W5P3 - Notebook LM Flashcards
What is the “impossible trinity” in international finance?
The “impossible trinity” states that a country cannot simultaneously have a fixed exchange rate, open capital markets, and an independent monetary policy. Countries must choose two of these three.
How effective is monetary policy under fixed exchange rates in the ASAD model?
Under fixed exchange rates, monetary policy is ineffective. The long-run aggregate demand is pinned down at the foreign inflation rate (π*).
How effective is fiscal policy under fixed exchange rates in the ASAD model?
Fiscal policy is effective in the short run but has no effect on output in the long run. An increase in government spending shifts short-run aggregate demand to the right, increasing inflation, but net exports decline in the long run, returning output to its initial level.
How effective is fiscal policy under flexible exchange rates in the ASAD model?
Under flexible exchange rates, fiscal policy is ineffective. The long-run aggregate demand is set at the money growth rate (µ).
How effective is monetary policy under flexible exchange rates in the ASAD model?
Monetary policy is effective in the short run, but has no effect on output in the long run. An increase in the money growth rate shifts the short-run aggregate demand to the right, increasing output. Over time, inflation expectations adjust, shifting the short-run aggregate supply to the left, returning output to its initial level but resulting in higher inflation.
What is the long-run impact of fiscal and monetary policy on output?
Both fiscal and monetary policy are demand-side policies that do not affect the long-run level of output. They can be used to stabilize the economy after a shock, but they do not affect the natural rate of output.
What effect does a supply-side shock have on the ASAD model?
Supply-side shocks shift the short-run aggregate supply schedule, causing either higher inflation and lower output or lower inflation and higher output. A negative supply shock creates a trade-off for policymakers, who must decide whether to prioritize stabilizing inflation or output.
What effect does a demand-side shock have on the ASAD model?
Demand-side shocks shift the short-run aggregate demand schedule. Unlike supply shocks, demand shocks do not create a trade-off for policymakers, who can use demand-side policies to stabilize both output and inflation.
What is the policy trade-off when facing a supply shock?
When faced with a negative supply shock, policymakers must decide whether to stabilize the level of inflation, risking a larger output gap and recession, or to stabilize the level of output, risking higher inflation.
What is the typical policy response to a demand shock?
Policymakers can use demand-side policies to offset the effects of a demand shock by shifting the aggregate demand curve and stabilizing both output and inflation.
Why is it difficult to respond to economic shocks?
The government and central bank often don’t know what kind of shock they are facing (demand or supply) and it is difficult to identify the natural rate of output, which makes policy decisions more complicated.
