Macro Policy Analysis

Question 1

How and Why would the Central Bank raise interest rates?

Answer 1

They raise interest rates using the Taylor Rule and they will raise interest rates when:
→ If inflation is above its target level
→ If unemployment is below its natural rate, or the real national income its above its sustainable level

Question 2

What has changed regarding how the government conducts Monetary Policy?

Answer 2

There is a shift in the way the CB handles inflation
→ Back in time, they used to manoeuvre money supply
→ Nowadays they target inflation directly manoeuvring the interest rate

→ To account for these changes, there is a new model:

ADI-ASI = (AD-AS + Inflation)

Question 3

What is the ASI-ASI Model?

Answer 3

AD-AS + Inflation

→ ADI = AD with inflation
→ ASI = AS with inflation
→ the vertical axis (π) measures the rate of inflation
→ the horizontal axis (Y) is the output
→ the downwards sloping curve is the ADI
→ the upwards sloping curve is the ASI
→ the horizontal line is the Inflation Target

Question 4

What does the ADI Curve represent?

Answer 4

A given ADI Curve represents a given monetary policy

Question 5

What does the ASI Curve show?

Answer 5

The ASI Curve shows how positive demand shocks initially boost output and prices, but eventually yield diminishing returns in output growth relative to price increases, resulting in a long run vertical curve where additional demand only raises prices further

Question 6

What does the positioning of the ADI curve mean?

Answer 6

The intersection of the ADI and Inflation Target is the Equilibrium Income (compatible with target)
→ In the long run, the central bank has to evaluate whether the equilibrium income associated with a certain inflation target is sustainable
→ If Y1 is the potential output, then there is no output gap because actual output corresponds to potential output

Question 7

What causes a shift in the ADI curve?

Answer 7

Any other policy (like Fiscal Policy) or external shocks that affect the components of AD, will affect the position of the ADI of the (𝜋,Y) diagram, so it will cause a shift in the ADI
→ demand shocks shift the ADI curve
→ if the central bank sets a new higher target rate of inflation, this will cause the ADI curve to shift right

Question 8

What affects the ASI Curve in the short run?

Answer 8

for a positive shock, firms increase production and prices (more than current inflation) to gain higher profits
→ upward sloping moderately steep (relatively flat) ASI curve

Question 9

What affects the ASI Curve in the medium run?

Answer 9

wages adjust to increase in prices, which means higher wages and lower profit opportunities
→ increase in inflation will be larger (larger than the increase in output)
→ upward sloping steeper ASI curve

Question 10

What affects the ASI Curve in the long run?

Answer 10

If positive demand shock persists, short run ASI will shift up as firms offer higher wages to recruit labour
→ income will be returning to its original level
→ vertical ASI curve

Question 11

What is a Supply Shock?

Answer 11

An unexpected change on the supply side of the economy, such as an oil price shock

Question 12

What does Supply Shocks do to the Phillips Curve?

Answer 12

Supply shocks shift the Phillips curve by affecting the labour market equilibrium
→ Supply shocks cause high and rising inflation
→ For example: an increase in the price of oil, will lead to a downwards shift of the price setting curve
→ Prices rise, Real Wages fall, there is a Positive Bargaining Gap, and this leads to persistently higher Inflation

Question 13

What will happen if there was a temporary shock (fall in oil prices)?

Answer 13

Initially, there is an equilibrium position (Y1) where ADI and ASI intersect

1) The ASI curve shifts to the right

2) Inflation will be below target inflation

3) The central bank reduces the interest rate, so the equilibrium position moves along the ADI curve from ASI to ASI2

4) Eventually, the ASI will shift back up and the original equilibrium (Y1) will be re-established

Question 14

What will happen if there is a permanent shock (technological advancement)?

Answer 14

Initially, there is an equilibrium position (Y1) where ADI and ASI intersect

1) The ASI curve shifts to the right
→ ASI will not return to its original position

2) The central bank reduces the interest rate for every rate of inflation (new monetary policy)

3) The ADI curve will shift up,

4) So there will be a new equilibrium position (Y2) where ADI2 and ASI2 intersect

Question 15

What are the Labour Market model and the Phillips curve explain?

Answer 15

The Labour Market Model and the Phillips Curve can explain why a one-off increase in the world oil price can lead to a combination of:
→ A one-off increase in the price level (inflation) at the time of the shock
→ Rising Inflation over time

Question 16

What does a rise in the oil price do?

Answer 16

→ Shifts the Price Setting Curve down = this leads to a positive bargaining gap and inflation
→ Shifts the Phillips Curve up = it will continue to shift up as expected inflation rises

Question 17

What happens when there is a demand shock?

