ECON0016: Macroeconomic Theory and Policy

Term 1, Problem set 3

1. Using the IS – MR – PC model

Starting from medium run equilibrium, explain the response of the economy to a
deflationary shock i.e. one that reduces inflation expectations. Make sure your
explanation follows the timeline (available on Moodle).

In addition to describing the paths over time of output, inflation and interest rates,
at each stage describe carefully what happens in the labour market and the goods
market

How could fiscal policy instead of monetary policy be used to respond to the
shock?

2. Policy effectiveness

(a) Describe how monetary and fiscal policy affect output. Please don’t draw
diagrams, just explain in words the mechanism by which changes in policy
transmit themselves to output.

(b) Give two reasons (based on the material covered in the course) why either
fiscal policy or monetary policy might have no effect on output. Explain your
answer in the context of the model
Discussion points (think about these for the class; don’t hand anything in)

(a) What is the mechanism by which the central bank announcing an inflation
target translates into an actual inflation rate?

(b) How would your answer to q1 change if households had rational

expectations?

(c) What issues might make using fiscal instead of monetary policy in q1
difficult in practice?

(d) How would the economy behave if monetary policy were passive (i.e. kept
the real interest rate constant)? Think of the two examples of shocks
covered in lecture 4

(e) Read the article “Fed hawks and doves”. Why is monetary policy decided
by committee?

(f) Does policy work in practice? Think of examples from the recent past.