Advanced Macroeconomic Theory (ECN 503)

Q 1.a) What costs are associated with imperfectly anticipated inflation? Discuss.

1. Redistribution of wealth:
o When inflation is higher than expected, it redistributes wealth within society.
Borrowers benefit because they can repay their fixed-rate debts (like mortgages) with
money that has decreased in value. However, lenders lose out, as the real value of
their loans diminishes. This shift in wealth can create economic disparities and affect
financial stability1.
2. Increased uncertainty and risk:
o High inflation leads to uncertainty. People become unsure about where to allocate
their money, and firms hesitate to invest due to unpredictable future prices, profits,
and costs. This uncertainty can hinder long-term economic growth and stability1.
3. Boom and bust economic cycles:
o Excessive inflationary growth is unsustainable and often followed by a recession.
Keeping inflation low promotes stable economic growth over the long term. For
instance, the UK experienced more stable growth during the period of low inflation
from 1992 to 2007 compared to previous boom-and-bust cycles1.
4. Menu costs:
o Frequent price changes due to high inflation incur costs for businesses. Updating
price lists, printing new menus, and adjusting price tags are examples of menu
costs. Although modern technology has reduced these costs, they still affect
productivity and profitability1.
5. Tax distortions:
o Inflation can distort the tax system. For instance:
▪ Higher inflation pushes people into higher tax brackets, reducing their
incentives to work and save.
▪ Capital gains taxes increase due to inflated asset values, discouraging
investment and innovation1.
6. Loss of purchasing power:
o When inflation exceeds expectations, people’s money buys fewer goods and
services. This erosion of purchasing power affects everyone, especially those on fixed
incomes like pensioners and low-wage workers1.
7. Reduced international competitiveness:
o If a country’s inflation rate surpasses that of its trading partners, its exports become
less competitive. This can lead to a decline in exports and a deterioration of the trade
balance. In a fixed exchange rate system (like the Eurozone), this uncompetitiveness
can harm economic growth. Even in a floating exchange rate system, high inflation
affects the terms of trade and import costs1.

In summary, imperfectly anticipated inflation has wide-ranging effects, impacting individuals,

businesses, and the overall economy. It underscores the importance of maintaining stable and
predictable inflation rates to promote sustainable growth and economic well-being1.
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1 (b) When inflation is higher than expected, who loses and who gains?

When inflation is higher than expected, it affects different groups of people in various ways:
1. Losers:
o Savers: People who hold cash or have fixed-income assets (like bonds) lose out. The
value of their money and interest income decreases due to rising prices, reducing
their purchasing power.
o Workers on Fixed-Wage Contracts: Workers with wage freezes suffer. If inflation is
5%, their wages at the end of the year can purchase 5% less than at the start. This
decline in real wages particularly affects those living close to the poverty line.
o Borrowers on Variable Mortgage Rates: Rising inflation can lead to higher interest
rates set by the government or central bank. This results in higher borrowing costs
for mortgage owners with variable mortgage rates.
2. Winners:
o Borrowers with Large Debts: Those with significant debts find it easier to pay back
loans because, with rising prices, the real value of their debt decreases.
o Stockholders: Inflation tends to increase the value of companies and their profits,
benefiting stockholders.
o Property Owners: Real estate values rise with inflation, protecting property owners
from rising rent costs.
o Physical Assets (e.g., Land): Land tends to hold value well during volatile times, and
demand for real estate can even increase during high inflation, driving up land prices.

In summary, the impact of inflation depends on individual circumstances and the ability to adjust to
changing prices

Q 2. Evaluate the argument that monetary policy should be determined by a rule rather than
discreation?

