Problem Set on Macroeconomic Stabilization Policy

Problem I.

You have been appointed as the Chief of the Fiscal Policy Section of the Council of Economic Advisors (CEA) of the Independent Republic of Middlebury (the IRM). Your first action is to hire the internationally famous econometric consulting firm "Joe Tham Econometrics Associates Inc." (JTEA) to estimate an Aggregate Demand Aggregate Supply model of the IRM. The JTEA produces the following set of equations:

Aggregate Demand Y_D = 4 * A - 2 * P

Short-run Aggregate Supply Y_S = 2 * P

Potential GDP Y_P = 200

Autonomous Spending A = CA + I + G + X

"P" refers to the GDP Deflator (1990 = 100). Autonomous Spending has been constant at 100 for the last 12 quarters. Government spending has been constant at 50 for the last 12 quarters. (A quarter is 3 months.)

1. Rewrite the Aggregate Demand and Aggregate Supply equations so they can be pictured on a normal Aggregate Demand-Aggregate Supply graph.

2. Construct an Aggregate Demand-Aggregate Supply diagram showing Aggregate Demand, Long-run Aggregate Supply and Short-run Aggregate Supply. Indicate the equilibrium level of real GDP and the GDP Deflator. (Label your axes and all curves.)

The only instrument of fiscal policy available to you is to increase or decrease Government Spending (G). Therefore, you ask the JTEA for a detailed analysis of the Government Spending multiplier. You want to know the numerical value of the multiplier and how long it takes for a change in Government spending to have its full effect on real GDP and the GDP Deflator.

The JTEA reports that:

(a) an increase of 1 unit of Government Spending will shift the Aggregate Demand curve to the right by 2 units.

(b) An increase of 1 unit of Government spending will have its full effect on the Aggregate Demand curve in the same quarter that the spending takes place. There is no "outside lag" in this case.

You also ask the JTEA to give you a forecast of total Aggregate Spending and Government Spending for the next four quarters. The JTEA provides you with the following information:

Quarter Total Autonomous Spending Government Spending

1 100 50

2 80 50

3 90 50

4 100 50

1. On the basis of this information, prepare your own forecast of real GDP and the GDP Deflator for the next 4 quarters.

Quarter Real GDP GDP Deflator

1 ____ ____

2 ____ ____

3 ____ ____

4 ____ ____

2. Construct an Aggregate Demand-Aggregate Supply diagram showing what would happen to real GDP and the GDP Deflator in the absence of macroeconomic stabilization policies. (Label the axes and the curves. Be sure to label each Aggregate Demand curve indicating the quarter to which it refers.)

3. Your goal is to maintain real GDP at its potential level (Y_P) in all four quarters. The only fiscal policy instrument available to you is Government Spending (G). Set the level of Government Spending in each quarter in such a way as to maintain the real GDP at its potential level. Calculate the following values:

Quarter Government Spending Change in Government Spending

due to fiscal policy.

1 ____ ____

2 ____ ____

3 ____ ____

4 ____ ____

4. On the basis of your active fiscal policy interventions, prepare a revised forecast of real GDP and the GDP Deflator for the next four quarters.

Quarter Autonomous Spending Real GDP GDP Deflator

1 ______ ______ ______

2 ______ ______ ______

3 ______ ______ ______

4 ______ ______ ______

Just as you were about to take your stabilization plan to the President of the IRM for his approval, a messenger from the JTEA arrived. He said that they had recalculated the multiplier and had discovered the following:

(a) An increase of 1 unit of Government Spending will shift the Aggregate Demand curve to the right by 2 units. (This has not changed.)

(b) An increase of 1 unit of Government spending will have no effect on the Aggregate Demand curve in the same quarter that the spending takes place. Instead, an increase of 1 unit of Government spending will have its full effect on the Aggregate Demand curve in the quarter that immediately follows the quarter in which the spending takes place. There is a one quarter "outside lag" in this case.

1. Revise your macroeconomic stabilization plan on the basis of this new information. Set the level of Government Spending in each quarter in such a way as to maintain real GDP at its potential level in all four quarters. Calculate the following values:

Quarter Government Spending Change in Government Spending

due to fiscal policy.

1 ______ ______

2 ______ ______

3 ______ ______

4 ______ ______

2. If the new information about the lagged multiplier had arrived just as the first quarter was ending, would it have been possible to have reached the potential level of real GDP in the second quarter? Explain your answer.

Just as you were about to take your revised stabilization plan to the President of the IRM for his approval, a second messenger from the JTEA arrived. He said that the JTEA had made a small error when they recalculated the multiplier and they have discovered the following:

(a) An increase of 1 unit of Government Spending will shift the Aggregate Demand curve to the right by 2 units. (This has not changed.)

(b) An increase of 1 unit of Government spending will have half of its effect on the Aggregate Demand curve in the same quarter that the spending takes place. An increase of 1 unit of Government spending will have the other half of its effect on the Aggregate Demand curve in the quarter that follows the quarter in which the spending takes place. There is a distributed "outside lag" in this case.

