You are an advisor to the Finance Minister of a small country. You are presented with the following facts about the coun
Posted: Thu May 05, 2022 7:05 am
You are an advisor to the Finance Minister of a small country.
You are presented with the following facts about the country’s
economy. Real GDP growth had been 5% a year in the past decade, but
growth slowed down to only 1% this year. However, nominal GDP is
growing at 7%, which is exactly its historical average.
Unemployment is usually 20% in this country, but has recently risen
to 25%. The central bank of this country is independent and has a
strict mandate to follow a Taylor rule that puts a very large
weight on inflation and only a small weight on the output gap (or
unemployment).
a) Given the information you have read, do you think this
economy was hit by an aggregate supply or aggregate demand shock?
Explain your answer and use an appropriate diagram to demonstrate
your case.
b) The Finance Minister argues that current economic conditions
appear to contradict the existence of a Phillips curve. Explain
what the Phillips curve is. Explain why the Finance Minister’s
statement that the macroeconomic data go against the Phillips curve
is correct. Given your answer to part (a) of the question explain
why this doesn’t contradict the theory underlying the
Phillips-curve relationship.
c) The Finance Minister asks you to predict what the central
bank will do in response to the new macroeconomic data and what the
implications will be for GDP growth, inflation, and
unemployment.
d) The Finance Minister is frustrated with your answer to part
(c) of this question. She thinks the central bank’s response is
inadequate. Explain the rationale for a independent central bank
following a rule-based policy. Argue why the central bank’s actions
are in the long-run interest of the country.
e) Give an argument for discretionary policy in the current
circumstances or for changing the central bank’s mandate to having
a higher weight on unemployment.
f) The Finance Minister wants to use fiscal policy to substitute
for the inadequate monetary policy response. Outline the main
factors that will determine whether fiscal policy will be effective
under current circumstances. Do they favour a strong fiscal
response?
g) Use appropriate diagrams to show the effects of an increase
in government spending followed by the expected response of the
central bank given its mandate.
h) Households in this economy have 90 pesos of mortgage debt for
every 100 pesos of housing wealth in the economy. Show the balance
sheet of the typical household if housing is the only asset and
mortgage debt is the only form of liability in this economy. Show
how the balance sheet would change if housing prices decline.
i) How does your answer to part (h) of the question affect how
you think about the potential for monetary and fiscal policy to
support this economy in the slowdown it is facing?
You are presented with the following facts about the country’s
economy. Real GDP growth had been 5% a year in the past decade, but
growth slowed down to only 1% this year. However, nominal GDP is
growing at 7%, which is exactly its historical average.
Unemployment is usually 20% in this country, but has recently risen
to 25%. The central bank of this country is independent and has a
strict mandate to follow a Taylor rule that puts a very large
weight on inflation and only a small weight on the output gap (or
unemployment).
a) Given the information you have read, do you think this
economy was hit by an aggregate supply or aggregate demand shock?
Explain your answer and use an appropriate diagram to demonstrate
your case.
b) The Finance Minister argues that current economic conditions
appear to contradict the existence of a Phillips curve. Explain
what the Phillips curve is. Explain why the Finance Minister’s
statement that the macroeconomic data go against the Phillips curve
is correct. Given your answer to part (a) of the question explain
why this doesn’t contradict the theory underlying the
Phillips-curve relationship.
c) The Finance Minister asks you to predict what the central
bank will do in response to the new macroeconomic data and what the
implications will be for GDP growth, inflation, and
unemployment.
d) The Finance Minister is frustrated with your answer to part
(c) of this question. She thinks the central bank’s response is
inadequate. Explain the rationale for a independent central bank
following a rule-based policy. Argue why the central bank’s actions
are in the long-run interest of the country.
e) Give an argument for discretionary policy in the current
circumstances or for changing the central bank’s mandate to having
a higher weight on unemployment.
f) The Finance Minister wants to use fiscal policy to substitute
for the inadequate monetary policy response. Outline the main
factors that will determine whether fiscal policy will be effective
under current circumstances. Do they favour a strong fiscal
response?
g) Use appropriate diagrams to show the effects of an increase
in government spending followed by the expected response of the
central bank given its mandate.
h) Households in this economy have 90 pesos of mortgage debt for
every 100 pesos of housing wealth in the economy. Show the balance
sheet of the typical household if housing is the only asset and
mortgage debt is the only form of liability in this economy. Show
how the balance sheet would change if housing prices decline.
i) How does your answer to part (h) of the question affect how
you think about the potential for monetary and fiscal policy to
support this economy in the slowdown it is facing?