HW10 (2)

Sahibzada Khan Econ 600 Money and Banking: Problem Set 10 Due: 11:59 pm, 12.10.2023 1 Short essay questions for the chapter 23 1. For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize | economic activity such as output and inflation. Assume the economy starts at a long-run equilibrium. () (b) (c) Consumers reduce autonomous consumption. Ans. A reduction in autonomous consumption reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity by lowering interest rates and, or increasing the money supply lli-regulations reduce the productivity of an economy. Ans. Less productivity means supply is greater than demand which leads to inflation. inflation can be reduce using monetary policy by increasing interest rates and buy selling government securities to reduce the money supply in the economy. A temporary oil shock increases the cost of production. In this case, you need to show how the Fed and government can stabilize output first and then inflation. Through this analysis, you will see that an active policy cannot stabilize both output and inflation at the same time against temporary supply shocks. Ans. Intially the economy is in a long run equilibrium. The oil shock, a supply-side shock, causes an upward shift in the SRAS curve, leading to higher inflation and lower output. In response, the Fed may initially stabilizes output by lowering interest rates. However, this can exacerbate inflation in the short term. Similarly, the government might adopt expansionary fiscal policies, such as increasing spending or reducing taxes to support output. Over time, as the impact of the oil shock starts to decline, the focus shifts to controlling inflation. The Fed may raise interest rates and the government implement contractionary policies. This scenario underlines a key effort to stabilize output following a supply shock can worsen inflation, and measures to control inflation can further suppress output. 2. Why do temporary negative supply shocks pose a dilemma for policymakers at central banks in pursuing dual mandates (inflation and output stabilizations)? Ans. These shocks inherently disrupt the balance between maintaining stable prices and maximizing output. With negative supply shocks, both inflation and the unemployment rate increase. In order to

Sahibzada Khan reduce the unemployment rate, an expansionary policy must be pursued, which further increases inflation On the other hand, pursuing a policy to reduce the inflation rate requires a contractionary policy, which further increases the unemployment rate. This conflicting nature of policy responses underlines the central bank's dilemma during such shocks: choosing which aspect of their mandate to prioritize. 2 Long essay question: zero lower bounds 1. Draw the aggregate demand and supply graph considering the zero-lower bound. How does the policy rate hitting a floor of zero nominal federal fund rate lead to an upward-sloping aggregate demand curve? — \ LRAR N 7 / When the policy rate hits a floor of the zero, the positive relationship between inflation and the real interest rate embodied by the MP curve becomes negative. A lower inflation rate will lead to a higher interest rate as the nominal interest rate is fixed at zero which will cause the planned expenditure to decrease so the output falls and it will lead to an upward sloping aggregate demand curve. 2. Explain what happens if an equilibrium arises at the upward slope of the aggregate demand curve. What economic outcome does the self-correcting mechanism lead to? Ans. In this situation, the economy is likely experiencing deflation. The upward slope of the AD curve at the ZLB suggests that deflation do not lead to an increase in aggregate demand as they would under normal circumstances. Instead, deflation may lead to decreased aggregate demand because of increased real debt burdens and potentially reduced consumer and business confidence. However, in a deflationary scenario like the one at the ZLB, the self-correcting mechanism may not function effectively. Deflation can lead to a vicious cycle where falling prices increase the real value of debt, leading to decreased consumption and investment. This reduction in aggregate demand can then lead to further deflation, making it harder for the economy to recover. The economy will go in deflationary spiral.