1. Once again, you must revise your macroeconomic stabilization plan on the basis of this new information. Set the level of Government Spending in each quarter in such a way as to maintain real GDP at its potential level in all four quarters. Calculate the following values:

Quarter Government Spending Change in Government Spending

due to fiscal policy.

1 ______ ______

2 ______ ______

3 ______ ______

4 ______ ______

2. If the new information about the distributed lag in the multiplier had arrived just as the first quarter was ending, would it have been possible to have achieved the potential level of real GDP in the second quarter? Explain your answer.

3. Is it likely that active fiscal policy will be necessary in the first quarter of the next year? Explain your answer.

4. The official who was in charge of actually implementing the infrastructure projects on which the IRM Government spends its money is very unhappy with your new spending proposals. Explain why she might not like your new spending plan.

5. The workers of the IRM know that the Government has committed itself to maintaining real GDP at the level of potential GDP. How might this knowledge change the way that they behave when bargaining for wages? Explain your answer.

The year is over. We now know the actual levels of real GDP and the GDP Deflator. The results of your stabilization policies are as follows:

Quarter Real GDP GDP Deflator

1 200 100

2 180 110

3 160 120

4 140 130

1. The Chairman of the Council of Economic Advisors is not happy with the results of your work. She demands that you prepare a report explaining why you were so very unsuccessful in stabilizing the economy last year. What are the most likely explanations for your failure?

Problem II.

You have been transferred from the Council of Economic Advisors of the IRM to the Central Bank where you have been appointed as Chief of the Monetary Policy Section. At the present time, the money supply (M1) and the price level are growing at the rate of 10% a year. Since the real money supply (L = M/P) has remained constant for some time, the economy is at the level of potential real GDP. Unemployment is currently at the natural rate (6%).

Your first task is to reduce the rate of inflation in such a way as to minimize the level of unemployment. Your boss has promised you a promotion if you can keep the unemployment rate below 6%.

The following table illustrates the possible outcomes.

THE CENTRAL BANK

HOLDS M₁ INCREASES M₁

CONSTANT BY 10%

THE UNIONS

HOLD WAGES G_P = 0% G_P = 5%

CONSTANT UnN = 6% UnN = 3%

Outcome A Outcome B

INCREASE WAGES G_P = 4% G_P = 10%

BY 10% UnN = 9% UnN = 6%

Outcome C Outcome D

1. Explain why the unemployment rate is at 6% in outcomes A and D.

2. Explain why the unemployment rate is less than 6% in outcome B.

3. Explain why the unemployment rate is more than 6% in outcome C.

4. Explain why the rate of inflation is 0% in outcome A.

5. Explain why the rate of inflation is less than 1Ù0% in outcome B.

6. Explain why the rate of inflation is greater than 0% in outcome C.

7. Explain why the rate of inflation is 10% in outcome D.

8. Econometric studies confirm that the M₁ velocity of money (VOÁN₁) is constant. If that is true and M₁ is growing at 10% in outcome B, while prices are rising at 5%, what is the approximate rate of growth of real GDP?

Assume the following:

(a) For any given level of unemployment, both the workers and the Central Bank would prefer a lower rate of inflation to a higher one.

(b) The workers prefer to be at the natural rate of unemployment (6%). They want full employment. They do not want less than full employment and they do not want more than full employment.

(c) The President of the Central Bank has told you that he wants to keep the unemployment rate as low as possible. He has made you responsible for doing that while minimizing the rate of inflation.

1. Which outcome do the workers prefer? Explain your answer.

2. Which outcome does the Central Bank prefer? Explain your answer.

You call in the workers and explain to them that they can maintain their current level of unemployment (6%) and have no inflation (outcome A) if they will simply do without a wage increase this year. The unions reply that they must bargain for a 10% wage increase just to cover the expected increase in their cost of living.

You assure the unions that you will not permit any growth in the money supply during the next year. Hence, the price level will not rise. Therefore, if the unions do not push up wages and prices, next year real money balances will be the same as they are now. The LM curve will not shift. In real terms the Aggregate Demand will be at the same level as it is today. There will be full employment and no inflation (Outcome A).

Because you appear to be such an honest person, the unions believe you and sign one year contracts calling for no wage increases.

1. Now that the unions have signed their contracts, which outcomes are open to you? Explain your answer.

2. If you wish to maximize your short-term gains, which option do you chose? Do you increase M₁ by 10% or do you hold M₁ constant? Explain your answer.

3. If you decide to increase M₁ by 0% what will happen to price levels, unemployment and your career at the Central Bank:

(a) in the short-run?

(b) in the long-run?

4. If you decide to increase M₁ by 10% what will happen to price levels, unemployment and your career at the Central Bank:

(a) in the short-run?

(b) in the long-run?

1. Why was your promise not to increase M₁ not credible?

2. How would it be possible to make your promises not to increase M₁ more credible?