Question & Answer

What is Goodhart’s Law? How is it relevant to (a) monetary policy; (b) using assignment grades to assess a student’s ability; (c) paying workers according to the amount of output they produce; (d) awarding local authority contracts to cleaning or refuse disposal companies on the basis of tendered prices?

What are the mechanics whereby the central bank raises the rate of interest?

Is it possible for the government to target the money supply over the longer term without targeting the level of public-sector net borrowing?

Assume that a bank has the following simplified balance sheet, and is operating at its desired liquidity ratio.

         Now assume that the central bank repurchases £5 million of government bonds on the open market. Assume that the people who sell the bonds all have their accounts with this bank.

         (a)  Draw up the new balance sheet directly after the purchase of the bonds.

         (b)  Now draw up the eventual balance sheet after all credit creation has taken place.

         (c)  Would there be a similar effect if the central bank rediscounted £5 billion of Treasury bills?

         (d)  How would such open market operations affect the rate of interest?

Why is it difficult to use fiscal policy to ‘fine tune’ the economy?

What factors determine the effectiveness of discretionary fiscal policy?

Of what significance are primary deficits or surpluses for the dynamics of a government’s debt-to-GDP ratio?      

If the government is running a budget deficit, does this mean that national income will increase?

Does it matter if a country has a large national debt as a proportion of its national income?

What are the problems of relying on automatic fiscal stabilisers to ensure a stable economy at full employment?

Assume that the economy is at potential output and the natural rate of unemployment and that inflation is at the target rate set for the central bank by the government. In each of the following scenarios apply the integrated EAPC, DAD/DAS and IS/MP framework to analyse the economy’s adjustment path.

(a) A temporary fall in aggregate demand under the assumption that inflationary expectations remain anchored.

(b) A temporary fall in aggregate demand where inflationary expectations are based on the rate of inflation in the previous period.

(c) A temporary positive supply shock where inflationary expectations are based on the rate of inflation in the previous period.

In what sense is it true to say that the Phillips curve is horizontal today?

Using the integrated DAD/DAS and EAPC/LRPC framework, analyse the effect of an unexpected increase in aggregate demand assuming that markets adjust relatively rapidly. Compare the adjustment path of the economy when inflationary expectations remain anchored with that when expectations are based on actual inflation in the previous period.

What is meant by inflation bias? What factors affect the potential magnitude of inflation bias?

For what reasons may the NAIRU increase?

How can adaptive expectations of inflation result in clockwise Phillips loops? Why would these loops not be completely regular?

What is the difference between adaptive expectations and rational expectations?

In the accelerationist model, if the government tries to maintain unemployment below the natural rate, what will determine the speed at which inflation accelerates?

Assume that inflation depends on two things: the level of aggregate demand, indicated by the inverse of unemployment (1/U), and the expected rate of inflation (π ^e_t). Assume that the rate of inflation (π_t) is given by the equation:

                             π_t = (48/U – 6) + π^e_t

Assume initially (year 0) that the actual and expected rate of inflation is zero.

(a)  What is the current (natural) rate of unemployment

(b)    Now assume in year 1 that the government wishes to reduce unemployment to 4 per cent and continues to expand aggregate demand by as much as is necessary to achieve this. Fill in the rows for years 0 to 4 in the following table. It is assumed for simplicity that the expected rate of inflation in a given year (π^e_t) is equal to the actual rate of inflation in the previous year (π_t–1).

(c)    Now assume in year 5 that the government, worried about rising inflation, reduces aggregate demand sufficiently to reduce inflation by 3 per cent in that year. What must the rate of unemployment be raised to in that year?

(d)    Assuming that unemployment stays at this high level, continue the table for years 5 to 7.

What are the possible channels through which hysteresis effects can arise, such that demand shocks have persistent effects on the macroeconomy?

Given the Keynesian explanation for the persistence of high levels of unemployment after the early 1980s and early 1990s recessions, what policies would you advocate to reduce unemployment in the years following a recession?

How might fluctuations in aggregate demand lead to changes in output even under the assumption of continuous market clearing?

Assume that there is a positive technological shock. How would this impact on the equilibrium level of employment and the economy’s potential output?  Illustrate using diagrams of both the labour and goods markets.

For what reasons may the natural rate of unemployment increase?

What impact would an increase in potential output have on the DAS curve? How would the long-term rate of economic growth be reflected by the DAS curve?