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Chapter 22 Understanding Business Cycle Fluctuations Conceptual and Analytical Problems Define the term stabilization policy and describe how it can be used to reduce the volatility of economic growth and inflation. Do stabilization policies improve everyone's welfare? Answer: Stabilization policies are monetary or fiscal policies designed to stabilize inflation and output. Both monetary and fiscal policies can be used to shift the dynamic aggregate demand curve to at least partially counteract the impact of economic shocks. While policymakers in principle can neutralize aggregate demand shocks, they cannot shift the aggregate supply curve and so cannot eliminate the effects of shifts in the short-run aggregate supply curve. According to Core Principle 5, stability improves welfare and so policies that promote economic stability improve the welfare of everyone. Explain why stabilization policies are usually pursued using monetary rather than fiscal policy. Answer: While fiscal policies can reduce a recessionary output gap by increasing government spending and or cutting taxes, it takes a long time for these policies to be enacted and the effect of tax cuts is not immediate. Fiscal policymakers are also likely to support programs that would allow them to make political gains, regardless of whether those programs are best from an economic standpoint. Monetary policy can stabilize the economy more quickly and if the central bank is independent, it is not influenced by politics. Explain why fiscal policy played a greater role than usual in the response to the 2007–2009 recession. Answer: The fact that monetary policymakers had cut interest rates almost to zero and that there was a risk of deflation underscored the importance of using all possible means to help stabilize the economy. Explain why monetary policymakers cannot restore the original long-run equilibrium of the economy if, in the short run, the economy has moved to a point where inflation is above target inflation and output is below potential output. Answer: If inflation is above target inflation and output is below potential output, the short-run aggregate supply curve has shifted to the left. Monetary policymakers can only shift the dynamic aggregate demand curve. An expansionary monetary policy could restore output to its long-run equilibrium level but this would come at the cost of permanently higher inflation. Explain why the rise in oil prices in 2008 created a particularly difficult situation for Federal Reserve policymakers. Answer: The rise in oil prices and consequent upward pressure on inflation came at a time when the U.S. economy was weak. Uncertainty surrounding the extent of the impact of the financial crisis on the economy meant that any hikes in interest rates to combat inflation could be very damaging to the economy’s growth prospects. The Fed faced a trade-off between its goals: should it tighten policy to combat inflation or loosen it to spur growth? Will changes in technology affect the rate at which the short-run aggregate supply curve shifts in response to an output gap? Why or why not? Provide some specific examples of how technology will change the rate of adjustment. Answer: Technological advancements will make it easier to change prices in response to an output gap. For example, instead of placing price stickers on items in the supermarket, prices could be displayed on electronic screens on shelves in front of items and could be changed from a computer. If it becomes easier to change prices, the short-run aggregate supply curve will shift more quickly in response to an output gap. After examining Figure 22.6, explain the potential link between innovations in financial markets and output volatility since the 1980s. You should consider both the “Great Moderation” and the recession of 2007–2009 in your answer. Answer: From the early 1980s until the onset of the recession in 2007, there was a marked moderation in the volatility of output growth that became known as the “Great Moderation”. From the early 1980s many new financial products appeared that made it easier for households and businesses to borrow—which facilitated consumption smoothing and contributed to output stability. It transpired, however, that some of these new financial products facilitated increased levels of risky debt that led to unprecedented levels of personal credit defaults during the financial crisis of 2007–2009. The loss of credit availability during this period contributed to the depth and duration of the associated recession. According to real-business-cycle theory, can monetary policy affect equilibrium output in either the short run or the long run? Answer: According to real-business-cycle theory, business cycle fluctuations arise due to changes in potential output and the short-run aggregate supply curve shifts so rapidly that it is irrelevant. Equilibrium in both the short run and the long run is determined by the intersection of the dynamic aggregate demand curve and the long-run aggregate supply curve. Shifts in the AD curve do not influence the equilibrium level of output and so monetary policy cannot influence equilibrium output either in the short run or the long run. The economy has been sluggish, so in an effort to increase output in the short run, government officials have decided to cut taxes. They are considering two possible temporary tax cuts of equal size in terms of lost revenue. The first would reduce the taxes on people with income above the median for one year. The second would cut taxes on people with incomes below the median for one year. Which change would shift the aggregate demand curve further to the right? Why? Answer: Temporary tax cuts usually