AS/AD Framework

Question 1

Policy Rule:

Answer 1

Rt - r̅ = m̅(πt - π̅)

Question 2

Why is the policy rule considered “closed loop”

Answer 2

Rt →Ỹ → π → Rt - 1 endogenous variable is determined by another

Question 3

AD Curve:

Answer 3

Ỹt = a̅ - b̅m̅(πt - π̅)

Question 4

How does the AD curve function?

Answer 4

If the central bank sees an inflation rate higher than its target π̅, the monetary policy rule dictates an increase in interest rates. The higher interest rates cause a reduction in I and a slowdown in economic activity - a movement along the AD curve

Question 5

What does m̅ describe?

Answer 5

willingness of the central bank to incite a recession/boom to combat inflation - the steepness of AD - high m̅ = flat (more ΔỸ), low m̅ = steep

Question 6

What is compared in the AD/AS diagram?

Answer 6

π vs Ỹ NOT Δπ

Question 7

What can shift the AD curve?

Answer 7

a̅ - temporary, π̅ - permanent

Question 8

AS Curve:

Answer 8

πt = πte + v̅Ỹt + o̅t

Question 9

What is the Stabilisation Problem associated with the AS/AD framework?

Answer 9

In the IS-MP model, it is possible to adjust R to keep Ỹ at potential, so there is no reason to go through the cycle.
The problem arises because the monetary policy rule responds only to inflation and not to changes in output.
The length of time it takes to ascertain whether a shock is a boom or a bust further complicates policy

Question 10

Policy Rule + Fisher equation =

Answer 10

it = r̅ + πt + m̅(πt - π̅)

Question 11

What is the Taylor Rule?

Answer 11

Taylor rule describes on average how central banks conduct MP. Has morphed from descriptive to prescriptive

Question 12

Taylor Rule Parameters:

Answer 12

m̅ = 1/2
r̅ = 2%
π̅ = 2%

Question 13

How long ahead do central banks forecast inflation and why?

Answer 13

Central bank tries to forecasts inflation 1-2 years in the future because of the MP lag

Question 14

What is Rational Expectations?

Answer 14

People use all information at their disposal to make their best forecast of the coming rate of inflation. people do not make systematic errors, they take all available information - people look to the long run

Question 15

R.E. + credible CB + o̅ =

Answer 15

If firms know that the CB will fight aggressively to keep inflation at a low rate no matter the consequences, then they are much less likely to raise prices sharply in response to an inflation shock.

Question 16

What can affect short run output under R.E.?

Answer 16

It is only surprises that can affect Ỹ - i.e. + o̅

Question 17

What is the Policy Ineffectiveness Proposition?

Answer 17

The government is unable to incite any output changes under R.E. as following any increase in G (AS curve shift) or tax changes as AD will shift immediately so short run output remains at potential

Question 18

What conditions are necessary for the Policy Ineffectiveness Proposition?

Answer 18

R.E. & fluid prices

Question 19

How can Central Banks control inflationary expectations?

Answer 19

Announce an explicit monetary policy rule or adopt an explicit target inflation rate for the medium horizon

Question 20

An explicit inflation target make it easier for the central bank to stabilise output?

Answer 20

Possibly, when the central bank eases monetary policy to stimulate the economy, if firms and workers understand the commitment to the target inflation rate, they won’t be tempted to deviate from their standard price setting behaviour and this will allow the monetary stimulus to exert its desired short term effect of output

Question 21

What does R.E. incentivise the Central Bank to do?

Answer 21

Under R.E. There is in principle an incentive for governments to control expectations in a way such that they can surprise the public - the only policy that matters (affects output) is the policy that isn’t anticipated

Question 22

What does coordination of inflationary expectations require?

Answer 22

Credibility and transparency on the part of the central bank

Question 23

What is constrained discretion?

Answer 23

The idea that a central bank has the flexibility to respond to shocks in the short run, but remain committed to a particular target inflation rate in the long run

Question 24

What is the Real Business Cycle?

Answer 24

Assumes R.E. - i.e. AD can’t affect Ỹ substantially
Assumes the classical dichotomy in both long and short run
Everything including cycles is determined by the real side
Cycle is caused by factors that affect Y̅
- Fluctuations are driven by real forces
- Savings rate, Investment rate, TFP, - productivity changes
Against stabilisation policies

Question 25

What is the New-Keynesian Business Cycle?

