Week 7 Inflation

Question 1

If there is unexpectedly high inflation, is this good for lenders or borrowers and why?

Answer 1

This is good for borrowers as the real interest rate is lower.

Question 2

What happens if inflation is uncertain?

Answer 2

There is then uncertainty in the credit market so they function inefficiently.

Question 3

What does the Phillip’s curve state?

Answer 3

The Phillips curve states that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa.

Question 4

In a Phillip’s curve model, what should a central bank do if it believes that inflation is too high?

Answer 4

Increase the nominal interest rate target.

Question 5

What is forward guidance and when is it used?

Answer 5

Is it used by promising higher inflation in the future to increase inflation and output today. Is is used when the nominal interest rate is already 0%, so cannot be lowered any more.

Question 6

What is Calvo pricing?

Answer 6

Where each firm has a random opportunity to change its price each period.

Question 7

In the basic NK model, if a firm was able to reset its price today, it will do so based on what?

Answer 7

What is best for the current period but also on what it believes will be the optimal price in future periods

Question 8

How can we write the Phillips curve?

Answer 8

i = bi’ + a(Y-Ym)

Question 9

In the Phillips curve, what should we assume about a and b and what do these stand for:
• i
• i’
• Ym

Answer 9

• a>0

* 0<b></b>

Question 10

If anticipated future inflation is to increase by 1%, what is the effect on current inflation?

Answer 10

Current inflation will increase by less than 1%.

Question 11

How do we write the Fisher equation?

Answer 11

r = R - i’

Question 12

What is the equation linking consumption and investment with real interest rates (the IS/output demand equation)?

Answer 12

Y − Ym = −α (r − r*)

Question 13

If the central bank changes the nominal rate of interest, is its affect on the real interest rate 1 to 1?

Answer 13

Yes

Question 14

So if we assume i’ is exogenous and equal to the target (0), what happens if r = r*, and what is the significance of this?

Answer 14

If r =r, then Y = Ym and R = R.
Therefore as long as r = r*, the output gap will be equal to 0 (note that this doesn’t mean that output will be constant).

Question 15

What does r* stand for and what is it?

Answer 15

The natural rate of interest is the interest rate consistent with maintaining economic growth at its trend rate and stable inflation.

Question 16

Do we assume that the marginal cost of a departure from the inflation target increases or decreases?

Answer 16

We assume that the marginal cost of a departure from the inflation target increases: ie a 1% increase in the actual inflation is more costly if the inflation rate is 10% than if it is 3%.

Question 17

What is the dual mandate given to the Fed?

Answer 17

The US government telling the Fed to care about price stability, but also “full employment”.

Question 18

If a central bank has to choose between a its achieving its output target or its inflation target, what should it do?

Answer 18

The optimal policy is the intermediate point between the 2 targets.

Question 19

What does an increase in expected inflation do to the Phillips Curve?

Answer 19

An increase in expected inflation causes the Phillips Curve to shift upwards, as we can see from the equation: i = bi’ + a(Y-Ym)

Question 20

Why could a temporary increase in z cause an increase in Ym?

Answer 20

Because a temporary increase in Ym would shift the output supply curve to the right; thus forming a new equilibrium with Yd.

Question 21

From starting at equilibrium when there is an increase in expected inflation, what should policy makers do?

Answer 21

Increase the nominal interest at more than one-to-one than the expected increase in inflation. This allows an intermediary point to be found between the output and inflation targets.

Question 22

What does a persistent increase in govt spending do to the IS curve?

Answer 22

It shifts it to the right.

Question 23

For r* to change, what should happen?

Answer 23

An exogenous aspect should come into play to lead to a change in r*, eg a change in technology.

Question 24

What does an increase in expected inflation do to real interest rates if the central bank does nothing and why?

Answer 24

Due to the Fisher equation (nom IR= real IR + i’), if i’ rises, than real interest rates must fall.

Question 25

What does a decrease in the natural rate of interest do to the Phillips Curve?

Answer 25

↓r*→ ↓Ym→ downwards shift in Phillips Curve

Question 26

Can the central bank always cancel a shock to the IS side of the model and how?

Answer 26

Yes, by matching the real interest rate to the natural rate of interest, making the output gap zero, which then also stabilises inflation.

Question 27

Can the central bank always cancel a shock to expected inflation?

Answer 27

No, a trade off has to be found between output and inflation.

Question 28

What is it called when a central bank can simply offset any shocks to the IS and that there is no trade-off between the stabilization of inflation and the stabilization of the welfare-relevant output gap (the gap between actual output and efficient output) for central banks?

Answer 28

This is called a divine coincidence.

Question 29

What is the ZLB?

Answer 29

The Zero Lower Bound is where the nominal interest rate is at or near 0, limiting the options available to policy makers,

Question 30

How does forward guidance work

Answer 30

Promising higher future inflation leads to an upwards shift in the PC and increases current and expected inflation. The increase in i’ therefore reducing the real interest rate, bringing it closer to i*.

Question 31

What is the problem with forward guidance?

Answer 31

In the next period, once out of the ZLB it is no longer optimal for there to be high inflation, and sticking to the inflation target is optimal. However, if there is no future high inflation, future promises of high inflation won’t be believed, so forward guidance won’t be a future policy tool.

Question 32

What is an alternative method to get out of the ZLB?

Answer 32

Certain types of expansionary fiscal policy which could increase r* back to its original value.

Question 33

What is rational expectations?

Answer 33

A modelling strategy under which the people in a macroeconomic model efficiently forecast future variables. This implies that people cannot be systematically fooled.

Question 34

How do we write the IS in a more dynamic model?

Answer 34

Y-Y’=-1/d (R-i’-r*)

Question 35

What does (R-i’-r*) mean?

Answer 35

The difference between the real interest rate (R-i’) and the natural rate of interest (r*)

Question 36

In a more dynamic model, what does the PC look like, and what does this also imply?

Answer 36

• i= a(Y-Ym)
• This implies that i’=a(Y’-Ym)

Remember to assume constant Ym

Question 37

Why do we want to get rid of output from this more dynamic model?

Answer 37

So we only have an equation for present and future interest rates.

Question 38

When eliminating output, what should we set Y as equal to?

Answer 38

Y= Ym+ (1/a)i

Question 39

What is the long run Fisher equation>

Answer 39

i = R-r*

Question 40

In a more dynamic model what does expected future output equal, and what is an important thing to remember about this?

Answer 40

• i’= a/a+d(R-r*) + (d/a+d)i
• d/a+d < 1
• The nominal rate is exogenous, we do not have an equation for it

Question 41

What is a steady state?

Answer 41

A state where inflation will not change, ie i=i’

Question 42

What is the indeterminacy problem?

Answer 42

There’s nothing in the model to pin down the initial inflation rate i0 given a constant nominal interest rate. Our equation shoes us where the path of inflation ends, but not where it starts.

Question 43

How do nominal interest rates respond under the Taylor rule?

Answer 43

Under the Taylor rule, nominal interest rates respond positively to inflation deviations from target and to Y − Ym

Question 44

What is the Taylor Principle?

Answer 44

The response to inflation is larger than one.

Question 45

What is Taylor’s rule for the response of nominal interest rates, and what do h and i* stand for? What must be true if the Taylor principle holds?

Answer 45

• R = r+i+ h(i-i*)
• h measures the response of interest rates
• i* is the inflation target
• If the Taylor principle holds, h > 1