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TUTORIAL 4

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5 views

TUTORIAL 4

Uploaded by

leighphilander4
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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SECTION A:

1. D
2. B
3. B
4. C
5. A
6. B
7. B
8. A
9. D
10. A

SECTION B:

1. Contractionary monetary policy is when the policy rate is low. A low policy rate
leads to an increase in output because greater investment is encouraged. A
higher output leads to a greater change in inflation. A positive output gap is when
output is above potential. When this happens, inflation is greater than the target
inflation. Higher output is generally associated with lower unemployment.

In the medium run, the economy moves to a stable inflation and natural level of
output. At the medium run equilibrium, the Wisckellian rate of interest is reached.
This is the natural rate of interest where output is at potential and inflation is
stable.

Let rn = natural interest rate (Wisckellian)


Let Yn = potential output
Let A’ = equilibrium in the medium run.
2. Monetary policy determines the rate of inflation and the nominal interest rate. The
monetary policy doesn’t affect any real variables in the medium run. The real
money supply (M/P) is equal to the natural level of output (Yn) multiplied by the
demand function (L), multiplied by the sum of the natural interest rate (rn) and
expected inflation rate (元). Ie. 𝑀/𝑃 = 𝑌𝑛𝐿 𝑟𝑛 + 元.
3.
The increase in taxes shifts the IS curve to the left from IS to IS’. New short run
equilibrium is at A’ on both graphs. At the rate rn, output decreases from Yn to Y’
and inflation is lower, ie. There is a recession.

In the medium run, the central bank is likely to decrease the policy rate until
output is back to potential since it is too low and inflation is below target. The
economy moves down the IS’ curve in the top graph and output increases. As
output increases, movement up the PC curve in the bottom graph until the
economy is back at potential. Medium run equilibrium is at A” in top and bottom
graphs. Output back at Yn, and inflation equal to target inflation. Real rate
needed to maintain output at potential is also lower, equal to rn’ rather than rn.

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