Macroeconomics (EC108)

Problem Set 14a

Dr Bhaskar Chakravorty

Department of Economics
University of Warwick

Pre-class Questions
To be answered before the class

Answers

The 3-Equation Model

1. What are the advantages and disadvantages of a target inflation rate of 2% as com-
pared with one of 0% per annum?

Answer Q1

A 0% inflation rate may seem attractive as the economy does not have to deal with
inflation issues. Prices will not change, there will be no costs related to inflation
(e.g. menu costs). However, positive inflation targets can prevent the economy from
falling into a deflation trap. When aggregate demand is very weak, the central bank
will want to reduce interest rates in order to stimulate interest-sensitive spending
like investment and consumer durables. This can push the nominal interest rate
close to its lower bound of zero. But when a nominal interest rate close to zero
is combined with falling prices (deflation), this implies a positive real interest rate
which may be too high to stimulate private sector demand and get the economy back
to equilibrium. Continued weak demand will make inflation more negative, thereby
pushing the real interest rate up. A second advantage of a positive inflation rate is
that in the light of the downward rigidity of nominal wages, a positive inflation rate
allows for changes in relative wages.

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2. Why can an economy fall into a deflation trap? How does central banks react to
this?

Answer Q2

This is represented by Figure 1 below. Please look at the ‘Deflation trap’ video on
Moodle.

Figure 1: Permanent negative demand shock can lead to deflation trap

The CB will be constrained in how much they can reduce interest rates to stimulate
the economy. After the 2008 financial crisis, various central banks around the world
adopted ’unconventional monetary policies’ such as quantitative easing, in their
attempt to stimulate their economies and avoid a deflation trap.
3. Can a central bank with an overly ambitious output target credibly commit to
targeting inflation? Explain.

Answer Q3

The inflation bias result suggests that a central cannot commit to a credible output
target of ye if it has a preference for output above equilibrium. This central bank will
have an incentive to use monetary policy in order to boost output above equilibrium
in the short-run. This will create inflation bias i.e. inflation will be above its target.

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4. Read the FT article “UK inflation climbs to 30-year high of 5.5%” (16 Feb 2022).
Use the 3-equation model to depict the UK economy. Remember to justify any
assumption you make.

Answer Q4

Figure 2: One potential description of the UK economy

Figure 2 shows a potential representation of the UK economy. In this graph, we have

assumed that the UK economy was hit by an inflation shock that shifted the PC
up and brought the economy to 5.4% (e.g. we consider that the increase of energy
prices is a temporary shock that affect the price level in the economy). The Bank
of England has responded to this by increasing interest rate (currently at 0.75%), in
order to bring inflation down. This is represented in point C in the graph. Notice
that at point C, output goes down, which may translate in higher unemployment
rate.
Another key assumption we have made in this graph, is that the UK economy was
in equilibrium at the time of the shock. This is a more problematic assumption,
as the economy has been recently hit by the COVID19 shock, and output has not
gone back to the pre-COVID levels. This may worry the Bank of England because
in this case, a contractionary monetary policy may negatively impact the economic
recovery. On the other hand, lack of action on tightening monetary policy, may
translate into failure of bringing inflation back under control with the detrimental
effects that high inflation has on the economy.

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Fiscal Policy
Choose the correct answer(s).

1. Among the government’s sources of funds are:

(a) transfer payments
(b) tax revenue *****
(c) government purchases
(d) all of the above

2. During a recession, the debt-to-GDP ratio typically:

(a) falls
(b) rises *****
(c) does not change

3. In order to maintain public debt sustainability...

(a) ... the government have to run a primary surplus for various years.
(b) ... the government requires a primary budget surplus if economic growth is
lower than the real interest rate paid on the debt *******
(c) ... is compatible with a primary budget deficit if economic growth is higher
than the interest rate paid on the debt *******
(d) ... government revenues need to be enough to cover government expenditure
on goods and services and interest payments on the debt

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