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Unformatted text preview: Macroeconomics, Econ 202, Review Questions Winter 2010 1. Consider the basic short-run model of the textbook: ~ Y t = & & b ( R t & & r ) : IS curve & t = & t & 1 + & v ~ Y t : Phillips curve R t = & r + & m ( & t & &) : Monetary policy Suppose the economy is initially at a full-employment equilibrium with ~ Y = 0 and & = & . Now suppose the central bank lowers its target for in&ation from & to & < & . Carefully discuss the adjustment of the economy in response to this change. A reduction in the in&ation target causes the central bank to immediately rise the policy interest rate (as can be seen from the policy rule). This rise in real interest rate reduces aggregate demand at each level of actual in&ation, so graphically the AD curve shifts to the left. The fall in demand leads to a negative output gap. This leads to a decline in in&ation. As in&ation declines, so do expectations of in&ation, shifting the Phillips curve downward. Eventually, the economy reaches a new equilibrium with the output gap again equal to zero but with in&ation equal to the new, lower target rate. 2. The basic short run model of the text book takes the form ~ Y t = & a & & b ( R t & & r ) & t = & t & 1 + & v ~ Y t plus a policy rule that species the behavior of R t . Suppose, however, that the central banks policy rate i t is related to the interest rate that appears in the IS relationship R t according to R t = R s t + & p , where & p is a mean zero shock to the risk premium. Policy is described by R s t = & r + & m ( & t & &) . (1) (a) Derive the aggregate demand curve linking ~ Y t and & t . How is it a/ected by a positive realization of & p ? (i.e., is it shifted to the left or right?) AD : ~ Y t = & a & & b ( R t & & r ) = & a & & b ( R s t + & p & & r ) = & a & & b & m ( & t & &) & & b & p A positive & p shifts the AD curve to the left (in ~ Y , & space). (b) Assume & a = 0 but suppose & p takes on a positive value (assume it remains permanently at this positive value). Describe the adjustment of the economy to such a shock. (Assume the economy starts out at ~ Y = 0 and & = & .) A positive & p is just like a negative & a it shifts the AD curve to the left (though a positive & p works by raising the real interest rate rather than directly a/ecting spending as an & a shock does), output falls and the output gap becomes negative. This acts to reduce in&ation. If the positive & p is permanent, the fall in in&ation shifts the Phillips curve downward and the economy returns to a zero output gap with lower in&ation. If it is temporary, then the AD shifts back to the right and the economy eventually returns to the same in&ation rate as before with a zero output gap. (c) Instead of (1), assume the central bank follows the policy rule given by R s t = & r + & m ( & t & &) & & p . (2) 1 What happens now if & p takes on a positive value? How does your answer di/er from that of part (b)? Why does it di/er? Now the AD cuve would be AD: ~ Y t = & a & & b ( R t & & r ) = & a &...
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- Winter '08