EC102: CLASS 4 LT
Christina Ammon
Today’s Plan
Will cover:
 Essay 3 question e,f,g
 Essay 4
 Quiz 4
Aggregate Supply
Distinguish between long run and short run
 Definition different from Micro
 Long run - Prices are flexible
 Short run - many prices are “sticky” at a predetermined level
Essay 3 Question e
Why is the aggregate supply curve horizontal in the short
run?
 Aggregate supply is fixed in the long run
 But can fluctuate in the short run
 Why?
•
Can build up/use up inventories
Reasons why prices can be sticky in the short run:
 Menu costs
 Information costs
 Consumer reaction
 Wage rigidity
Essay 3 Question f
Use the AD-AS framework to illustrate the effects of an
increase in desired consumption due to “animal spirits”
 What happens to the AS?
 What happens to AD?
 What happens to output and the price level?
 What happens when we try to look at the long run?
Essay 3 Question g
 Use the AD-AS framework to illustrate the effects of an
increase in interest rates
Monetary Policy
 In our model: Central Bank controls the money supply
 Controls the money supply through Open Market Operations
 = buying and selling short-term government bonds
 No banks exist otherwise
 Money supply matters for the real economy by affecting the
interest rate
 CB has two objectives
• Stabilizing inflation
• Stabilizing output
Question 1
An increase in the money supply M can be represented as
 A movement along the AD curve
 A shift in the AD curve
 A change in the slope of the AD curve
 None of the above
Essay 4 Question b
Faced with a negative demand shock, the central bank needs
to strike a balance between doing “too much” and doing “too
little”. Explain.
 What happens if the central bank does nothing?
• Answer similar to the central bank doing too little
 What happens if the central bank does too much?
• Which objective does it not reach if it does too much?
• Which objective does it not reach if it does too little?
Quiz Question 5
 If the economy is not initially in recession, following a
monetary expansion we expect to see
•
•
•
•
First an increase in prices and then an expansion in the economy
First an expansion in the economy and then an increase in prices
A simultaneous increase in prices and expansion in the economy
An increase in prices followed by a contraction in the economy due to
inflation
Quiz Question 5
Essay 4 Question c
When will a monetary expansion not result in inflation?
Essay 4 Question
Describe the mechanism by which quantitative easing is
thought to help the economy recover.
 How does QE differ from other OMOs?
• QE a specific form of OMO’s
 Normally: CB only trades in short term bonds
 => Affects the short-term interest rate
 => Indirectly affects the long term interest rate
• Which interest rate are we the most interested in?
 When does monetary policy become inefficient?
 How can quantitative easing help in this situation?
Fiscal Policy
 Alternative/Complement to Monetary Policy
 = changes in G
 Effectiveness depends on the fiscal multiplier
 What is the fiscal multiplier?
 How does it vary over the business cycle?
 What are the effects on the other parts of AD?
Quiz Question 2
 Responsible fiscal policy involves:
• Running a balanced budget at all times
• Having a debt less than 60% of GDP
• Running a budget surplus at all times
• Running a deficit some of the time
Quiz Question 3
 If the fiscal multiplier is between 0 and 1, a fiscal expansion
will result in
•
•
•
•
a fall of GDP
a fall of C and/or I and/or NX
a decline in employment
a decline in public debt
Question 4
 If a central bank drops money from a helicopter
• It won’t affect interest rates as there is no corresponding purchase of
bonds
• It will have the same effects as an OMO for the same amount
• Will affect demand positively through lower interest rates and negatively
through inflation
• Combines elements of monetary and fiscal stimulus
Essay 4 Question a
Macroeconomic policy can both be a problem and a solution
in economic fluctuations. Explain.
 Ideally: stabilizing influence – can balance out other demand
shocks
•
•
Fiscal stimulus after Financial Crisis 2008
Quantitative easing to alleviate liquidity constraints
 But can sometimes be cause of fluctuations
• Suddenly needs to change fiscal policy (e.g. to reduce debt)
• Southern Euro area + possibly UK?
• Wrong monetary policy decisions