2) Explain why a stable 5% inflation rate can be preferable to one that averages

Question

2) Explain why a stable 5% inflation rate can be preferable to one that averages 4% but varies between 1–7% regularly.

3) Explain the difference between active and passive monetary policy.

4) Suppose the economy is in long-run equilibrium, with real GDP at $16 trillion and the unemployment rate at 5%. Now assume that the central bank unexpectedly decreases the money supply by 6%. a. Illustrate the short run effects on the macro-economy by using the aggregate supply-aggregate demand model. Be sure to indicate the direction of change in Real GDP, the Price Level and the Unemployment Rate. Label all curves and axis for full credit.

5) Suppose the economy is in long-run equilibrium, with real GDP at $16 trillion and the unemployment rate at 5%. Now assume that the central bank increases the money supply by 6%. a. Illustrate the short-run effects on the macro-economy by using the aggregate supply-aggregate demand model. Be sure to indicate the direction of change in Real GDP, the Price Level, and the Unemployment Rate. Label all curves and axis for full credit.

Explanation / Answer

(2)

Economists, Central banks & governments mostly prefer a stable (albeit little bit higher) inflation to a lower but fluctuating inflation.

This is because, unstable & fluctuating inflation rate comes with associated undesirable costs as follow.

(a) Export competitiveness

Higher domestic inflation leads to reduced export competitiveness since price of exportables increase due to inflation. Export demand decreases & import demand increases, causing higher trade deficit. Again, higher import demand depreciates domestic currency that increases exchange rate, further deteriorating the trade balance.

If inflation keeps fluctuating, this sequence of events gets randomly repeated and exchange rate keeps widely fluctuating. So inflation stability is of utmost importance.

(b) Menu costs

Inflation increases the price of every god and sellers need to increase the price of their output. The more frequent the price change, the more frequent is the need to increase prices & change the price list. On the other hand, if the firm doesn't incur this menu cost & keeps his price unchanged, he incurs a loss (or reduced profit) by selling a lower-priced good.

(c) Shoe-leather cost

Since inflation lowers purchasing power of cash held, people are reluctant to hold money as cash & instead deposits cash in bank, requiring more frequent trips to the bank.

(d) Lower investor confidence

Foreign investors lose confidence on stability of an economy where price level regularly fluctuates. A loss of investor confidence will lower foreign investments in the country.

(e) Income re-distribution

Inflation re-distributes income in the form of benefitting borrowers and harming lenders. Fluctuating inflation will keep disturbing this balance.

For all these reasons, a stable albeit higher inflation is preferred to a lower but fluctuating inflation.

(3)

An active policy is discretionary, which is used in response to a specific macroeconomic event. For example, if inflation has soared above 10%, Fed initiates an open market sale of federal bonds to the public, to mop up excess liquidity from the economy. This lowers money supply and inflation.

Active policy is based on the judgment by decision-makers who rely on their experience in evaluating the economic event & deciding on the policy tool. Accordingly, active policy may be subject to judgment errors. An active policy may also be undertaken to render short run benefits which may be detrimental to the economy in long run.

In contrast, Passive Policy is undertaken on basis of a set of policy rules. Such rules are rigid in that they recommend an exact quantitative course of action to be taken when a specified macroeconomic event is observed. For example, a policy rule may state that if inflation increases by 2%, money supply has to be reduced by 3%. If inflation increases 2%, Fed automatically implements the passive rule & starts open market operations or reducing federal funds rate or reserve ratio to reduce money supply by 3%. Implementation of this rule doesn't require any manual, judgmental intervention.

The major benefit of Passive policy is that it eliminates (or minimizes) the judgmental error that is possible in case of an active policy. Policy-makers are required only to implement & monitor the policy effected, and not to set out to do the policy-setting activities.

NOTE: Out of 4 questions, the first 2 are answered.

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