1. EC102: Class 4 LT
Christina Ammon

2. Today’s Plan
Will cover:
Essay 3 question e,f,g
Essay 4
Quiz 4

3. 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

4. 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

5. 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?

6. Essay 3 Question g
Use the AD-AS framework to illustrate the effects of an increase in interest rates

7. 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

8. 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

9. 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?

10. 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

11. Quiz Question 5

12. Essay 4 Question c
When will a monetary expansion not result in inflation?

13. Essay 4 Question
Describe 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?

14. 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?

15. 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

16. 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

17. 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

18. 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