governments fund wars?

Answer 16

• Wars lead to large increase in government spending
• Question for government is to fund whether through debt or taxation.

Question 17

Discuss the effect of deficit financing in relation to war.

Answer 17

• Sharp increase in government spending increases demands for goods
• Output is fixed thus interest rates will go up
• Investment will decrease sharply

Question 18

What is tax smoothing?

Answer 18

Running large deficits when government spending is exceptionally high and small surpluses the rest of the time

Question 19

Discuss the effect of taxation financing in relation war.

Answer 19

• Increase in taxation lowers consumption sharply
• By how much depends on expectations - how long will war last etc
• Increase in gov spending is offset by decrease in consumption meaning increase in interest rate and decrease in investment is smaller

Question 20

What are the economic justifications for imposing rules on countries participating in a monetary union?

Answer 20

• Euro area sovereign debt crisis has at its roots large increases in the Debt-to-GDP ratios of many countries in the Euro area

Question 21

Why systematically run public deficits?

Answer 21

• Increase public spending before elections in order to increase probability of re-election
• Govs spend above their means to pass burden to future generations
• Advanced countries population are ageing - meaning high spending on public pensions relative to contributions paid by the population in working age

Question 22

Why are countries of monetary unions subjects to constraints on their fiscal policies?

Answer 22

• To correct the incentive to pass on the costs of fiscal expansion
• To prevent financial crisis in one country spreading to all other members

Question 23

Rules of the money growth rate.

Answer 23

• Until the 90s the design of monetary policy revolved around nominal money growth
• Central banks chose a nominal money growth for the medium run

Question 24

Rules of inflation targeting.

Answer 24

• Central banks tend to have adopted an inflation target rather than a nominal money growth rate
• In this case CBs consider short run policy to move nominal interest rate rather than movements in nominal money growth

Question 25

Does inflation target eliminate all deviations of output from natural level? Explain your answer.

Answer 25

No
- Central banks cannot always achieve the rate of inflation it wants in the short run
- Philips Curve relationship does not hold exactly

Question 26

What are the 4 main costs of inflation?

Answer 26

• Shoe leather costs
• Tax distortions
• Money illusion
• Inflation variability

Question 27

Describe shoe leather costs.

Answer 27

• Costs of making more trips to the bank in the presence of inflation - reflect an increase in the opportunity cost of holding money
• Trips would be avoided if inflation were lower

Question 28

Describe tax distortions.

Answer 28

• Taxation on capital gains - higher the inflation higher the tax
• Effective tax rate is the ratio of the tax you pay to the price of which you sell your house

Question 29

Describe money illusion.

Answer 29

• The notion that people appear to make systematic mistakes in assessing nominal v real changes
• When they compare their income to previous years, individuals must take into account inflation

Question 30

Describe inflation variability.

Answer 30

Higher inflation is associated with more variable inflation

Question 31

What are the three benefits of inflation?

Answer 31

• Seignorage
• The option of negative real interest rates
• Money illusion revisited

Question 32

Describe seignorage.

Answer 32

• Money creation is one of the ways governments can finance its spending
• Important source of government finance in countries with high inflation
• Much more limited for OECD countries

Question 33

Describe negative real interest rates.

Answer 33

An economy with a higher average inflation rate has more scope to use monetary policy to fight a recession

Question 34

Describe money illusion revisited.

Answer 34

• Presence of inflation can permit downward real wage adjustments more easily than if there was no inflation
• Inflation grease the wheels of the economy

Question 35

Describe how some see price stability (zero inflation) as an optimal inflation rate.

Answer 35

• Gives stability to prices
• Eliminates money illusion which eases decision making
• Given time inconsistency, price stability is a credible and stable inflation target

Question 36

Describe why some see small inflation as optimal inflation rate.

Answer 36

• Indexing the tax system and bonds prevents some costs of inflation
• Reducing inflation could have non-linear costs