86.The central banks of two nearly identical countries, Fixland and Flexland, desire low inflation and low unemployment. There is a similar short-run tradeoff between unemployment and unexpected inflation in both countries. Private agents in both Fixland and Flexland form expectations rationally and understand the incentives that central banks may have to renege on low-inflation policies. Initially, the rates of inflation and unemployment are the same in both countries. The central bank of Fixland makes a credible announcement that it will operate according to a low-inflation rule. The central bank of Flexland announces that it plans to follow a low-inflation policy, but retains the right to deviate from this policy at its discretion. a.In which country would you expect the rate of inflation to be lower? b.In which country would you expect the unemployment rate to be lower? 87.The following notice appeared on a full page of the Wall Street Journal on February 9, 2009: "There is no disagreement that we need action by our government, a recovery plan that will help to jumpstart the economy.” —President-Elect Barack Obama, January 9, 2009 With all due respect Mr. President, that is not true. Notwithstanding reports that all economists are now Keynesians and that we all support a big increase in the burden of government, we the undersigned do not believe that more government spending is a way to improve economic performance. More government spending by Hoover and Roosevelt did not pull the United States out of the Great Depression in the 1930s. More government spending did not solve Japan's “lost decade” in the 1990s. As such, it is a triumph of hope over experience to believe that more government spending will help the United States today. To improve the economy, policymakers should focus on reforms that remove impediments to work, saving, investment and production. Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth. The statement was signed by over 200 economists, including 3 Nobel Laureates. a.Comment on the extent to which the disagreement between the President and the economists involves a disagreement about whether policy should be passive or active. b.Identify the rationale(s) used to support the economists' position. 88.Compare two procedures for conducting monetary policy: Method 1: Maintain a steady money growth of 6 percent per annum, and Method 2: Maintain a steady inflation rate of 3 percent per annum. Be sure to consider whether the methods involve: (1) active or passive monetary policy and (2) rules or discretion. Discuss why one method might be preferred over the other. 89.Explain why each of the following statements is a rationale for conducting active or passive policy: a.Economic circumstances can change dramatically between the time that an economic downturn begins and the time when policy actions have an effect on the economy. b.Economists are not very accurate forecasters. c.Increases in government spending generate increases in economic output. d.Fluctuations in economic output have been less severe since World War II. 90.Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and an inflation rate of 10 percent. Assume that there is a short-run tradeoff between inflation and unemployment as described by a Phillips curve. Use the Phillips curve to graphically illustrate why a central bank that desires both low inflation and low unemployment has the incentive to renege on an announced policy to reduce inflation to 3 percent, if people set wages and prices on the expectation of 3 percent inflation and the central bank has the discretion to change its monetary policy after these expectations are set. Page 1

86.The central banks of two nearly identical countries, Fixland and Flexland, desire low inflation and low unemployment. There is a similar short-run tradeoff between unemployment and unexpected inflation in both countries. Private agents in both Fixland and Flexland form expectations rationally and understand the incentives that central banks may have to renege on low-inflation policies. Initially, the rates of inflation and unemployment are the same in both countries. The central bank of Fixland makes a credible announcement that it will operate according to a low-inflation rule. The central bank of Flexland announces that it plans to follow a low-inflation policy, but retains the right to deviate from this policy at its discretion.

a.In which country would you expect the rate of inflation to be lower?

b.In which country would you expect the unemployment rate to be lower?

87.The following notice appeared on a full page of the Wall Street Journal on February 9, 2009:

"There is no disagreement that we need action by our government, a recovery plan that will help to jumpstart the economy.” —President-Elect Barack Obama, January 9, 2009

With all due respect Mr. President, that is not true. Notwithstanding reports that all economists are now Keynesians and that we all support a big increase in the burden of government, we the undersigned do not believe that more government spending is a way to improve economic performance. More government spending by Hoover and Roosevelt did not pull the United States out of the Great Depression in the 1930s. More government spending did not solve Japan's “lost decade” in the 1990s. As such, it is a triumph of hope over experience to believe that more government spending will help the United States today. To improve the economy, policymakers should focus on reforms that remove impediments to work, saving, investment and production. Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth.

The statement was signed by over 200 economists, including 3 Nobel Laureates.

a.Comment on the extent to which the disagreement between the President and the economists involves a disagreement about whether policy should be passive or active.

b.Identify the rationale(s) used to support the economists' position.

88.Compare two procedures for conducting monetary policy:

Method 1: Maintain a steady money growth of 6 percent per annum, and

Method 2: Maintain a steady inflation rate of 3 percent per annum.

Be sure to consider whether the methods involve: (1) active or passive monetary policy and (2) rules or discretion. Discuss why one method might be preferred over the other.

89.Explain why each of the following statements is a rationale for conducting active or passive policy:

a.Economic circumstances can change dramatically between the time that an economic downturn begins and the time when policy actions have an effect on the economy.

b.Economists are not very accurate forecasters.

c.Increases in government spending generate increases in economic output.

d.Fluctuations in economic output have been less severe since World War II.

90.Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and an inflation rate of 10 percent. Assume that there is a short-run tradeoff between inflation and unemployment as described by a Phillips curve. Use the Phillips curve to graphically illustrate why a central bank that desires both low inflation and low unemployment has the incentive to renege on an announced policy to reduce inflation to 3 percent, if people set wages and prices on the expectation of 3 percent inflation and the central bank has the discretion to change its monetary policy after these expectations are set.

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