have little impact on the spending of taxpayers who are not liquidity or credit constrained. Put differently, higher-income taxpayers may save a temporary tax cut, rather than spend it, because they can use their savings or access to credit to smooth their spending across temporary income fluctuations. However, taxpayers who are liquidity or credit constrained are more likely to spend the tax cut, because it relaxes their funding constraint. For that reason, a tax cut focused on lower-income taxpayers may have a greater impact on aggregate spending. Starting with the economy in long-run equilibrium, use the aggregate demand-aggregate supply framework to illustrate what would happen to inflation and output in the short run if there were a rise in consumer confidence in the economy. Assuming the central bank takes no action to offset this rise in confidence, what would happen to inflation and output in the long run? What policy adjustment is the central bank undertaking? Answer: A rise in consumer confidence would shift the dynamic aggregate demand curve (AD) to the right, increasing both inflation and output in the short run (point B). In the absence of a policy response, the economy will eventually self-adjust, with the short-run aggregate supply curve (SRAS) shifting to the left to restore long-run equilibrium at point C. At C, output has returned to Y* but inflation is higher than its original level. The central bank has implicitly raised its inflation target. Consider again the rise in consumer confidence described in Problem 10. What would happen to inflation and output in the long run if the central bank remained committed to it original inflation target and responded with an immediate policy tightening? Compare the outcome to that in Problem 10 using the aggregate demand–aggregate supply framework. Answer: If the central bank tightens policy immediately in response to the upward movement in inflation and output, the rightward AD curve shift due to the rise in confidence will be immediately offset. Output will remain at Y* and, in contrast to the implicit rise of the inflation target in Problem 10, inflation will remain at the original target level. Suppose that consumer confidence unexpectedly rises six months before the central bank detects the change. Compared to your answer to Problem 11, what happens to inflation and output in that interval? How does monetary policy return the economy to long-run equilibrium at the initial inflation target? Answer: The rise in consumer confidence implies a rightward shift in the dynamic AD curve, from AD to AD′. This shift leads to a rise in the inflation rate to π′, along with an increase in output to Y′. Since the central bank took six months to recognize the change in aggregate demand, the central bank’s response is delayed. Once it recognizes the change, the central bank will act to shift the MPRC curve to the left, moving the dynamic AD curve back to its original position. The inflation rate and output return to their initial levels. In the meantime, however, there is a business cycle expansion accompanied by a rise in inflation. How would a shock that reduces production costs in the economy (a positive supply shock) affect equilibrium output and inflation in the both short run and the long run? Illustrate your answer using the aggregate demand–aggregate supply framework. You should assume that the shock does not affect the potential output of the economy. Answer: A positive supply shock will shift the SRAS curve to the right. In the short run, equilibrium output will increase while equilibrium inflation will fall. In the absence of a policy response, the expansionary gap will put upward pressure on inflation, shifting the SRAS back to the left. In the long-run, the initial levels of output and inflation will be restored. Suppose, instead of waiting for the economy described in Problem 13 to return to long-run equilibrium, the central bank opted to use the positive supply shock as an opportunity to move to a lower inflation target. Illustrate the impact of this change in the inflation target using an aggregate demand–aggregate supply diagram. Compare this with a graph of a situation where the central bank lowers its inflation target in the absence of a positive supply shock. Answer: If the central bank uses the positive supply shock as an opportunity to lower its inflation target without inducing a recession, the rightward shift in the SRAS curve will be followed by a leftward shift in the AD curve. In the long run, output returns to Y* at a lower inflation level. In contrast, if the central bank lowers its inflation target in the absence of a positive supply shock, it first moves to point B where output falls below Y*. In the long run, the recessionary gap puts downward pressure on inflation, shifting the SRAS curve to the right to restore long-run equilibrium at point C as above. Suppose a natural disaster reduces the productive capacity of the economy. How would the equilibrium long-run real interest rate be affected? Assuming the central bank maintains its existing inflation target, illustrate the impact on the monetary policy reaction function and on equilibrium inflation and output both in the short run and in the long run. Answer: As a result of a natural disaster that reduces the productive capacity of the economy, the long-run real interest rate would increase. Monetary policymakers respond by shifting the monetary policy reaction curve (MPRC) to the left, increasing the interest rate for every level of inflation. In the aggregate demand–aggregate supply framework, both the SRAS and the LRAS curves would shift to the left as a result of the natural disaster, increasing inflation and reducing output in the short run (point