Short run closed economy (IS/PC/MR; Traditional Keynesian vs. NKPC)

Question 1

Why do we have sticky prices?

Answer 1

Due to adaptive expectations - people form their expectations about what will happen in the future based on what has happened in the past.

Question 2

What is the equation for adaptive inflation expectations?

Answer 2

Inflation at t = expectations of inflation formed at t-1 + proportion of the output gap + error term

π_t= π_t^e+ a(y_t- y_n) + u_t

Question 3

How do wage price spirals work (as a result of adaptive expectations)?

Answer 3

People base their wage demands on inflation. If inflation is above target, they ask for a pay rise. Firms, not wanting lower profit margins, set prices above those that workers were expecting. The process continues due to adaptive expectations.

Question 4

What is the problem with price stickiness?

Answer 4

It leads to boom and bust - distortion of prices means that monetary policy isn’t reactive enough, demand doesn’t always equal supply

Question 5

What are the characteristics of the IS curve? [3]

Answer 5

1) Interest rate against output 2) Downward-sloping 3) Moved by demand shocks

Question 6

What are the characteristics of the PC? [3]

Answer 6

1) Inflation against output 2) Upward-sloping 3) Moved by cost-push shocks / expectations

Question 7

What are the characteristics of the MR curve? [4]

Answer 7

1) Inflation against output 2) Downward-sloping 3) Steepness reflects inflation-aversion of central bank: the flatter the line, the more inflation-averse, the more willing they are to see output fall to combat inflation 4) Moved by policy shocks (changes)

Question 8

What happens in the three-equation model when there is an unforeseen negative demand shock? [6] (May help to draw diagram)

Answer 8

1) Shift left in IS 2) At first, expectations do not change, so move along PC 3) Next period, inflation is lower, so PC shifts downwards 4) The central bank must choose its position along this new PC, according to its Monetary Rule, through changing interest rates 5) Tend to assume they care more about inflation than output, so end up expanding economy beyond the natural level of output 6) This effects a gradual reflation to target inflation, with expectations slightly higher each time Problem - likely to overshoot the target!

Question 9

What is the difference in MPC reaction between a foreseen/unforeseen temporary/permanent shock?

Answer 9

Temporary: rates will go back to where they were Permanent: rates will stay high permanently Unforeseen: have to go through process of deflation/reflation Foreseen (e.g. government spending): bank immediately sets the interest rate to where it will get y_n This allows the bank to completely eliminate the shock immediately - hence why fiscal multipliers can be zero

Question 10

Why might price level targeting be a better approach than inflation targeting?

Answer 10

Otherwise we have inflation at 2% and the path of prices permanently lower. However, price-level targeting would mean causing inflation on purpose to get back on track - problem of shoe leather costs

Question 11

Define the problem of the Zero Lower Bound

Answer 11

Nominal interest rates are at zero, but real interest rates are not low enough to raise demand enough to get out of the trough

Question 12

Explain how a demand shock can cause the problem of the ZLB

Answer 12

1) IS shifts inwards 2) Central bank wants to lower nominal interest rates to move along new IS curve back to Y_n 3) However, they can only drop nominal rates to zero - where real interest rates then equal the negative of expected inflation 4) If actual inflation is falling, and expected inflation follows, the problem worsens as the ZLB line gets pushed up

Question 13

How can governments best solve the ZMB problem?

Answer 13

With a credible price level target - which raises expected inflation (at the ZLB, real interest rates = negative of expected inflation)

Just promising a future boom is not enough because of the problem of time inconsistency - but if the central bank were committed to returning the pricel level to target, it would have to encourage high inflation.

Question 14

What happens when there is a supply shock (e.g. an unexpected oil price increase / increase in VAT)?

Answer 14

1) Input costs up, so producer prices up. Consumer prices up due to imported inflation - the PC moves upwards 2) Real wages (w/p) fall, so the PS shifts downwards, and output/employment falls (assume the WS curve does not change) 3) What happens to inflation depends whether expectations are adaptive or not…

Question 15

What happens if you have an unexpected oil price increase (supply shock), and expectations don’t change? [3]

Answer 15

1) Imported inflation shifts the PC upwards (cost-push shock) 2) Inflation is then managed by interest rates back down to the target level 3) Output is lower as the economy has moved along the PC

Question 16

What happens if you have an unexpected oil price increase (supply shock), and expectations do change? [5]

Answer 16

1) Imported inflation shifts the PC upwards (cost-push shock) 2) Inflation expectations rise, and the PC shifts up again 3) Following the MR, the central bank must raise interest rates to choose its position on the new PC 4) The economy is deflated back to target, with inflation expectations lowering each period 5) Output/employment is below the natural rate in order to lower inflation expectations

Question 17

What were the differences between the 1970 and 2005 oil crises? [6]

Answer 17

1) Expectations models changed - introduction of inflation targeting 2) Wage rigidity fell - for a given shift in the PS curve, output did not fall as far 3) “Output optimism” and “inflation pessimism” in the 1970s - banks overestimated their positive impact and underestimated their negative impact 4) Advances in computation and communication, reducing the amplitude of fluctuations in business inventory stocks 5) 1970s oil price shock coincided with other large shocks 6) Substitution away from the use of oil

Question 18

What happens when you introduce inflation targeting?

Answer 18

It allows rational expectations to be formed. As long as expected inflation equals the inflation target, there is not the need to deflate output - disinflation is costless, people do the work for the central bank

Question 19

What is the rational expectations hypothesis?

Answer 19

Individuals use all available information and set expectations as their best guess of the future value of inflation. Expectation = what inflation turns out to be + any random unpredictable error

Question 20

Why do people like the rational expectations hypothesis?

Answer 20

Because it is microfounded - we accept rationality in microeconomics, so why not macro? People should learn from systematic mistakes

Question 21

Define the New Keynesian Phillips Curve (NKPC)

Answer 21

Inflation depends on expected inflation next period: π_t = β*π_(t+1)^e + α(y_t-yⁿ) where β is a discount factor close to 1.

Question 22

What does price stickiness depend on in the NK model? [3]

Answer 22

1) Calvo contracts 2) Menu costs 3) Sticky information on the appropriate level of prices

Question 23

What is a Calvo contract? [3]

Answer 23

1) Each period, only a random fraction of firms can reset their price 2) When they do reset, a firm must take into account that the price may be fixed for many periods 3) The optimal solution is to set the price equal to the weighted average pf the prices that it would have expected to set in the future if there weren’t any price rigidities

Question 24

What is good about the NKPC?

Answer 24

It offers a solution to the ZLB problem - raising future demand. Promising a future boom raises inflation today, reducing interest rates today, stimulating the economy. Just requires that we trust the central bank

Question 25

What are problems with the NKPC? [2]

Answer 25

1) No country has ever achieved costless disinflation 2) Inflation appears to follow, rather than lead, excess demand/output

Question 26

Name six differences between the traditional PC and the NKPC

Answer 26

1) Expectations: adaptive vs. rational 2) Excess output: followed by inflation vs. caused by inflation 3) Inflation: has inertia vs. is able to jump 4) Disinflation: requires deflation through PC loops vs. credible disinflation being costless 5) Main problem: underestimates rationality vs. doesn’t match data 6) Prices: respond quickly vs. sticky in short run