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Aggregate Supply and Philips curve
1. Suppose that in elections President Push wanted to help out Congressional candidates in his party by making the economy look strong: high GDP figures and low inflation. Suppose he increased government spending, hoping to make GDP statistics rise in the period prior to the election. He knows this can lead to higher inflation, but he hopes this policy will affect inflation statistics (CPI) mainly after the election is over.
Discuss the short-run and long run implications of the president’s fiscal policy on output, the price level and real interest rate. Use IS-LM & AS-AD graphs, where the short-run aggregate supply assumes that output is some positive function of price surprises.
How does the success of the president’s strategy depend on how flat or steep the short-run aggregate supply curve is? Thinking of our stories of aggregated supply, what are some things that determine the steepness of this curve?
2. Answer the following questions about the short-run aggregate supply equation:
a. Let a= 0.5. Draw the aggregate supply curve.
b. As the term a increases, how does this change the supply curve?
c. If the expected price level increases, how does this change the supply curve?
3. What is the difference between cost-push and demand-pull inflation? Which was the primary cause of inflation in the early 1970’s? What type of inflation had the Federal Reserve been trying to prevent in 1998 and 1999? What about in 2005 and 2006?
4. a. Explain the link between the aggregate supply curve and the Phillip’s curve.
b. If the natural rate of unemployment falls, how will this affect the Phillip’s curve?
c. If the sacrifice ratio was 5 and the central bank wanted to lower inflation by 8 percentage points, how much GDP would have to be sacrificed? Would you recommend reducing the inflation all at once, or spreading it out over several years? What would a proponent of rational expectations theory recommend?
Alternative Perspectives on Stabilization Policy
1. According to the Lucas critique, why should policy makers not rely upon the Phillips curve relationship between inflation and unemployment as the formula for monetary policy.
2. Describe how automatic stabilizers can help to “cool off” an economic boom.
3. Describe two benefits and two costs of an inflation-targeting rule for monetary authorities.
4. Why do you think the level central-bank independence is not correlated with a country’s average growth rate of real GDP?
Open Macro Economy
1) Neoclassical Model of Open Macro Economy:
Consider an economy described by the following equations:
Y = C + I + G + NX,
Y = 5,000,G= 1,000,T = 1,000,
C = 250 + 0.75(Y – T),
I = 1,000 – 50r,
NX = 500 – 500 e,
r= r* = 5.
In this economy, solve for national savings, investment, the trade balance, and the equilibrium exchange rate.
Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.
Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000). Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.
2) What will happen to the trade balance and the real exchange rate of a small open economy when government purchases increase, such as during a war?
3) Mundell-Fleming Model
Use the Mundell-Fleming Model to predict what happens to aggregate income y, the exchange rate e, and the trade balance NX, under both floating and fixed exchange rates in response to each of the following shocks:
A fall in consumer confidence about the future induces consumers to spend less and save more.
The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars.
The introduction of automatic teller machines reduces the demand for money.