topic 2 - a review of the demand side of the economy

Question 1

what are the good reasons for the target rate of inflation to be a small but positive number?

Answer 1

1) there are measurement errors so that some price increases are justified by improvements in the goods being sold
2) at all times the economy is evolving with the thriving sectors and dying ones. ideally labour should shift towards the thriving ones but there are many barriers to such movements. workers resist cuts in the nominal wage much more than any change in the real wage. some price inflation is said to act as lubricant for these shifts as workers in thriving sector get wage increase that exceeds current inflation gaining in real terms and those who don’t switch suffer a fall in real wages
3) the nominal interest rate can practically only ever go down to zero. given the fisher relationship, a positive inflation can therefore push the real interest rate into negative territory which is sometimes needed as has been case since financial crisis.

Question 2

what are the good reasons for the ideal level of output being at the equillibrium level Ye and nothing futher

Answer 2

can only be justified by introducing forward looking firms and households according to a rational expectations model which will be done at a later stage
such a model will also provide a justification for the implicit institutional setup of the 3 equation model of an inflation targetting central bank that enjoys a substantial degree of autonomy or independence in chooosing how to achieve such a target. the first such arrangement can be perhaps traced to the new zealand reserve bank around 1989. it is the culmination of a theoretical and policy debate that started in the early 1980s. but again rational expectations are needed to give a somewhat accurate account of it, which will be done at a later stage

Question 6

what does the parameter B measure in the monetary rule?

Answer 6

the paramenter B measures the relative weight between the output and the inflation obkectives.

Question 7

if the relative weight between output and inflation objectives are treated symmetrically what is the value of the parameter B and what is the shape of the indifference curves?

Answer 7

the value of the parameter B is equal to 1 and the indifference curve are perfectly circular

Question 8

if the relative weight between output and inflation objectives are treated asymmetrically, what is the value of parameter B and what is the shape of the indifference curves?

Answer 8

the value of parameter B is not equal to 1 than 1 and the indifference curve is elliptical.
if the parameter B is less than 1 then the indifference curves bulge out vertically and if the value is greater than 1 then the parameter B bulges out horizontally.

Question 9

if the parameter B is less than 1, then what is the monetary rule averse to?

Answer 9

it is unemployment averse when the parameter is less than 1

Question 10

if the parameter is greater than 1, then what is the monetary rule averse to?

Answer 10

it is inflation averse when the parameter is greater than 1

Question 11

how does the parameter B affect the reaction to an inflation shock?

Answer 11

depending on the value of B, the inflation averse policy will react more aggresively to an inflation shock and the MR will be flatter. conversely an unemploymen averse policy maker will adopt a more gradualist approach in order to limit the loss in output and the MR will be steeper.

Question 12

what is one of the reason for the longevity of the IS curve?

Answer 12

one reason for the longevity of the IS curve is that it can be many things to many people and yet synthetically take the exact same specification as y=A-ar , with an exogenous component determining its vertical intercept ad the negative sensitivity to the interest rate determining the slope.

Question 13

what are the key features that the keynsian cross capture that were what keynes intended?

Answer 13

it is a macroeconomic model
the causa causans or prime cause of equillibrium is investment (or any other autonomous component of expenditure)
savings adjusts endogenously and passively through the process of the multiplier
as a result it can be said that the direction of causation is from investment to savings

Question 14

what were the key features that are unquestionably different from what keynes intended?

Answer 14

1. It is a microeconomic model aggregated up assuming the process of aggregation to be neutral;
2. The prime cause of equilibrium is saving
3. Once the available Savings are determined, Investment becomes viable and the equilibrium is reached where the interest rate equals the Marginal Product of Capital (MPK)As a result it can be said that the direction of causation is from Savings to Investment.

Question 15

why are the IS and MR useful?

Answer 15

the IS has successfully and synthetically captured key determinants of output demanded and its simplicity has proven a reason for its resilience
the objective function underlying the MR has summarized the key institutional setup of inflation targeting independent central banks

Question 16

why are the IS and LM wrong?

Answer 16

the IS curve ends up being the night in which all cows are balck because it reduced form hides too much of its underlying casual mechanics. interpreting the IS curve originating from investment multiplier mexus is a departure from the underlying dynamic stochastic general equillibrium model where instead inter temporal optimisation is assumed with a loanable funds chain of causation
the objective function of central banks has been evolving particularily after the financial crisis and covid so that its specification would have to be revisited in ways that are not necessarily obvious or settled