Answer 25

Fluctuations the result of AS & AD, although actual output can be affected by Y̅ as well Possibly driven by “animal spirits” i.e. optimism or pessimism Shocks are often propagated due to rigidities in the economy Pro stabilisation policies

Question 26

What are the New-Keynesian Business Cycle shock propagation mechanisms?

Answer 26

Multipliers Sticky prices/inflation/wages Imperfect information

Question 27

What is the Austrian Business Cycle?

Answer 27

Fluctuations largely the result of credit cycles (mal-investment) Optimism → Booms → ↑I (in bad projects) → ↑Credit (in bad projects) →Defaults → Bust .com boom Sources of credit/debit fluctuations aren’t specified - animal spirits Libertarian, cautious of G intervention in spite of market inefficiencies

Question 28

What is the Hetrodox (Post Keynesian) theory?

Answer 28

Fluctuations largely the result of credit cycles (mal-investment) Diagnosis is similar to Austrian Prefer government intervention - scope for stabilisation

Question 29

What is the Marxian BC theory?

Answer 29

Fluctuations largely consequence of distributive struggle between capitalists and workers Battle between wage earners & capital earners over Y̅ share & resources

Question 30

How can the right mix of MP and fiscal policy help the economy?

Answer 30

Help a country out of a recession Improve the trade position without ↑Ỹ or ↑π Slow down an overheating economy Stimulate I & K accumulation

Question 31

Case against balanced budget amendment:

Answer 31

Would also eliminate the use of fiscal policy as a macro policy instrument A constitutional amendment is not the only way to achieve deficit control & reduction

Question 32

Case for balanced budget amendment:

Answer 32

Would eliminate the problem of deficits Lags in the legislative process prevent the government from changing fiscal policy in time to stabilise the economy Rules that Parliament may impose on itself can be changed by a vote later on

Question 33

Arguments for policy restraint:

Answer 33

Policy makers may have good intentions but they may end up doing more harm than good because of uncertainty and time inconsistency. Policy makers do what’s best for them instead of the country such as with the political business cycle

Question 34

How can Central Banks establish credibility?

Answer 34

Make the central bank independent and away from political pressure Chose a conservative central banker who dislikes inflation Gain a reputation e.g. of not raising interest rates in lieu of a recession Drawing up rules for the central bank i.e. ways to commit to initial promise

Question 35

What is Time Inconsistency?

Answer 35

An announcement is made about policy, but when time to implement comes around the optimality of following through is different

Question 36

What is an example of Time Inconsistency?

Answer 36

After firms and workers have formed their expectations about inflation and built them into their contracts and pricing strategies, the central bank has an incentive to pursue expansionary policy to that the economy will boom

Question 37

What can cause a higher v̅?

Answer 37

(steeper) Less sticky inflation - customers more willing to accept price changes, computerised price setting, weaker unions

Question 38

What effect would weaker C or I multipliers have on the AD curve?

Answer 38

Would be steeper

Question 39

What effect would a lower b̅ have on the AD curve?

Answer 39

Steeper, weaker I response to R

Question 40

What effect would a lower m̅ have on the AD curve?

Answer 40

Steeper, CB cares less about inflation

Question 41

Taylors suggestion to incorporate Ỹ into the AD curve:

Answer 41

Ỹ = (a̅/(1+bn)) - (bm/(1+bn)) (π - π̅) If n = 0 then normal AD curve b/c 1+bn > 0, new AD is steeper + more muted to a̅ shocks

Question 42

A policy rule to completely offset AD shocks:

Answer 42

Ỹ = a̅ - a̅ → Ỹ = a̅ - b̅(a̅/b̅) → R - r̅= a̅/b̅

Question 43

What is the Taylor Principle?

Answer 43

When π increases by 1%, CB must increase i > 1% for R to increase π↑1% + i↑<1% → R↓ = i↑ - π↑↑

Question 44

Liquidity Trap Solution:

Answer 44

↑Ms, buy long maturity bonds to ↓ L.T. i/r

Question 45

How can the fed keep unemployment constantly low?

Answer 45

By increasing inflation forever - temporary trade off