Week 9 - Macroeconomic Policy & Philips Curve

Question 1

What is a contraction in AD caused by?

Answer 1

 Waves of pessimism
 Stock-market bust
 Drop in exports
 Monetary contraction (e.g., due to disinflation, etc)

Question 2

What is a contraction in AS caused by?

Answer 2

 Sudden increase in production cost
 Increase in price expectation

Question 3

Stagflation

Answer 3

occurs when high unemployment, slow economic growth and high inflation all happen at the same time

Question 4

Monetary policy

Answer 4

changes in the supply and/or interest rates

Question 5

Fiscal policy

Answer 5

changes in government spending

Question 6

How changes in monetary policy shift the AD curve?

Answer 6

• Increase in money supply: lower interest rates which is expansionary (shifts AD to the right for any given price level)
• Decrease in money supply: higher interest rates which is contractive (shifts AD to the left for any given price level)

Question 7

What does fiscal policy do to AD?

Answer 7

Fiscal policy directly shifts the AD curve to right if the policy is expansionary and to the left if the policy is contractive

Question 8

What is the effectiveness of fiscal policy dependent on?

Answer 8

Multiplier effect – amplifies the effect on AD of an increase in net expenditure
 The government increases their purchases which shifts AD to the right.
 Consumers respond by increasing their spending (spending multiplier)
 Firms respond by increasing their investing (investment accelerator)
 This leads to a further shift to the right in AD
 However, the multipler size is dependent on the marginal propensity to consume (MPC), as the larger the MPC, the larger the multiplier

Marginal propensity to consume – the fraction of extra income that consumers spend on consumption

Question 9

Active stabilisation policy

Answer 9

means that the authorities use fiscal and monetary policy to stabilise the economy in the face of shocks to the economy and waves of optimism and pessimism (animal spirits)

Question 10

Arguements AGAINST active stabilisation policy

Answer 10

• AD is too difficult to control since policy affected the economy with ‘long and variable’ lags
• Policy must be based on unreliable economic forecasts which leads to mistakes (e.g., expansionary policy may cause overheating and run-away inflation)
• It’s better to leave the economy alone and let markets mechanisms deal with short run fluctuations

Question 11

Automatic stabilisers

Answer 11

automatic changes in spending that stimulate AD when the economy goes into a recessions

Question 12

How do automatic stabilisers operate?

Answer 12

• Fewer taxes collected in a recession so AD increases
• More unemployment benefits paid out in a recession, so AD increases

Question 13

Arguments AGAINST automatic stabilisers

Answer 13

• They are not sufficiently strong enough to prevent business cycles completely
• How strong they are depends on the public sectors size relative to GDP
• But without them output and employment would be more volatile than is the case

Question 14

Philips curve

Answer 14

details the short run trade-off between inflation and unemployment

• It illustrates the negative association between the inflation rate and the unemployment rate
• Therefore the curve is downward sloping

Question 15

Shifts in the Philips curve

Answer 15

• Supply shocks
• Changes in inflationary expectations

Question 16

What are the costs of reducing inflation?

Answer 16

Contractionary monetary policy implies:
 Aggregate demand contracts, which lowers inflation (“moving down the Philips curve”)
 But also, to higher unemployment
 But over time, the short-run Phillips curve
shifts left returning unemployment to its
natural rate but now with a lower rate of
inflation

Sacrifice ratio - an economic ratio that measures the effect of rising and falling inflation on a country’s total production and output
 Percentage points of annual output lost in the
process of reducing inflation by 1 percentage point
 Typical estimate: 3 to 5, so for each percentage point that inflation is reduced, 3 to 5 percent of annual output must be sacrificed in the transition

Rational expectations
 People optimally use all information they have including information about government
policies when forecasting the future, so if people strongly believe that the central bank will fight inflation, they might immediately lower their inflation
expectations