The debate over whether monetary policy should be determined by a rule or discretion has
been a longstanding topic in economics. Let’s assess the arguments for both approaches:
1. Monetary Policy Rules:
o Definition: A monetary policy rule specifies a systematic plan of action that the
central bank must follow. It provides clear guidelines for adjusting interest rates or
money supply based on specific economic conditions.
o Advantages:
▪ Predictability: Rules enhance predictability and stability. When the central
bank follows a well-defined rule, businesses and households can anticipate
future policy actions, leading to more stable expectations.
▪ Reduced Uncertainty: A rule-based approach reduces uncertainty for
investors, borrowers, and lenders. They can make better decisions knowing
how the central bank will respond to economic shocks.
▪ Discipline: Rules prevent central bankers from reacting impulsively to short-
term fluctuations. This discipline helps maintain long-term economic stability.
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o Examples:
▪ The Taylor Rule suggests adjusting interest rates based on inflation and
output gaps.
▪ The monetary aggregate targeting rule focuses on controlling the money
supply growth rate.
2. Monetary Policy Discretion:
o Definition: Discretion allows central bankers flexibility to adjust policy based on their
judgment and real-time economic conditions. It allows them to react to unforeseen
events.
o Advantages:
▪ Adaptability: Discretionary policy can respond swiftly to changing economic
circumstances (e.g., financial crises, supply shocks, or recessions).
▪ Context-Specific: Discretion allows central banks to consider unique features
of each situation rather than rigidly adhering to predetermined rules.
▪ Complexity: The economy is multifaceted, and discretion allows central
banks to consider various factors (e.g., financial stability, exchange rates, and
global shocks).
o Challenges:
▪ Time Inconsistency: Discretion can lead to time inconsistency, where
policymakers deviate from their initial plans due to short-term pressures.
▪ Credibility: Discretionary actions may erode the central bank’s credibility if
they appear arbitrary or politically motivated.
▪ Lack of Clarity: Discretion can create uncertainty for economic agents,
affecting investment decisions.

The debate over whether fiscal policy should be determined by a rule or discretion has significant
implications for economic stability and government decision-making. Let’s explore the arguments for
both approaches:
1. Fiscal Policy Rules:
o Definition: Fiscal policy rules prescribe specific guidelines for government spending,
taxation, and debt management. These rules are often based on empirical research
using economic models.
o Advantages:
▪ Predictability: Rules provide clarity and predictability for economic agents
(such as households, businesses, and investors). When policymakers follow a
well-defined rule, it reduces uncertainty about future fiscal actions.
▪ Discipline: Rules impose discipline on policymakers, preventing them from
making short-term decisions that may harm long-term economic stability.
▪ Avoiding Political Bias: Rules can mitigate the influence of political
considerations on fiscal policy decisions.
o Examples:
▪ Balanced Budget Rule: Requires that government spending not exceed tax
revenues over a specified period.
▪ Debt-to-GDP Ratio Rule: Sets a limit on government debt relative to the size
of the economy.
2. Fiscal Policy Discretion:
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o Definition: Discretion allows policymakers flexibility to respond to changing

economic conditions without being bound by rigid rules. It involves judgment and
adaptation.
o Advantages:
▪ Adaptability: Discretionary policy can address unique economic challenges
(e.g., recessions, natural disasters, or financial crises) that may not fit
predefined rules.
▪ Context-Specific: Discretion allows policymakers to consider real-time
economic data and tailor responses accordingly.
▪ Counter-Cyclical Response: Discretion enables countercyclical fiscal
measures (e.g., stimulus during recessions).
o Challenges:
▪ Time Inconsistency: Policymakers may deviate from their initial plans due to
short-term pressures, leading to time inconsistency.
▪ Credibility: Discretionary actions can erode public trust if perceived as
arbitrary or politically motivated.
▪ Lack of Transparency: Discretionary decisions may lack transparency,
making it harder for economic agents to anticipate policy changes.
3. Balancing Act:
o Optimal Approach: Striking a balance between rules and discretion is essential.
Some advocate for a hybrid approach that combines rules with flexibility.
o Economic Context Matters: The appropriateness of rules or discretion depends on
economic conditions, institutional factors, and the specific policy goal.
o Transparency and Accountability: Regardless of the approach, transparency and
accountability are crucial for effective fiscal policy.

In summary, the choice between fiscal policy rules and discretion involves trade-offs. While rules
enhance predictability and discipline, discretion allows policymakers to respond to unique
challenges. A pragmatic approach considers both stability and adaptability

Q 3. What is dynamic inconsistency? Explain How it might arise in the case of short ran
trade off between inflation and unemployment?

Dynamic inconsistency, also known as time inconsistency, refers to a situation where a decision-
maker’s preferences change over time in such a way that a preference can become inconsistent at
another point in time. Let’s explore this concept:
1. In Economics:
o Definition: Dynamic inconsistency occurs when a decision-maker’s optimal plan for
the future is not credible because it is not in their best interest to carry it out when
that future period arrives.
o Example: Consider monetary policy. A central bank may announce a rule to keep
inflation low, but when faced with a recession, it might find it more beneficial to
deviate from that rule and pursue expansionary policies (like lowering interest rates).
This inconsistency arises because the central bank’s preferences change over time.
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oImplications: Dynamic inconsistency can lead to suboptimal outcomes, as it

