Rule Based Monetary Policy & Debts and Deficits 1) Rule Based Monetary Policy :
ID: 1096751 • Letter: R
Question
Rule Based Monetary Policy & Debts and Deficits
1)Rule Based Monetary Policy: Below draw an AD/AS graph and a money market graph side-by-side. For the money market, use an upward sloping money supply curve and assume that the equilibrium interest rate in the money market is 5%. Also, assume that actual GDP is at full employment and that the equilibrium price level in the AD/AS graph is 100. Now shift AD to the right based on an increase in animal spirits. Show how the money market graph will adjust to a new equilibrium. Then explain and show what happens if the Fed acts to keep the equilibrium quantity of money constant. Is this rule based policy pro-cyclical or countercyclical? (explain)
2) Debts and Deficits: Compare the traditional view versus the view of Ricardian equivalence of the effects of a debt-financed tax cut on:
i) Current Consumption
ii) Current National Savings
iii) Current Interest rates
Explanation / Answer
In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical.[1] That is, any quantity that tends to increase when the overall economy is growing is classified as procyclical. Gross Domestic Product (GDP) is an example of a procyclical economic indicator. Many stock prices are also procyclical, because they tend to increase when the economy is growing quickly.
Conversely, any economic quantity that is negatively correlated with the overall state of the economy is said to be countercyclical.[2] That is, quantities that tend to increase when the overall economy is slowing down are classified as 'countercyclical'. Unemployment is an example of a countercyclical variable.[3] Similarly, in finance, an asset that tends to do well while the economy as a whole is doing poorly, is typically referred to as countercyclical. For example, this could be a business, or a financial instrument whose value is derived from a business, that sells aninferior good.
Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations.
In particular, the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn.[4] A similar criticism has been directed at fair value accounting rules.[5] The effect of the single Eurozone interest rate on the relatively high-inflation countries in the Eurozone periphery is also pro-cyclical, leading to very low or even negative real interest rates during an upturn which magnifies the boom (e.g. 'Celtic Tiger' upturn in Ireland) and property and asset price bubbles whose subsequent bust magnifies the downturns.
Conversely, an economic or financial policy is called countercyclical if it works against the cyclical tendencies in the economy.[6] That is, countercyclical policies are ones that cool down the economy when it is in an upswing, and stimulate the economy when it is in a downturn.[7]
Keynesian economics advocates the use of automatic and discretionary countercyclical policies to lessen the impact of the business cycle. One example of an automatically countercyclical fiscal policy is progressive taxation. By taxing a larger proportion of income when the economy expands, a progressive tax tends to decrease demand when the economy is booming, thus reining in the boom. Other schools of economic thought, such as monetarism and new classical macroeconomics, hold that countercyclical policies may be counterproductive or destabilizing, and therefore favor a laissez-faire fiscal policy as a better method for maintaining an overall robust economy. When the government adopts a countercyclical fiscal policy in response to a threat of recession the government might increase infrastructure spending.
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In 1974, Robert J. Barro provided some theoretical foundation for Ricardo's hesitant speculation[4] (apparently in ignorance of Ricardo's earlier notion and De Viti's subsequent extensions).[1][5][6] Barro's model assumed the following:
Under these conditions, if governments finance deficits by issuing bonds, the bequests that families grant to their children will be just large enough to offset the higher taxes that will be needed to pay off those bonds. Among his conclusions, Barro wrote:
... in the case where the marginal net-wealth effect of government bonds is close to zero ... fiscal effects involving changes in the relative amounts of tax and debt finance for a given amount of public expenditure would have no effect on aggregate demand, interest rates, and capital formation.
The model was an important contribution to the New Classical Macroeconomics, built around the assumption of rational expectations.[6]
In 1979, Barro defined the Ricardian Equivalence Theorem as follows:
... shifts between debt and tax finance for a given amount of public expenditure would have no first-order effect on the real interest rate, volume of private investment, etc.[5]
noting that "the Ricardian equivalence proposition is presented in Ricardo". However, Ricardo himself was skeptical of this equivalence.
Ricardian equivalence requires assumptions that have been seriously challenged.[1][8] The perfect capital market hypothesis is often held up for particular criticism because liquidity constraints invalidate the assumed lifetime income hypothesis.[citation needed] International capital markets also complicate the picture.[citation needed] However, even in a laboratory setting where all assumptions required are ensured to hold, behavior of individuals is inconsistent with Ricardian equivalence.[9]
In a 1976 comment, Martin Feldstein argued that Barro ignored economic and population growth. He demonstrated that the creation of public debt depresses savings in a growing economy.[8] In the same issue James M. Buchanan also criticized Barro's model, noting that "[t]his is an age-old question in public finance theory", one already mooted by Ricardo and elaborated upon by De Viti.[1]
In a response to the comments of Feldstein and Buchanan, Barro recognized that uncertainty may play a role in affecting individual behavior with respect to government finance. Nevertheless, he argued that "it is much less clear that this complication would imply systematic errors in a direction such that public debt issue raises aggregate demand."[10]
In 1977, Gerald P. O'Driscoll stated that Ricardo, in expanding his treatment of this subject for an Encyclop
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