EC2013 SEMESTER 2

TUTORIAL 3

MACRO POLICY IN THE 3-EQUATION MODEL

Please prepare your answers in advance of the tutorial.

1. Why is monetary policy chosen over fiscal policy as the preferred tool for stabilization policy? What does the government gain from controlling monetary policy? Why would they choose to delegate responsibility for monetary policy to an independent central bank?

2. ‘If the economy has high but stable inflation, the government has much to lose and little to gain by reducing inflation to a low rate.’ Explain and assess this statement.

3. What are the advantages and disadvantages of a target inflation rate of 4% as compared with one of 0% per annum?

4. Explain what is meant by the central bank’s loss function. How are the central bank’s preferences reflected in the loss function? Draw the loss ‘circles’ for the cases where,

(a)          β          =          1          (b)          β          <          1          (c)          β          >          1

In which of the three cases will the central bank reduce inflation back to target quickest after an inflation shock? Is there any downside to adopting this policy stance?

5. Following an inflation shock, explain why unemployment goes up before the economy returns to medium-run equilibrium.

6. Draw the 3-equation model and give a detailed period by period description of the adjustment process for the case where the economy is hit by a permanent negative aggregate demand shock.

7. Use the 3-equation model diagrams to show how the economy can fall into a deflation trap. Explain, with reference to the diagram, how the central bank/government can intervene to escape the trap. Show the relevant IS curve and re-label the MR as the PR to indicate that fiscal policy is being used. Are there any reasons why these policies might not work? does have an independent central bank, did inflation fall when the central bank gained independence? Propose some reasons why. (d) If the country does not have an independent central bank, have they managed to find other mechanisms to establish a low inflation monetary policy regime? Propose some reasons why.