B). The monetary policy tightening shifts the AD curve to the left and long-run equilibrium occurs at point C, where inflation is back at its target level and output is at the new lower potential level of output. Monetary policymakers observe an increase in output in the economy and believe it is a result of an increase in potential output. If they were correct, what would the appropriate policy response be to maintain the existing inflation target? If they were incorrect and the increase in output resulted simply from a positive supply shock, what would the long-run impact be of their policy response? Answer: To maintain the existing inflation target, monetary policymakers should shift their MPRC to the right, shifting the AD to the right. This would restore long-run equilibrium at the existing inflation target and the new, higher level of potential output. If, however, the increase in output resulted simply from a positive supply shock, the expansionary monetary policy would increase the expansionary gap. In the long run, the SRAS curve would shift to the left and long-run equilibrium would occur at the original level of output but at a higher level of inflation. Consider a previously closed economy that opens up to international trade. Use the aggregate demand–aggregate supply framework to illustrate a situation where this would lead to lower inflation in the long run. Answer: Opening up to international trade increases potential output and the SRAS and LRAS curves shift to the right. If monetary policymakers use this as an opportunity to reduce the inflation target and do nothing, the SRAS curve will shift farther to the right to close the recessionary gap. In the long run, output will be at the new higher potential level while inflation is lower. How could you use the aggregate demand–aggregate supply (AD/AS) framework to explain the impact of the financial crisis of 2007–2009 on inflation and output in the economy? Answer: You can think of the disruption in financial markets as an AD shock. Lack of access to credit by consumers and businesses and loss of consumer and investor confidence would shift the AD curve to the left. In the absence of other changes, this would put downward pressure on both output and inflation. Changes in oil prices shift the short-run aggregate supply curve (SRAS). Consider how volatility in oil prices may influence the economy’s short-run equilibrium, which occurs at the intersection of the dynamic aggregate demand (AD) curve and the SRAS curve. Suppose the monetary policy reaction curve is relatively steep. What does this imply about the slope of the AD curve? What does it imply about the variability of output and inflation when the SRAS curve shifts? Explain. Suppose the monetary policy reaction curve is relatively flat. What does this imply about the slope of the AD curve? What does it imply about the variability of output and inflation when the SRAS curve shifts? Explain. Answer: In the diagram below, suppose that SRAS fluctuates between SRAS’ and SRAS”, with a typical position at SRAS. The impact of these fluctuations on output and inflation in the short run depends on the slope of the dynamic aggregate demand (AD) curve. As shown in text Figures 22.13 and 22.14, the steeper the MPRC, the flatter the AD curve. With a relatively steep MPRC, a given rise in the inflation rate leads to a larger policy-driven rise in the real interest rate that triggers a bigger decline of interest-sensitive spending. That is, the rise in the inflation rate leads to a comparatively large fall in output demanded, so the dynamic AD curve is relatively flat. With a flat AD, the variability in output is fairly large, fluctuating between Y′ and Y″ in the diagram below. Note the relatively small variability in the inflation rate. If the MPRC is relatively flat, a given rise in the inflation rate leads to a smaller policy-driven increase in the real interest rate, resulting in a smaller decline of interest-sensitive purchases. So, the same increase in the inflation rate as in part (a) leads to a smaller decline in the quantity of output demanded in the economy. Put differently, the AD curve in this case is relatively steep. As in the diagram below, the steep AD curve means that output volatility is smaller. Note, however, that relatively stable output is associated with larger inflation fluctuations. You are asked to advise a central bank of an advanced economy that is about to set an inflation target for the first time. Officials are leaning toward adopting a 2 percent target, in line with the practice in many other countries. Suggest two factors that the central bank should consider before settling on 2 percent. Answer: You might suggest the central bank officials consider: 1) estimates of the neutral real interest rate in their economy; and 2) the historical depths of recessions in their economy. In a situation where the neutral real interest rate is very low and/or recessions are very deep, you might advise them to consider a higher inflation target to provide more scope for the use of conventional monetary policy tools before hitting the effective lower bound. Suppose that a government imposes trade barriers that raise the domestic cost of production and lower potential output. What would you expect to happen to inflation and output in the short run and the long run, assuming monetary policymakers only recognize the fall in potential output with a lag and keep their inflation target unchanged? Answer: The fall in potential output would be reflected in a shift to the left of both the SRAS and LRAS curves. In the short run, before policymakers realize that potential output has fallen, inflation will rise and output will fall as the economy moves to the new short-run