Unit 5: Macroeconomic Policy Model and New Normative Macroeconomics Flashcards
SR and LR responses of pi and the Y-Gap if a rise in G causes r* to inc. but the Fed does not change r^e*
Both symbolically and graphically.
SR and LR responses of pi and the Y-Gap if pi^e rises.
Both symbolically and graphically.
What are the four types of economic costs of inflation?
1.
What individuals benefit from higher inflation and which ones lose?
Three types of economic costs of output loss.
1.
What are the benefits and costs of
unemployment for workers?
Benefits:
- fjkdlsf
Costs:
- it sucks
Show how each of the following would initially affect the assets and liabilities of the Federal Reserve. Indicate the particular type of assets or liabilities that change.
a. The Federal Reserve sells $100,000 in domestic credit to a bank.
b. The Federal Reserve reduces its foreign reserves by $250,000 by conducting a sterilized
foreign exchange intervention.
Macroeconomic policy trilemma
How do the United States, Germany, and Argentina differ in their approaches to
the macroeconomic policy trilemma?
Taylor-style nominal interest rate rule
Direct and Indirect effects of real exchange rates on target interest rate in Taylor-style nominal interest rate rule.
Based on the research of the U.S. economy, does the real exchange rate have a direct effect on the Federal Reserve’s target nominal interest rate?
Phillips Curve [Alg.]
Natural Rate Property
There is no long-run trade-off
between inflation and output.
Simplifications to f from the the Phillips Curve
f = f(), where f is a constant such that f>0
Which theories support the positive relationship between output and inflation?
- Imperfect Information Theory
- Staggered Wage Setting Model
What does the economic environment affect within the Phillips Curve?
- Responsiveness of pi to the Y-Gap.
- The formation of pi^e
Two primary factors that influence f
- Degree of Wage Indexing
- Forecasted length and severity of a business cycle
Wage Indexing’s influence on f
The higher the value of ai, the more responsive
π is to (Y-1 – Y*)/Y*. This is reflected in the modified Phillips
curve equation, with a larger value of f.
Wage-Price Spiral (An Inc. in Y)
Inc. in Y -> W/P inc. 1% -> MC inc. 1% -> P(pi) inc. by 1% -> W/P inc. ai%
-> pi inc. ai%
The total effect of wage indexing on price inflation
Worker’s expectations of future average wages from the expectation of a long vs short recession. Its effect on MC and price inflation.
They are lower when expectation are of a long recession, so they are more willing to accept lower wages. Causes a large decline in MC -> a large reduction in P inflation.
The expectation of a long business cycle means pi is ___ responsive to ____ than if it is expected to be short. What does it mean for f?
more; the output gap; larger value for f
The most difficult component of the Phillips curve to measure is
_____
the expected inflation rate, πe.
Two important factors to consider when measuring
π^e.
a. Forward-looking forecasts of future prices and wages
influence the process of current wage setting and, thus,
affect the expected inflation term.
b. Staggered contracts and backward-looking wage behavior
influence the expected inflation term because they contain
inertia that cannot be changed immediately.
Expectations augmented Fisher equation
R = r + πe
Exact Fisher Equation
Modified IS Curve (Graph and Alg.)
Relationship between interest rate gap and output gap on the IS Curve
Macroeconomic Policy Curve (Alg.)
Macroeconomic Policy Curve (Graph)
Factors that shift the MP curve
a. An increase in π* shifts the MP curve rightward.
b. An increase r* without an equal increase in re* causes the
MP curve to shift rightward. (Ex., A permanent increase
in G causes r* to rise.)
G increases permanently (MP/PA Curve)
This change causes r* to
rise. If the Fed does not change re*, then this increase in r*
causes the MP curve to shift rightward.
pi* dec. permanently (MP/PA Curve)
pi^e rises (MP/PA Curve)
Five General Principles of Macro Policy Analysis
- When making decisions, people think about the future.
- Macroeconomic policy can be described and evaluated as a
monetary policy rule. - If a particular policy rule is to work well, policymakers must
commit to that rule. - Since the economy is basically stable, output and employment
eventually, return to their long-run trends after an economic
shock. - The objective of macro policy is to keep inflation low while
simultaneously minimizing fluctuations in output, employment,
and inflation after an economic shock.
