EC102: CLASS 4 LTChristina Ammon

Today’s Plan

Will cover: Essay 3 question e,f,g Essay 4 Quiz 4

Aggregate Supply

Distinguish between long run and short run Definition different from Micro

Long run - Prices are flexible Short run - many prices are “sticky” at a predetermined level

Essay 3 Question e

Why is the aggregate supply curve horizontal in the short run? Aggregate supply is fixed in the long run But can fluctuate in the short run Why? • Can build up/use up inventories

Reasons why prices can be sticky in the short run: Menu costs Information costs Consumer reaction Wage rigidity

Essay 3 Question f

Use the AD-AS framework to illustrate the effects of an increase in desired consumption due to “animal spirits”

What happens to the AS? What happens to AD?

What happens to output and the price level? What happens when we try to look at the long run?

Essay 3 Question g

Use the AD-AS framework to illustrate the effects of an increase in interest rates

Monetary Policy

In our model: Central Bank controls the money supply Controls the money supply through Open Market

Operations = buying and selling short-term government bonds No banks exist otherwise

Money supply matters for the real economy by affecting the interest rate

CB has two objectives• Stabilizing inflation• Stabilizing output

Question 1

An increase in the money supply M can be represented as A movement along the AD curve A shift in the AD curve A change in the slope of the AD curve None of the above

Essay 4 Question b

Faced with a negative demand shock, the central bank needs to strike a balance between doing “too much” and doing “too little”. Explain.

What happens if the central bank does nothing?• Answer similar to the central bank doing too little

What happens if the central bank does too much?• Which objective does it not reach if it does too much?• Which objective does it not reach if it does too little?

Quiz Question 5

If the economy is not initially in recession, following a monetary expansion we expect to see• First an increase in prices and then an expansion in the economy• First an expansion in the economy and then an increase in prices• A simultaneous increase in prices and expansion in the economy• An increase in prices followed by a contraction in the economy due to

inflation

Quiz Question 5

Essay 4 Question c

When will a monetary expansion not result in inflation?

Essay 4 QuestionDescribe the mechanism by which quantitative easing is thought to help the economy recover.

How does QE differ from other OMOs? • QE a specific form of OMO’s

Normally: CB only trades in short term bonds => Affects the short-term interest rate => Indirectly affects the long term interest rate• Which interest rate are we the most interested in?

When does monetary policy become inefficient? How can quantitative easing help in this situation?

Fiscal Policy

Alternative/Complement to Monetary Policy = changes in G

Effectiveness depends on the fiscal multiplier What is the fiscal multiplier? How does it vary over the business cycle? What are the effects on the other parts of AD?

Quiz Question 2

Responsible fiscal policy involves:• Running a balanced budget at all times• Having a debt less than 60% of GDP• Running a budget surplus at all times• Running a deficit some of the time

Quiz Question 3

If the fiscal multiplier is between 0 and 1, a fiscal expansion will result in• a fall of GDP• a fall of C and/or I and/or NX• a decline in employment• a decline in public debt

Question 4

If a central bank drops money from a helicopter• It won’t affect interest rates as there is no corresponding purchase of

bonds• It will have the same effects as an OMO for the same amount• Will affect demand positively through lower interest rates and

negatively through inflation• Combines elements of monetary and fiscal stimulus

Essay 4 Question a

Macroeconomic policy can both be a problem and a solution in economic fluctuations. Explain. Ideally: stabilizing influence – can balance out other demand

shocks• Fiscal stimulus after Financial Crisis 2008• Quantitative easing to alleviate liquidity constraints

But can sometimes be cause of fluctuations• Suddenly needs to change fiscal policy (e.g. to reduce debt)• Southern Euro area + possibly UK? • Wrong monetary policy decisions