equilibrium at the intersection of the new SRAS and the original AD curves. When policymakers realize potential output has fallen, in order to restore the initial inflation target, they would need to shift the monetary policy reaction curve to the left. This would shift the AD curve left until it intersected the new SRAS and LRAS at the original inflation target. In the long run, the overall impact of the protectionist policies would be to lower output and leave inflation unchanged. (A reversed version of Figure 22.11 should be included with the answer.) High debt ratios led many countries in recent years to reduce government spending. Suppose the cut in spending started from a point with the economy at long-run equilibrium. How might monetary policymakers react, assuming their inflation target remained unchanged? Answer: The cut in government spending shifts the AD curve to the left, reducing inflation below expected inflation and below the inflation target and also lowering output below potential output. Realizing that the long-run real interest rate had fallen, monetary policymakers would respond by shifting the MPRC to the right. This, in turn, shifts the AD curve right, restoring AS-AD equilibrium with inflation at the original target level and output equal to potential output. Data Exploration Display as a bar chart the periods since 1854 that are designated as U.S. recessions by the National Bureau of Economic Research (FRED code: USREC). Why has the frequency of recessions declined over time? Could improvements in monetary policy have played a role? Improvements in fiscal policy? Can you think of any other causes? Answer: The frequency of recessions has notably diminished, especially after the Great Depression. Monetary policy has improved over time, especially with the advent of a monetary policy framework stressing transparency, credibility and central bank independence. However, the short-run variability of both velocity and the money multiplier challenges even the best policy makers. Furthermore, while the frequency or recessions has fallen, the financial crisis of 2007-2009 makes clear that the severity has not. Fiscal policy usually is more difficult to use to counter recessions because these downturns average less than one year in duration, while the time required to implement a fiscal policy change can be long. At least two other possibilities exist. First, one hypothesis is that the data prior to World War II, and especially prior to World War I, is not sufficiently accurate to reliably capture the business cycle. Second, technological advances (including information and communications technology) may make markets more effective, allowing for better private decisions that restore equilibrium more quickly with policy interventions of smaller magnitudes. However, the weak recovery following the 2007-2009 recovery highlights the limits of the economy’s self-correcting forces. In the past, policymakers occasionally became aware of a recession only well after it began. Can they do better? Plot the probability of a recession from a statistical model (FRED code: RECPROUSM156N). To what extent could the model help improve monetary or fiscal policy or both? Answer: The probabilities are plotted below. With the exception of the mild downturn in 2001, a recession occurs whenever the statistical probability rises above 50 percent. Furthermore, there are no “false signals” with the available evidence. However, while the model may help monetary policy respond more quickly to an emerging recession, the probabilities do not always convey the depth or duration of the recession. Fiscal policy would benefit less given the long lags for implementation of new tax and spending policies. Compare the frequency and timing of recessions in key European economies since 1960. Make separate bar charts for Germany (FRED code: DEURECM), Italy (FRED code: ITARECM), and Spain (FRED code: ESPRECM). Do their business cycles appear sufficiently well-aligned to make them operate easily in a single currency area with a common monetary policy? Answer: The plots are below. While there appears to be some overlap, the timing and duration of recessions in the European countries are not identical. These differences may reflect differing mixes of goods and services, different trade and financial patterns, and differing economic policies (aside from the common monetary policy after 1999). If the cycles differ sufficiently across countries, monetary policy that successfully smooths the business cycles in some countries may exacerbate the cycles in other countries To keep inflation low and steady, central banks would like to keep output reasonably close to its potential level, but can they anticipate changes in potential GDP? Plot since 1960 the percent change from a year ago of the Congressional Budget Office’s estimate of potential GDP (FRED code: GDPPOT). Suppose that the FOMC assumed that the growth rate of potential GDP remained permanently at its 1960s average. What would you expect to happen to inflation? Why?
Answer: The plot appears below. According to the CBO, potential GDP growth averaged 4.3 percent in the 1960s. From 1970 to mid-2016, it averaged 2.8 percent. Had the FOMC assumed that potential GDP growth of 4.3 percent would persist, it would have accommodated unsustainably rapid economic expansion, leading to higher inflation, based on the AS/AD model. Research suggests that Fed overestimation of potential growth in the 1970s partly accounts for the rising inflation that it tolerated until 1979, when double-digit inflation prompted the FOMC (under its new leader, Federal Reserve Board Chairman Paul Volcker) to tighten monetary policy sharply.
indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