undermines the credibility of policy commitments and creates uncertainty for
economic agents.
2. Behavioral Economics Perspective:
o Multiple Selves: Think of decision-makers as having different “selves” at different
points in time. Each self represents the decision-maker’s preferences at a specific
moment.
o Time Inconsistency Example:
▪ Consider the short-run trade-off between inflation and unemployment.
Policymakers may face a choice:
▪ High Inflation, Low Unemployment: In the short run, expansionary
policies (like increasing government spending) can reduce
unemployment but lead to higher inflation.
▪ Low Inflation, High Unemployment: Alternatively, contractionary
policies (like reducing government spending) can lower inflation but
increase unemployment.
▪ Policymakers may initially choose high inflation to reduce unemployment.
However, over time, people adjust their expectations of inflation. As
expectations catch up, the trade-off disappears, and policymakers face the
long-run Phillips curve, which is vertical (no trade-off).

In summary, dynamic inconsistency highlights the challenges policymakers face when their
preferences change over time, affecting the credibility and effectiveness of their decisions

4.Show using IS and LM curves ,why money has no effect on output in the
classical supply case?

Certainly! In the classical supply case, money is considered neutral. Let’s explore why
using the IS-LM model:
1. LM Curve (Liquidity-Money Curve):
o In the classical view, money supply does not impact real variables like output or
production.
o The LM curve is vertical because changes in the money supply do not affect the
interest rate.
o Classical economists believed that money supply adjustments would only lead to
proportional changes in prices, leaving real output unaffected1.
2. IS Curve (Investment-Savings Curve):
o The IS curve represents equilibrium in the goods market.
o In the classical model, changes in money supply do not alter investment or
savings decisions.
o An increase in government spending aimed at expanding the economy (which
would shift the IS curve) would be ineffective because money has no impact on
output1.
 Advanced Macroeconomic Theory (ECN 503)

In summary, the classical view asserts that money is neutral, meaning it does not affect
real economic variables. Therefore, changes in the money supply have no impact on
output in the classical supply case

5. a. Define an open market sale by the Fed.

b. Show the impact of an open market sale on the interest rate and output.
Show both the Immediate- and the longer-term impacts.

a.). An open market sale by the Fed refers to the sale of government bonds and other
securities with the aim to reduce the money supply in the economy and increase interest
rates.
This open market operation process is undertaken by the Fed when their goal is
contractionary, that is when the economy is overburdened and inflation is at its peak. The
Fed will sell bonds and other treasury securities to the banks, which takes money out of the
financial systems by reducing their reserves, reducing the money supply. This will cause
interest rates to increase thus discouraging individuals and businesses from investing and
borrowing while encouraging them to save more. This will slow inflation and economic
growth.

b.). An open market sale by the Fed will reduce the amount of reserves in the banking
system which requires banks to decrease their outstanding loans hence reducing credit
availability and ultimately the money supply. As a result, the interest rates will increase
reducing investments and overall output in both the short-term and long-term.
This will shift the supply of loanable funds to the left from the original supply curve (S0) to S1,
resulting in a new equilibrium of E1 and a higher interest rate of i1, and a decreased output of
Y1.

This is displayed by the below graph:

6. What is crowding out and when would you except it to occur?

Crowding out effect refers to the phenomenon where increased government borrowing and
spending leads to a reduction in private sector investment. It occurs when government
demand for funds in the financial market increases, causing interest rates to rise.

6.b In
the face of substantial crowding out,which will be more successful fiscal or
monetary policy

When substantial crowding out occurs, the effectiveness of fiscal policy versus monetary
policy becomes crucial. Let’s explore both:
1. Fiscal Policy:
o Definition: Fiscal policy involves government actions related to taxation, spending,
and borrowing. It directly influences aggregate demand and economic activity.
o Effectiveness during Crowding Out:
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Challenges: In the face of substantial crowding out, fiscal policy may be less
▪
effective. When government borrowing increases, it competes with private
investment, leading to higher interest rates and reduced private spending.
▪ Trade-Offs: Expansionary fiscal policy (increased government spending or tax
cuts) may boost short-term demand but could exacerbate crowding out. The
impact depends on the magnitude of the fiscal stimulus relative to the
crowding out effect.
▪ Long-Term Considerations: Fiscal policy can be more successful if it focuses
on productive investments (e.g., infrastructure, education, research) that
enhance long-term growth and productivity.
2. Monetary Policy:
o Definition: Monetary policy involves central bank actions related to interest rates,
money supply, and credit conditions. It indirectly influences aggregate demand and
economic activity.
o Effectiveness during Crowding Out:
▪ Advantages: Monetary policy can be more successful during crowding out.
Central banks can adjust interest rates to influence borrowing costs and
investment decisions.
▪ Interest Rate Control: If crowding out leads to higher interest rates, the
central bank can counteract this by lowering its policy interest rates (e.g., the
federal funds rate in the U.S.).
▪ Liquidity Provision: Central banks can inject liquidity into financial markets
through open market operations or quantitative easing, supporting private
sector borrowing.
▪ Short-Term Impact: Monetary policy acts more swiftly and directly on
interest rates, affecting investment and consumption decisions.

