3 Aggregate Supply Distinguish between long run and short run Definition different from MicroLong run - Prices are flexibleShort run - many prices are “sticky” at a predetermined level
4 Essay 3 Question eWhy is the aggregate supply curve horizontal in the short run?Aggregate supply is fixed in the long runBut can fluctuate in the short runWhy?Can build up/use up inventoriesReasons why prices can be sticky in the short run:Menu costsInformation costsConsumer reactionWage rigidity
5 Essay 3 Question fUse 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 gUse 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 bondsNo banks exist otherwiseMoney supply matters for the real economy by affecting the interest rateCB has two objectivesStabilizing inflationStabilizing output
8 Question 1 An increase in the money supply M can be represented as A movement along the AD curveA shift in the AD curveA change in the slope of the AD curveNone of the above
9 Essay 4 Question bFaced 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 littleWhat 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 5If the economy is not initially in recession, following a monetary expansion we expect to seeFirst an increase in prices and then an expansion in the economyFirst an expansion in the economy and then an increase in pricesA simultaneous increase in prices and expansion in the economyAn increase in prices followed by a contraction in the economy due to inflation
12 Essay 4 Question cWhen will a monetary expansion not result in inflation?
13 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’sNormally: CB only trades in short term bonds=> Affects the short-term interest rate=> Indirectly affects the long term interest rateWhich 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 multiplierWhat 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 timesHaving a debt less than 60% of GDPRunning a budget surplus at all timesRunning a deficit some of the time
16 Quiz Question 3If the fiscal multiplier is between 0 and 1, a fiscal expansion will result ina fall of GDPa fall of C and/or I and/or NXa decline in employmenta 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 bondsIt will have the same effects as an OMO for the same amountWill affect demand positively through lower interest rates and negatively through inflationCombines elements of monetary and fiscal stimulus
18 Essay 4 Question aMacroeconomic policy can both be a problem and a solution in economic fluctuations. Explain.Ideally: stabilizing influence – can balance out other demand shocksFiscal stimulus after Financial Crisis 2008Quantitative easing to alleviate liquidity constraintsBut can sometimes be cause of fluctuationsSuddenly needs to change fiscal policy (e.g. to reduce debt)Southern Euro area + possibly UK?Wrong monetary policy decisions