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QUIZ 8: Macro – Winter 2011 Name: ______________________ You must always show your thinking to get full credit. Question 1 Please comment briefly this statement than Ben Bernanke, the Fed chairman, included in his Semiannual Monetary Policy Report to the Congress Before the Committee on Financial Services, U.S. House of Representatives, February 15, 2006: “Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation.” (6 pts) The statement emphasizes the upward pressure on prices deriving from an outward shift in aggregate demand (i.e. prices in the economy increase when the level of aggregate demand of goods and services increases beyond what the economy can produce). As we have seen in class, a positive shock to AD moves output above the full-employment level, Y*, at the cost of higher prices both in the short-run (given the positively sloped SRAS) and in the long run. Monetary policy could however outset the jump of AD to the right. How? By reducing money supply (and increasing the real interest rate) the Fed can reduce both investment and consumption (both negative functions of r) and hence counterbalance the increase in AD through a commensurate reduction in AD. Question 2 What is the reason (or what is the logic) behind the fact that the Phillips curve predicts that ‘Higher expected inflation leads to higher inflation’? Following this logic complete the following sentence using either ‘higher’ or ‘lower’: Explain below. (3 pts. each) ‘According to the Phillips curve, given expected inflation, the ___higher_______ unemployment, the ____ lower ______ inflation’. The reason why the Phillips curve predicts that ‘Higher expected inflation leads to higher inflation’ is that higher expected prices lead to higher nominal wages and in turn to higher prices. Therefore, according to the Phillips curve, higher expected inflation leads to higher actual inflation. In addition, given expected prices, a higher unemployment rate leads to lower wages, and thus lower prices. Therefore, it holds that: ‘According to the Phillips curve, when we increase expected inflation, the ____ higher ______ unemployment, the ____ lower ______ inflation’. An increase in the level of expected inflation has the effect of shifting the expectationsaugmented Phillips curve outwards, but does not change its slope. This implies that the answer in terms of the relationship between unexpected inflation and cyclical unemployment is unchanged. ‘According to the Phillips curve, when we increase expected inflation, given unemployment, the _____ higher ______ inflation’. An increase in the level of expected inflation has the effect of shifting the expectationsaugmented Phillips curve outwards, but does not change its slope. This implies that for given unemployment, the level of inflation is going to be higher. Question 3 Suppose that the Phillips curve in an economy is given by the equation πt − πet = -3 *(u t−0.06), where πet=ƒ* πt-1. In addition, suppose that in period t-1, the unemployment rate is equal to the natural rate, and the inflation rate is 0 percent. a. What is the natural rate of unemployment in this economy? Alternatively, how is the natural rate of unemployment defined according to the Phillips curve? According to the Phillips curve, the natural rate of unemployment is the unemployment rate required to keep inflation constant. When the actual unemployment rate exceeds the natural rate, inflation decreases; when the actual unemployment rate is less than the natural rate, inflation increases. Given the equation for the Phillips curve above, the natural rate of unemployment ū will be: πt = πet → ū = 0.06 → 6% b. Suppose that beginning in period t, the authorities bring the unemployment rate down to 5% and keep it there indefinitely. Determine the inflation in periods t, t+1, t+2 and t+3 when ƒ=0. Then do the same for ƒ=1. Assuming that u t-1= ū = 0.06 and πt-1= 0: If ƒ=0: u t = 0.05 and πet=ƒ* πt-1=0 → πt = -3 *(0.05−0.06)=0.03 → 3% u t+1 = 0.05 and πet+1=ƒ* πt =0 → πt+1 = -3 *(0.05−0.06)=0.03 → 3% u t+2 = 0.05 and πet+2=ƒ* πt+1 =0→ πt+2 = -3 *(0.05−0.06)=0.03 → 3% u t+3= 0.05 and πet+3=ƒ* πt+2 =0→ πt+3 = -3 *(0.05−0.06)=0.03 → 3% If ƒ=1: u t = 0.05 and πet=ƒ* πt-1=0 → πt = -3 *(0.05−0.06)+ πet =0.03 → 3% u t+1 = 0.05 and πet+1=ƒ* πt =0.03 → πt+1 = -3 *(0.05−0.06) )+ πet+1 =0.06 → 6% u t+2 = 0.05 and πet+2=ƒ* πt+1 =0.06→ πt+2 = -3 *(0.05−0.06) + πet+2 =0.09 → 9% u t+3= 0.05 and πet+3=ƒ* πt+2 =0.09→ πt+3 = -3 *(0.05−0.06) + πet+3 =0.12 → 12% c. For which of the two values of ƒ does this policy imply a continually increasing rate of inflation? For the value of ƒ=1, keeping the unemployment rate permanently below the natural rate of unemployment implies continually increasing rate of inflation. This is does not happen when expected inflation depends on past inflation values (when ƒ=0, actual inflation does not change and we can achieve permanent unemployment values below the natural rate without generating increases in the inflation rate). Question 4 What are the pros and cons of ‘too loose Monetary Policy’? You can recall the arguments in The Economist article “Overflowing” (from March 2004) or use your own reasoning. (5 pts.) If the interest rates are being kept too low for too long by the Fed, there may be excess liquidity in the market, which may encourage excess credit growth, asset-pricing bubbles or it may also boost inflation. This argument may be explained differently by arguing that there exists a ‘neutral rate of interest’. This is the rate that neither stimulates the economy nor tightens it, but allows it to expand in line with its underlying productive potential, keeping inflation constant. Once the circumstances that required lower interest rates have passed, rates need to rise towards the ‘natural rate of interest’; but, if the rate set by central banks is lower than the natural rate, firms will invest more, boosting growth and, eventually, inflation. Another reason why too low interest rates for too long may be harmful for the economy is that, if interest rates are too low and a recession comes, the Fed would not have room to cut rates in order to stabilize the economy. In summary and according to the reasoning in The Economist article mentioned above, the longer the Fed leaves rates so low, the greater the risk that asset prices will inflate to unsustainable levels and the greater the risk of a deeper downturn in the future.