In summary, while both fiscal and monetary policies play critical roles, during substantial crowding
out, monetary policy may be more successful due to its direct impact on interest rates and liquidity
provision. However, a coordinated approach that considers both policies is often optimal

8.a) Are budget deficit is a problem. Why or why not?

A budget deficit occurs when government expenses exceed revenue. It is a term commonly used to
refer to government spending and receipts rather than businesses or individuals. Let’s explore
whether budget deficits are problematic:
1. Effects of Budget Deficits:
o National Debt: Budget deficits contribute to the national debt, which is the
cumulative total a country owes to creditors. Persistent deficits lead to a growing
debt burden.
o Interest Payments: Higher deficits result in increased borrowing. As debt
accumulates, interest payments on that debt rise. These interest payments divert
funds away from other essential programs.
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o Reduced Reinvestment: When the government borrows heavily, it competes with

private borrowers for available funds. High deficits can lead to higher interest rates,
discouraging private sector investment.
o Impact on Future Generations: Excessive deficits can burden future generations
with debt repayment obligations.
2. Balancing Act:
o Short-Term Demand Management: During economic downturns, moderate deficits
can stimulate demand and support economic recovery. Temporary deficits may be
necessary.
o Long-Term Sustainability: Persistent deficits can harm economic stability.
Governments must strike a balance between short-term stimulus and long-term fiscal
responsibility.
3. Prevention Strategies:
o Raising Taxes: Governments can increase tax revenue to reduce deficits. However,
excessive tax hikes can hinder economic growth.
o Cutting Spending: Reducing non-essential expenditures can help control deficits.
Prioritizing essential programs is crucial.
o Productive Investments: Focusing on investments that enhance long-term growth
(e.g., infrastructure, education) can yield positive returns.

In summary, budget deficits can be problematic if they persistently strain the economy, lead to
unsustainable debt, or crowd out private investment. Prudent fiscal management is essential to
balance short-term needs with long-term sustainability

10.b) Why does it matter whether inventor changes are planned or unplanned ?

Whether inventor changes are planned or unplanned can significantly impact various aspects of a project
or business. Here are a few reasons why it matters:

Resource Allocation: Planned inventor changes allow for better resource allocation and scheduling.
When changes are anticipated, teams can allocate resources, such as time and budget, more effectively
to accommodate them. Unplanned changes can disrupt workflows and may require urgent reallocation
of resources, potentially leading to delays and increased costs.

Risk Management: Planned inventor changes can be integrated into risk management strategies. Teams
can proactively identify potential risks associated with these changes and develop mitigation plans
accordingly. On the other hand, unplanned changes may introduce unforeseen risks, which can be more
challenging to manage effectively.

Quality Control: Planned inventor changes provide an opportunity for thorough testing and quality
control measures. Teams can assess the impact of the changes on the overall product or project and
make necessary adjustments to maintain quality standards. Unplanned changes may not undergo the
same level of scrutiny, increasing the risk of introducing errors or compromising quality.
 Advanced Macroeconomic Theory (ECN 503)
Stakeholder Communication: Communicating planned inventor changes to stakeholders allows for
better alignment and expectations management. Stakeholders can be informed in advance about the
rationale behind the changes, potential impacts, and timelines. This fosters transparency and trust. In
contrast, unplanned changes can lead to confusion and dissatisfaction among stakeholders if not
communicated effectively.

Project Planning and Documentation: Planned inventor changes are typically documented as part of the
project plan, making it easier to track and manage them over time. This documentation provides a
valuable reference for future decision-making and ensures that all team members are aware of the
changes. Unplanned changes may not be well-documented initially, leading to challenges in tracking and
understanding their implications.

Overall, whether inventor changes are planned or unplanned can significantly influence the success and
efficiency of a project or business, highlighting the importance of proactive planning and effective
change management processes