Macro.Week10.2008 - II 10/1 Review material at end of last...

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II - 10/1 Review material at end of last week: Why does monetary policy fail in major recession?? Notice that links are far less direct. In case of Fiscal Policy: increase G or cut TA or increase TR increase in G directly stimulates demand Cut in TA or rise in TR directly increases DI, and consumers are in bad shape, so C naturally rises
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II -10/2 In contrast, look at case of Monetary Policy: increase MS by buying bonds MS increase largely depends on banks lending out excess reserves MS increase must lower r, but L flattens as r drops near zero Diagram of liquidity preference: lower r increases I, but assumes households and firms want to invest! Diagram of inelastic investment curve:
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II - 10/3 So return to basics Linked diagram of macro model: Now let’s look at policy possibilities using these linked diagrams
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II - 10/4 Case 1 - Recessionary or Deflationary gap Two options for policy Option 1: Do nothing and wait for external forces to change, or for wages to fall show linked diagram and long run adjustment mechanism when wages fall
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II - 10/5 Option 2 : Try to fix using expansionary fiscal policy or expansionary monetary policy show linked diagram with increase in AE and shift of AD to return economy to full employment
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II - 10/6 Case 2 - Inflationary Gap Two options for policy Option 1: Do nothing and wait for external forces to change, or for wages to rise RISK is Stagflation show linked diagram with rising wages leading to return to full employment, then discuss danger that expectations will set in and inflation will continue, pushing up wages in wage-price spiral so that economy overshoots full employment
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II - 10/7 Option 2 : Try to fix using contractionary fiscal policy or contractionary monetary policy show linked diagram with decrease in AE and shift of AD to return economy to full employment
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II - 10/8 Notice key role of expectations in inflationary gap situation Once expectations set in, you have a real problem. If don’t expand the money supply, worsens recession part; if expand
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