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Econ 205- Answers to some tute questions

Answers=Chp10.Conceptual Problems: 3. Expansionary monetary policy lowers the interest rate, which stimulates the level of investment spending and therefore aggregate demand. If there is perfect capital mobility, lower interest rates will also lead to a capital outflow, which will result in a depreciation of the currency. Export goods will be cheaper for foreigners, so more of them will be demanded. The increase in net exports will lead to an even higher level of aggregate demand and therefore national income.

i
E` E i=if

LM LM` E`` BP=0

IS` IS 0
Y1 Y2

4.

Expansionary fiscal policy will have its maximum effect under a fixed exchange rate system with perfect capital mobility. This is because fiscal expansion must always be combined with monetary expansion to bring domestic interest rates back in line with foreign interest rates. Expansionary fiscal policy will increase the level of output demanded and the interest rate. But with perfect capital mobility, the higher domestic interest rates will attract funds from abroad, which will put upward pressure on the value of the domestic currency. To avoid currency appreciation, the central bank will have to increase money supply to bring interest rates back in line with world levels. Therefore, no crowding out will take place and the level of output will increase by the full multiplier effect. (See Question 2 for a diagram.)

Chp9. 3.A liquidity trap is a situation in which the public is willing to hold, at a given interest rate, however much money the RBA is willing to supply. In this case, the LM-curve is horizontal and monetary policy is totally ineffective. Fiscal policy (which will shift the IS-curve) is clearly the better choice to stimulate the economy in such a situation, since no crowding out will occur. This means that fiscal policy will have its maximum effect.

Chp.6
2. In the short run, when wages and prices are assumed to be fixed, there can be no inflation and thus the Phillips curve makes no sense over this very brief time frame. But in the medium run (in this chapter also often referred to as the short run), the Phillips curve is downward-sloping, as inflationary expectations are assumed to be constant. In the long run, the Phillips curve is vertical at the natural rate of unemployment, which corresponds to the vertical long-run AS-curve at the fullemployment level of output.

Chp17. 1. In the long run no major inflation can persist without rapid money growth, since the inflation rate is equal to the growth rate of money supply adjusted for the trend in real output and changes in velocity. In the short run, however, changes in output growth and velocity are quite unpredictable and affect the inflation rate. Such short-run fluctuations can be caused by supply shocks or policy changes.

5. What are the relative merits of a cold turkey over a gradualist approach to fight inflation? In
your answer discuss the concept of time inconsistency and the importance of credibility.

The key question for governments desiring to reduce inflation is how cheaply (in terms of lost output) they want to achieve a desired inflation rate. A gradual strategy attempts a slow and steady return to a low inflation rate by reducing monetary growth slowly in an attempt to avoid a significant increase in unemployment. This approach takes a lot longer than the cold-turkey approach that attempts to reduce inflation quickly by immediately and sharply reducing monetary growth. While inflation and inflationary expectations will be reduced faster under the cold-turkey approach, a higher level of unemployment leading to a decrease in the level of output will result in the short run until the economy has time to adjust back to the full-employment level of output. Which strategy policy decision-makers will choose mostly depends on how fast wages and prices are believed to adjust to their equilibrium level. If policy makers have a credibility problem, inflationary expectations will not adjust downwards quickly and it will take a lot longer (and probably a much higher increase in the unemployment rate) to reduce inflation. With a gradual approach, people will be very reluctant to change their inflationary expectations, since they may not be convinced that the central bank will actually stick to its announced policy objective of reducing inflation. A cold-turkey approach may be more attractive since it has a credibility bonus, that is, there is an immediate confirmation that the central bank is committed to reducing inflation. Therefore a new full-employment equilibrium can be reached more quickly. 2

6. Neutrality of Money
The neutrality of money is a very important proposition in macroeconomics: In the long run, once wages and prices have had time to adjust fully the money stock has no real effectsaccording to the dynamic model of aggregate supply, money only affects pricesprices will rise in proportion to a change in the level of the money stock and inflation is equal to the growth rate of the money stock. Is money neutral in the short run? In the classical case a monetary expansion leads immediately to a rise in prices with no real expansionprices rise immediately in proportion to the money supply and real balances remain the same. So, in the classical case money is neutral in the short run also.

Empirical evidence suggests this is quite unrealistic. In a more realistic model of aggregate supply such as that based on an inflation expectations-augmented Phillips curve with, or without rational expectations, money is neutral in the long run but not in the short run. Here, both prices and output rise in the short and medium terms, and only in the long run do we reach the classical case. In the short run the predictions of such an aggregate supply model more closely resemble the Keynesian case, and the more slowly wages adjust to changes in employment, the greater the resemblance. Because the adjustments of wages and prices are, in fact, slow, for all of the reasons we outlined in the chapter plus many other possible reasons, the short- and medium-term adjustments are an essential aspect of macroeconomics. This is a point on which nearly all groups of macroeconomists agree.
8. A cold-turkey approach is better than a gradualist approach for fighting inflation, since it requires a shorter time to establish a long-run equilibrium at a desired lower inflation rate. Comment on this statement. The gradualist approach lowers money growth over a long period of time to minimise the severity of any resulting recession. The cold-turkey approach achieves the reduction in the inflation rate more quickly, but at the cost of a significant increase in short-run unemployment. Normative considerations determine the relative merits of the two approaches. The cold-turkey approach may benefit from a credibility bonus, since workers and firms do not have to guess whether the government is really committed to lowering the inflation rate. They may therefore reduce their inflationary expectations faster and the economy will adjust back to full-employment much faster. However, if long-term contracts exist, wages and prices cannot adjust quickly and a rapid return to a low-inflation equilibrium at full-employment is fairly unlikely.

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