Answer 17

There is initially an equilibrium position (Y1) where ADI and ASI intersect
→ equilibrium output is consistent with the inflation target set by the central bank

1) when there is a demand shock, ADI curve shifts up from ADI1 to ADI2

2) there is movement along the ASI curve

3) there is a new equilibrium position where ADI2 and ASI intersect, and this equilibrium is above the inflation target rate

4) One of 2 things must happen:
→ the central bank must accept a higher target rate of inflation
→ or the central bank must reduce aggregate demand back to ADI1

Question 18

When is there Capacity Utilisation and what is the affect of it?

Answer 18

If Y1(the original equilibrium) is potential output, there is no output gap = so Capacity Utilisation
→ this leads to a rise in consumer confidence

Question 19

What happens if the central bank accepts the new higher target inflation rate?

Answer 19

The economy is producing above potential output capacity:

Y2 > Y1 (which is a positive output gap)

→ this is not sustainable
→ higher prices translate into higher wages
→ ASI will shift up (to the left) to become AS3
→ long run equilibrium is restored at higher inflation
→ ASI in the long run will be vertical at the original output equilibrium (Y1)

Question 20

What happens if the central bank reduces ADI to return to its original equilibrium?

Answer 20

This can be achieved with tighter monetary policy
→ for each inflation rate, the Central Bank will set a higher real inflation rate than before
→ output falls back down to the original equilibrium position (Y1) because higher interest rates leads to lower AD and output
→ so ADI2 will shift back down to ADI1

Question 21

What is a Demand Shock?

Answer 21

An unexpected change in aggregate demand

Question 22

How can the government stabilise the economy after a demand shock?

Answer 22

Governments can use both fiscal and monetary policy to stabilise the economy after a demand shock
1) Monetary Policy: decreasing the nominal interest rate
2) Fiscal Policy: tax cuts and increased government spending

Question 23

What is the ADI-ASI model suitable for?

Answer 23

ADI-ASI is more comprehensive, suitable for analysing overall economic policy, inflation targeting, and how the Central Bank’s actions affect the broader economy

Question 24

What does the Policymaker’s Indifference Curve focus on?

Answer 24

The policymaker’s indifference curves focuses on the labour market and the central bank’s potential short run trade-offs between inflation and unemployment

Question 25

How can the Policymaker's Indifference Curve and ADI-ASI Curve be used together?

Answer 25

1) Policymakers can use the Phillips Curve (with indifference curves) to understand the potential short term consequences of achieving their inflation targets on employment 2) The ADI-ASI model can then be used to plan and implement monetary policy that steers the economy towards those targets while considering broader economic implications

Question 26

What does the ADI-ASI Model focus on?

Answer 26

The ADI-ASI model focuses on the relationship between aggregate demand (ADI) influenced by monetary policy and aggregate supply (ASI) over different time periods: short, medium and long run → it illustrates how the central bank's policy affects inflation and output in various economic scenarios, taking into account the interplay between real interest rates, inflation and real output

Question 27

What does the position of the ADI curve indicate?

Answer 27

The position of the ADI curve indicates the stance of monetary policy at a given point in time and its impact on the economy's output and inflation rate

Question 28

What shifts the ADI Curve?

Answer 28

Shifts in the ADI curve can result from changes in monetary policy or from external factors such as fiscal policy and economic shocks

Question 29

What does the ASI curve show?

Answer 29

The ASI curve shows how inflation expectations and adjustments in wages and prices can affect the economy's supply side over time → it allows us to observe the transition from short run fluctuations to the long run equilibrium, where the economy eventually returns to a vertical ASI, with potential output unaffected by demand shocks

Question 30

What are the limitations of Monetary Policy?

Answer 30

1) The short term nominal interest rate (policy rate) cannot go below zero (“zero lower bound”) When the economy is in a slump, a nominal interest rate of zero may not be low enough to stabilise the economy 2) A country without its own currency does not have its own monetary policy, and so can’t tailor their interest rates to their economy (like countries in the eurozone)

Question 31

When the interest rate is already near 0, how can the central bank stabilise the economy?

Answer 31

Through Quantitative Easing = central bank buys financial assets to increase investment by reducing yields, as demand for assets increase, which will increase the price of assets and if the prices are higher, it means the yield decreases

Question 32

What is another reason for the inflation-unemployment trade off?

Answer 32

Capacity Constraints → Firms respond to rising capacity utilisation by increasing investment → But, in the short run, firms are capacity constrained (unable to meet excess demand for output) so they raise prices → Wage price spiral when other firms respond in the same way

Question 33

What are the different Lag Types?

