Unit 5: Macroeconomic Policy Model and New Normative Macroeconomics

Question 1

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.

Question 2

SR and LR responses of pi and the Y-Gap if pi^e rises.

Both symbolically and graphically.

Question 3

What are the four types of economic costs of inflation?

Answer 3

1.

Question 4

What individuals benefit from higher inflation and which ones lose?

Question 5

Three types of economic costs of output loss.

Answer 5

1.

Question 6

What are the benefits and costs of
unemployment for workers?

Answer 6

Benefits:

• fjkdlsf

Costs:

• it sucks

Question 7

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.

Question 8

Macroeconomic policy trilemma

Question 9

How do the United States, Germany, and Argentina differ in their approaches to
the macroeconomic policy trilemma?

Question 10

Taylor-style nominal interest rate rule

Question 11

Direct and Indirect effects of real exchange rates on target interest rate in Taylor-style nominal interest rate rule.

Question 12

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?

Question 13

Phillips Curve [Alg.]

Answer 13

Question 14

Natural Rate Property

Answer 14

There is no long-run trade-off
between inflation and output.

Question 15

Simplifications to f from the the Phillips Curve

Answer 15

f = f(), where f is a constant such that f>0

Question 16

Which theories support the positive relationship between output and inflation?

Answer 16

• Imperfect Information Theory
• Staggered Wage Setting Model

Question 17

What does the economic environment affect within the Phillips Curve?

Answer 17

• Responsiveness of pi to the Y-Gap.
• The formation of pi^e

Question 18

Two primary factors that influence f

Answer 18

1. Degree of Wage Indexing
2. Forecasted length and severity of a business cycle

Question 19

Wage Indexing’s influence on f

Answer 19

The higher the value of a_i, 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.

Question 20

Wage-Price Spiral (An Inc. in Y)

Answer 20

Inc. in Y -> W/P inc. 1% -> MC inc. 1% -> P(pi) inc. by 1% -> W/P inc. a_i%
-> pi inc. a_i%

Question 21

The total effect of wage indexing on price inflation

Answer 21

Question 22

Worker’s expectations of future average wages from the expectation of a long vs short recession. Its effect on MC and price inflation.

Answer 22

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.

Question 23

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?

Answer 23

more; the output gap; larger value for f

Question 24

The most difficult component of the Phillips curve to measure is
_____

Answer 24

the expected inflation rate, π^e.

Question 25

Two important factors to consider when measuring
π^e.

Answer 25

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.

Question 26

Expectations augmented Fisher equation

Answer 26

R = r + π^e

Question 27

Exact Fisher Equation

Answer 27

Question 28

Modified IS Curve (Graph and Alg.)

Answer 28

Question 29

Relationship between interest rate gap and output gap on the IS Curve

Answer 29

Question 30

Macroeconomic Policy Curve (Alg.)

Answer 30

Question 31

Macroeconomic Policy Curve (Graph)

Answer 31

Question 32

Factors that shift the MP curve

Answer 32

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.)

Question 33

G increases permanently (MP/PA Curve)

Answer 33

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.

Question 34

pi* dec. permanently (MP/PA Curve)

Answer 34

Question 35

pi^e rises (MP/PA Curve)

Answer 35

Question 36

Five General Principles of Macro Policy Analysis

Answer 36

1. When making decisions, people think about the future.
2. Macroeconomic policy can be described and evaluated as a
   monetary policy rule.
3. If a particular policy rule is to work well, policymakers must
   commit to that rule.
4. Since the economy is basically stable, output and employment
   eventually, return to their long-run trends after an economic
   shock.
5. The objective of macro policy is to keep inflation low while
   simultaneously minimizing fluctuations in output, employment,
   and inflation after an economic shock.

Question 37

When making decisions, people think about the future [Principle]

Answer 37

1. When modeling expectations, we assume that people are
   familiar with economic fluctuations over the business cycle.
2. People use this information to form unbiased (but not error-free) forecasts of future economic conditions.

Question 38

Macroeconomic policy can be described and evaluated as a
monetary policy rule. [Principle]

Answer 38

1. Since people are forward-looking, their expectations of
   current and future policy actions affect their current behavior
   and the present state of the economy.
2. To evaluate the effect of an explicit policy on the economy,
   we need to specify how policy responds to current and future
   events.

Question 39

If a particular policy rule is to work well, policymakers must
commit to that rule. [Principal]

Answer 39

1. 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.
2. 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.
3. Thus, the willingness of policymakers to deviate from their
   policy rule for short-run gains has negative long-run
   consequences.

Question 40

The macro policy problem involves choosing a policy rule that
describes how _____.

Answer 40

the instruments of policy should respond to
economic conditions in order to improve the performance of
target variables.

Question 41

The Instruments of Macro Policy

Answer 41

a. Monetary base
b. Nominal interest rate

Question 42

The Target Variables of Macro Policy

Answer 42

a. Inflation rate
b. Unemployment
c. Output

Question 43

A social welfare function summarizes _____

Answer 43

the cost of having the
target variables deviate from their desired levels.

Question 44

Example of Social Welfare Function

Answer 44

welfare = [(Y – Y*)/Y*]² + [π – π*]²

Question 45

Reason U is not included in welfare function.

Answer 45

The Y-gap captures this deviation from the natural rate of U.

Question 46

Why are Y and pi squared in the social welfare function?

Answer 46

Small deviations in both are preferable to a large deviation in one variable.

Question 47

A major problem for macro policy is that its benefits do not ____

Answer 47

occur at the same time as its costs.

Question 48

Economic costs of inflation (4)

Answer 48

1. Shoe-leather costs
2. Additional tax costs
3. Some people gain and some lose
4. Institutional Costs

Question 49

Shoe-leather costs

Answer 49

The cost of making extra trips to the bank in order to avoid
holding currency that is constantly losing its purchasing
power.

Question 50

The additional tax costs of inflation

Answer 50

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.

Question 51

When inflation hits, some people gain and some lose.

Answer 51

• 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.

Question 52

Institutional costs of inflation

Answer 52

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.

Question 53

Some general views of inflation (2)

Answer 53

• 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).

Question 54

Costs of output loss (3)

Answer 54

1. A reduction in disposable income.
2. A decline in corporate retained earnings.
3. A drop in tax revenue that will lead to cuts government
   services and/or increases in future taxes.

Question 55

Costs and Benefits to being Unemployed

Answer 55

1. Unemployed workers, particularly the young, miss out on
   valuable job training.
2. 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.
3. Periods of unemployment can also have benefits for unemployed workers if they acquire additional
   skills (i.e. education) or enjoy their additional leisure time.

Question 56

Macro policy focus on reduction of inflation variation (MP Curve)

Answer 56

βπ is large and βY is small. Thus, the MP curve is flat.

Question 57

Macro policy focus on reduction of output gap

Answer 57

βπ is small and βY is large. Thus, the MP curve is steep.

Question 58

Inflation Persistence Formula

Answer 58

Question 59

If macro policy is focused on reducing variations in π, inflation deviation will ____

Answer 59

not persist for long periods

Question 60

If macro policy is focused on reducing variations in the output gap, inflation deviation will ____

Answer 60

persist for long periods.

Question 61

The costs of strict price stability (i.e., π = π*) are large
fluctuations in ___

Answer 61

output.

Question 62

The costs of strict output stability (i.e., Y = Y*) are large
fluctuations in ___.

Answer 62

inflation