Understanding Fiscal and Monetary Policy: Interactions and Implications, Esquemas y mapas conceptuales de Economía I

¡Descarga Understanding Fiscal and Monetary Policy: Interactions and Implications y más Esquemas y mapas conceptuales en PDF de Economía I solo en Docsity! Principles of Economics - Course 2020-2021 - Problem Set 12 Conceptual Questions Write down a short and concise answer. When you are asked to solve the question in class, explain the concept clearly and give examples or pieces of evidence. 1. In the event of a financial crisis, would it be preferable for the government to stabilize the economy using fiscal or monetary policy? Fiscal policy is usually less flexible because of the need to obtain agreement for changes in expenditure or taxes. In particular, cuts in expenditure or rises in tax might be politically difficult to introduce. Therefore, monetary policy may be quicker to react to shocks.. What are the dangers of using fiscal policy? Fiscal policy may be problematic especially where there is the danger of sovereign credit risk (sovereign debt crisis), which may reduce a country's ability to finance increased spending or tax cuts by issuing new bonds (i.e. by borrowing). When might the govermnent have no choice but to use fiscal policy? When interest rates are at the zero lower bound, the government is unable to use interest rate policy, although they can use unconventional policy like quantitative easing (this is what many central banks did in the aftermath of the recent financial crisis) with the aim of stimulating aggregate demand by boosting asset prices (and reducing yields). Also, when the country is in a currency union and so monetary policy is not under its control, fiscal policy may be its only option. Explain why a change in the central bank's policy interest rate affects the exchange rate through the market for financial assets (such as government bonds).. The interest rate affects the exchange rate because much of the demand for a country's currency comes from foreign investors, who want to hold and trade financial assets from around the world. These investors prefer to earn a higher return and so prefer assets with a high yield (high interest rate). Therefore, demand for a country's bonds is positively related to its policy interest rate. In order to take advantage of higher interest rates on foreign bonds, for example, it is necessary to have foreign currency. Hence a change in the policy interest rate affects the supply of and demand for foreign exchange, and hence, the exchange rate. Tf the central bank lowers the policy rate, demand for that country's bonds declines, and so will demand for that country”s currency (which is needed to buy those bonds). This decline in demand for currency leads to a depreciation, which in turn increases demand for their exports (domestic goods become relatively cheaper). This exchange rate channel may be more important for smaller economies, where net exports and foreign investment constitute a larger share of GDP than domestic demand. 1 Problems The following questions refer to Figure 15.5. a Inflation (%) a. What would the policymaker”s indifference curves look like if the policymaker cared only about low unemployment? Which point on the Phillips curve would that policymaker choose? What would the policymaker”s indifference curves look like if the policymaker cared only about low inflation? Which point on the Phillips curve would this policymaker choose? What would the indifference curves look like if to be re-elected, the policymaker needed the support of pensioners more than that of working- age people? The policymakers' preferences The policymakers' preferences and the Phillips curve trade-off Phillips curve Labour supply ! Feasible set ¿ Labour Worse outcomes : supply E E .2 EOS = E 2 o NS 7 y > U-=6% Policymaker's l Bestoutcome Policymaker's indifference curves indifference curves Employment, N Employment, N Tn this case they are vertical (see diagram below), e.g. through U=3% because the policymaker cares only about unemployment, therefore willing to achieve the optimal level of employment at whatever inflation rate required. The indifference curve with highest utility would lie somewhat to the left of the labour supply curve since the policymaker requires a finite rate of inflation. Since the policymaker aims for low unemployment, she will choose the point where the Phillips curve intersects her right-most indifference curve a. Itleads to higher bond prices, which results in higher demand for UK bonds. c. Itleads to the UK exports becoming cheaper and imports becoming more expensive. d. Ithas opposing effects on the UK”s aggregate demand (AD): it discourages investment, which lowers AD, but results in cheaper imports, which boosts AD. a. Aninterest rate rise does lead to higher demand for UK bonds, but due to their lower prices. b. Higher interest rates attract international investors, which in turn raises demand for GBP. c. Higher interest rates lead to lower bond prices, resulting in higher demand for UK bonds. This in turn leads to a GBP appreciation, making UK imports cheaper and exports more expensive, which depresses aggregate demand in the UK. d. Cheaper imports mean greater leakages from the domestic economy. This reduces aggregate demand. 4. The diagram depicts the Phillips curve and the indifference curves of an economy. This economy has an independent central bank with an inflation target of 2%. Based on this information, which of the following statements is correct? a. The central bank will try to achieve zero unemployment while keeping the inflation at 2%. b. The shape of the indifference curves indicates that the central bank is willing to trade higher inflation with lower unemployment at all times. Consider an aggregate demand shock that increases unemployment. The central bank would raise the interest rate to put downward pressure on inflation, in order to bring it back to the target rate. Labour supply z E E 2 3 Central bank's Phillips curves £ indifference curves Inflation 2 Inflation-targeting central bank's target best outcome: target inflation and the inflation-stabilizing o unemployment rate Employment, N U=6% Employment at labour market equilibrium, inflation-stabilizing unemployment rate . The Phillips curve relationship means that this is not achievable. The inflation- stabilising unemployment rate is shown to be 6%, whichis the outcome of the wage and profit curves. . This is true in the upward-sloping parts of the indifference curves. Where the indifference curves are downward-sloping (e.g. when unemployment is higher than 6% and the inflation is lower than 2%), the trade-offis between higher unemployment and higher inflation. Tfunemployment increases, inflation falls along the Phillips curve. If the central bank does not respond, a downward wage-price spiral can begin, with the Phillips curve shifting downwards. .. For an aggregate demand shock that increases unemployment, inflation will fall below the target along the Phillips curve. Therefore the central bank should lower interest rate to put upward pressure on inflation, in order to bring it back up to the target rate.