Answer 33

1) Recognition lag = the time that it takes for policy makers to recognise the existence of a boom or slump → the time it takes for policy makers to realise that there is a problem 2) Implementation lag = the time that it takes to put the desired policy into effect once economists and policy makers recognise that the economy is in a boom or a slump 3) Response lag = the time that it takes for the economy to adjust to the new conditions after a new policy is implemented, it is the lag that occurs because of the operation of the economy itself → it is the time it takes for the economy to feel the effects of the policy

Question 34

What does the Policies affect?

Answer 34

1) Fiscal Policy affects the IS relationship 2) Monetary Policy affects the LM & MP relationships

Question 35

What does too much or too little AD cause?

Answer 35

1) Excessive growth in AD can cause unsustainable short term growth and higher rates of inflation 2) Too little AD can result in a recession, with negative growth and rising unemployment

Question 36

What are the Keynesian Views on AD management?

Answer 36

Keynesians = favour fiscal policy as a means of smoothing out fluctuations in AD → advocates for discretionary policy = changing policies in response to changes in the macroeconomy → government pursues active demand management

Question 37

What are the Monetarist Views on AD management?

Answer 37

Monetarists = believe in using monetary policy to target inflation → inflation results from excessive growth in the money supply → advocates for the use of rules as a means of controlling inflation, growth in the money supply, and the public sector net cash requirement

Question 38

What does Goodhart's Law suggest?

Answer 38

According to Goodhart’s Law, a single inflation target may just turn into a misleading way to conduct monetary or fiscal policy → Instead of inflation targeting, many economists favour the Taylor Rule, which takes into account inflation and real national income or unemployment → The Taylor Rule tries to get the best degree of stability between inflation and unemployment

Question 39

What is the role of institutions such as the central bank?

Answer 39

→ The central bank will respond to excess inflation by increasing the interest rate → The central bank will be concerned about real effects of its policy → The result will be a policy that takes into account the trade-off between stabilising inflation and output

Question 40

What does a flatter and steeper ADI curve show?

Answer 40

Flatter ADI Curve → relatively more weight on stabilising inflation → relatively less weight on stabilising output Steeper ADI Curve → relatively more weight on stabilising output → relatively less weight on stabilising inflation → there is a trade-off between inflation stability and real income stability

Question 41

What does the Keynesian Position assume with IS and MP?

Answer 41

Keynesians assume that: 1) IS is relatively steep and very unstable = investment and savings is not very responsive to variations of the interest rate, and savings is simply disposable income that was not consumed 2) MP is relatively flat = the central bank reacts mildly + output changes have a limited effect on inflation and also on interest rates → so monetary policy has little effect on output → fiscal policy is more effective for demand management

Question 42

What does the Monetarist Position assume with IS and MP?

Answer 42

Monetarists assume that: 1) IS is relatively flat = investment is very sensitive to variations of the interest rate + savings is also very sensitive to variations of the interest rate 2) MP is relatively steep = the central bank reacts aggressively to output and inflation changes + interest rates respond strongly to economic conditions → fiscal policy generates huge crowding out effects (steep MP pushes Interest Rates up) → so monetary policy is more effective

Question 43

What is Discretion for demand management?

Answer 43

government contrasts macroeconomic shocks (like a fall in AD) through discretionary monetary or fiscal policy

Question 44

What are rules as demand management?

Answer 44

governments adhere to the rules to promote fiscal and monetary policy in a more rational way

Question 45

What are the reasons for Discretion as demand management?

Answer 45

1) Unpredictable and Violent Shocks = Keynesians argue that the economy is inherently unstable, and that discretionary demand management is the best way to contrast this. → Shocks could be caused by slowdowns or waves of pessimism (low confidence), and the government can’t foresee these easily + rules would be too rigid 2) Instability = Monetarists claim that discretion brings instability, but Keynesians argue that unexpected shocks can only be dealt with discretionary demand management. → Lack of gov intervention would cause even more uncertainty about the future and discourage economic activity

Question 46

What are the reasons for Rules as demand management?

Answer 46

1) Political Self Interest = governments may be tempted to use fiscal/monetary policy in a discretionary way to increase their popularity in the short run (close to elections) rather than promoting economic growth in the long run. → This behaviour hinders government’s credibility and generates uncertainty in the markets

Question 47

What are the problems with Discretion as demand management?

Answer 47

1) Time lags = the effects of a policy might be felt months later, when it is not of use anymore, as the government requires time to actually make a decision and implement it → As monetary or fiscal policies will not result in an immediate change in AD, policymakers have to forecast the state of the economy in the future → For example, if the economy is experiencing an inflationary boom, interest rates can be raised to remedy this situation (so firms and households cut back on their spending) and the AD curve will shift to the left. The problem is that firms and households may have already planned their future spending

Question 48

What are the advantages of Rules as demand management?

