Questions for Week 8 Flashcards
(17 cards)
What is a policy reaction function (PRF), and how does it guide monetary policy?
The PRF describes how the central bank adjusts the interest rate in response to changes in inflation and output gaps. It sets higher rates if inflation exceeds the target to cool demand, and lowers rates if inflation is below target to stimulate the economy.
How is the Taylor Rule represented in a PRF?
The Taylor Rule formula is:
𝑟 = 𝑟∗ + 0.5(𝜋 − 𝜋∗) + 0.5(𝑌 − 𝑌∗)
where:
𝑟 = nominal interest rate,
𝑟∗ = neutral rate,
𝜋 = inflation rate,
𝜋∗ = target inflation,
𝑌 − 𝑌∗ = output gap.
How does changing the inflation target (πT) in the PRF affect monetary policy?
Raising πT implies a more expansionary policy, lowering interest rates and shifting AD right. Lowering πT makes policy contractionary, increasing interest rates and shifting AD left.
What is inflation targeting, and why is it important for monetary policy?
Inflation targeting is a framework where the central bank sets a specific inflation range (e.g., 2-3%) as a policy goal, stabilizing expectations and guiding interest rate adjustments to maintain price stability.
What is disinflation, and how does it affect the economy in the short run and long run?
Disinflation is the process of reducing the inflation rate. In the short run, it causes a recessionary gap as AD decreases, leading to lower output. In the long run, inflation stabilizes at the lower target, restoring output to potential levels as prices adjust.
What are the short-run effects of a positive output gap in the AD-AS model?
A positive output gap (Y > Y*) increases inflationary pressure as demand exceeds supply. This shifts the SRAS upward over time, reducing output back toward potential GDP as prices adjust.
How does the AD-AS model illustrate the effects of a permanent tax cut on output and inflation?
A temporary tax cut shifts AD right, raising short-run output and inflation. If perceived as permanent, it may shift LRAS right by increasing potential output, stabilizing output at a higher level without sustained inflation.
What is the difference between temporary and permanent tax cuts in the AD-AS model?
A temporary tax cut raises AD and output in the short run but reverts in the long run. A permanent tax cut can increase potential output by raising LRAS, sustaining higher output without persistent inflation.
How does a permanent increase in government spending affect the AD-AS model?
Permanent government spending increases AD, raising both output and inflation in the short run. In the long run, SRAS shifts up, stabilizing output at potential but with a higher price level.
What are the effects of a sharp drop in oil prices in the AD-AS model?
Lower oil prices reduce production costs, shifting SRAS down and increasing output. This creates an expansionary gap, but inflation may gradually increase as demand adjusts to new conditions.
How would a contractionary monetary policy (e.g., raising interest rates) affect the AD-AS model?
Higher interest rates shift AD left, reducing inflationary pressures and output. In the long run, output returns to potential as SRAS adjusts to lower inflation expectations.
How does the AD-AS model reflect the effects of an increase in consumer confidence?
Increased confidence raises consumption, shifting AD right. Short-run output and inflation increase, with potential adjustment toward long-run equilibrium as SRAS rises.
Describe how a policy-induced disinflationary process adjusts the economy in the AD-AS model.
Disinflationary policy (e.g., rate hikes) shifts AD left, creating a recessionary gap. Over time, SRAS shifts down as inflation expectations adjust, restoring output to potential but with a lower inflation rate.
How does inflation inertia affect inflation adjustments in the AD-AS model?
Inflation inertia, due to wage and price setting based on past inflation, causes inflation to persist even when AD shifts, requiring persistent policy adjustments to stabilize expectations.
How does inflation adjust when there is a recessionary gap according to adaptive expectations?
With a recessionary gap, downward pressure on wages and prices reduces inflation over time. As inflation expectations decrease, SRAS shifts down, moving output back to potential.
What are the effects of an adverse supply shock, like an oil price spike, on the AD-AS model?
An adverse supply shock shifts SRAS up, increasing inflation and reducing output, creating a stagflation scenario. The central bank may tighten policy to curb inflation, deepening the output reduction short-term.
How does the Reserve Bank respond to an inflationary supply shock in the AD-AS model?
The RBA might raise interest rates to control inflation, shifting AD left. This reduces inflation but exacerbates output loss. Eventually, SRAS adjusts downward as inflation expectations stabilize.