When making decisions, people think about the future [Principle]
- When modeling expectations, we assume that people are
familiar with economic fluctuations over the business cycle. - People use this information to form unbiased (but not error-free) forecasts of future economic conditions.
Macroeconomic policy can be described and evaluated as a
monetary policy rule. [Principle]
- Since people are forward-looking, their expectations of
current and future policy actions affect their current behavior
and the present state of the economy. - To evaluate the effect of an explicit policy on the economy,
we need to specify how policy responds to current and future
events.
If a particular policy rule is to work well, policymakers must
commit to that rule. [Principal]
- In economies where people believe policymakers are
following a certain policy, policymakers have a short-run
incentive to boost output by deviating from that policy. - When policymakers deviate from their policy rule to boost
output, people expect policymakers to conduct similar
policies in the future. People respond by increasing their
inflation expectations, which results in higher inflation but
output does not change. - Thus, the willingness of policymakers to deviate from their
policy rule for short-run gains has negative long-run
consequences.
The macro policy problem involves choosing a policy rule that
describes how _____.
the instruments of policy should respond to
economic conditions in order to improve the performance of
target variables.
The Instruments of Macro Policy
a. Monetary base
b. Nominal interest rate
The Target Variables of Macro Policy
a. Inflation rate
b. Unemployment
c. Output
A social welfare function summarizes _____
the cost of having the
target variables deviate from their desired levels.
Example of Social Welfare Function
welfare = [(Y – Y*)/Y*]2 + [π – π*]2
Reason U is not included in welfare function.
The Y-gap captures this deviation from the natural rate of U.
Why are Y and pi squared in the social welfare function?
Small deviations in both are preferable to a large deviation in one variable.
A major problem for macro policy is that its benefits do not ____
occur at the same time as its costs.
Economic costs of inflation (4)
- Shoe-leather costs
- Additional tax costs
- Some people gain and some lose
- Institutional Costs
Shoe-leather costs
The cost of making extra trips to the bank in order to avoid
holding currency that is constantly losing its purchasing
power.
The additional tax costs of inflation
The public incurs additional tax costs because some
components of the tax system, such as capital gains taxes, are
not indexed to the inflation rate.
When inflation hits, some people gain and some lose.
- Retired people whose pensions are in fixed dollars lose.
- Ex. homeowners with a fixed rate mortgage gain because
they can pay off their mortgages in less valuable dollars.
Institutional costs of inflation
Some economic institutions, such as private retirement
arrangements, do not adapted rapidly to inflation so people
who rely on these institutions suffer when there is inflation.
Some general views of inflation (2)
- Some people see inflation as a breakdown in the government’s
responsibility to provide a stable unit of purchasing power. - Some people do not understand that incomes move up with
prices but instead view higher prices as diminished real income (it is for those not currently working).
Costs of output loss (3)
- A reduction in disposable income.
- A decline in corporate retained earnings.
- A drop in tax revenue that will lead to cuts government
services and/or increases in future taxes.
Costs and Benefits to being Unemployed
- Unemployed workers, particularly the young, miss out on
valuable job training. - The experience of unemployment can also cause workers to become physically or mentally ill and
makes it more likely that the worker may turn to crime. - Periods of unemployment can also have benefits for unemployed workers if they acquire additional
skills (i.e. education) or enjoy their additional leisure time.
Macro policy focus on reduction of inflation variation (MP Curve)
βπ is large and βY is small. Thus, the MP curve is flat.
Macro policy focus on reduction of output gap
βπ is small and βY is large. Thus, the MP curve is steep.
Inflation Persistence Formula
If macro policy is focused on reducing variations in π, inflation deviation will ____
not persist for long periods
If macro policy is focused on reducing variations in the output gap, inflation deviation will ____
persist for long periods.
The costs of strict price stability (i.e., π = π*) are large
fluctuations in ___
output.
The costs of strict output stability (i.e., Y = Y*) are large
fluctuations in ___.
inflation