Answer 48

1) If the government follows a set of rules, this will reduce uncertainty = for example, if people know that the government’s target rate of inflation is around 2%, they will not expect high inflation. It is more likely that the government will be able to achieve its target 2) If there is no risk of a sudden expansionary/contractionary, firms will be able to plan ahead, which encourages long term investment and economic growth

Question 49

What are the criticisms of Rules as demand management?

Answer 49

1) Keynesians argue that having to stick to money supply or inflation rules will lead to fluctuations in interest rates + this may also have an impact on firms’ long term investment plans 2) Another criticism is whether the government can meet its targets, and if it finds this difficult, uncertainty and instability may worsen

Question 50

What is the aim of the government?

Answer 50

To stabilise the economy, as instability can cause uncertainty, leading to a fall in investment and a subsequent fall in economic growth

Question 51

What do we need to do when rules are implemented?

Answer 51

If rules are implemented, we need to set targets but we need to choose a target

Question 52

What are issues with choosing targets?

Answer 52

1) Goodhart’s Law = controlling a symptom of a problem or only one part of the problem will not cure the problem, it will simply mean that the part that is being controlled now becomes a poor indicator of the problem → Example: the inflation target of 2% may mean inflation becomes a poor indicator of the status of the economy → If people expect a low rate of inflation, their actions will make it more likely that the target is met, but just because the target rate is being met, does not mean that the economy is experiencing stable economic growth → In 2008, the UK economy slowed down, but inflation remained on target (due to cost push factors)

Question 53

What does the ADI-ASI model show?

Answer 53

The ADI-ASI model explicitly models inflation on the vertical axis → the economy adjusts through short run, medium run, and long run ASI dynamics

Question 54

What shifts the ASI Curve?

Answer 54

Supply Shocks (like oil prices) shifts the ASI curve and creates a policy dilemma → policy dilemma is when policymakers face situations that involve conflicting interests and trade-offs + harder to make decisions (depends on mandate)

Question 55

How does the Central Bank use the Taylor Rule?

Answer 55

1) The Central Bank must decide whether to accept higher inflation or tighten policy to restore the original target 2) The Taylor Rule formalises the Central Bank’s reaction, weighting both inflation deviations and output gaps + the debate between rules and discretion centres on whether governments and central banks can be trusted to act wisely in real time or whether binding rules produce better long run outcomes

Question 56

What would be the slope of the ADI curve is the central bank prioritises keeping inflation stable?

Answer 56

If the central bank cares a lot about keeping inflation stable, and doesn’t care much about output fluctuations, it would be shown by a flatter ADI curve as any movement along the curve leads to fewer changes in inflation rate and greater changes in output

Question 57

Why do we need both IS-MP and ADI-ASI?

Answer 57

IS-MP shows the interest rate, the transmission mechanism and the cost of borrowing ADI-ASI shows inflation, the target, and short/medium/long run adjustments

Question 58

Under an inflation targeting regime, what is the priority?

Answer 58

1) Tighter Monetary Policy = strict control over IR + allows central bank to swiftly make changes to interest rates without gov intervention + higher interest rates limits inflation 2) Fiscal Rules (automatic stabilisers) = long term constraints in gov spending + taxation to prevent demand pull inflation 3) Constant Money Supply = strict stability of money supply keeps expectations stable → interest rates will be more effective in controlling inflation → rise in money supply leads to a fall in interest rates so its important to keep it stable 4) Use of Fiscal Discretion 5) Focus on Real Output Growth

Question 59

What are Fiscal Rules?

Answer 59

Automatic Stabilisers → It is long term constraints in gov spending + taxation to prevent demand pull inflation

Question 60

What is the Keynesian Argument vs the Monetarist Argument?

Answer 60

Keynesian: Argues that gov spending = income = output, which leads to employment + there is no economic growth through cutting gov spending Monetarist: Argues that if gov spending is manipulated too much, it will lead to inflation and discourage growth

Question 61

Benefits of Inflation Targeting:

Answer 61

1) Increases confidence + certainty as households will have stable expectations on price, so it will lead to greater demand and firms will be more likely to invest 2) Easier to control then exchange rate targeting as exchange rate depends on external factors as well, such as imports and exports + foreign reserves

Question 62

When is Exchange Rate Targeting beneficial?

Answer 62

Exchange Rate targeting will be beneficial if the country is a main importer or exporter → predictable exchange rate environment fosters greater trade and foreign investment + providing certainty to businesses and investors

Question 63

What happens if average product of labour falls?

Answer 63

1) Price Setting Curve will shift down as productivity will decrease so cost of production will increase, which can increase the price of goods 2) Wage Setting Curve will shift down as workers have less bargaining power 3) Employment would increase as productivity is lower so firms will have to hire more workers to reach the same output level as before