178.300 Macroeconomic Policy and Applications: The Path Back

1. Open economy model

Assume you are in a small open economy with flexible exchange rates.

The economy experiences a permanent positive demand shock.

• Draw the PC −MR, the IS −RX and the ERU −AD graphs to help you explain the path back to medium run equilibrium.

• Draw a graph of the real exchange rate over time and give a brief explanation of its path.

• How does the medium run equilibrium vary from that in the closed economy?

2. Supply-side shock

Oil prices fell dramatically in 1986. Use the WS−PS and ERU diagrams to explain the effect of this supply-side shock on a small open economy. At the initial real exchange rate, what has happened to real wages and the level of employment?

3. Demand-side shock

Consult Chapter 11 and use the mathematics from Section 11.4.1 of the Appendix to derive the RX curve after a negative demand shock in bloc B.

4.  The loss function

Central bank has the following loss function:

Consult Chapter 13 to answer the following questions:

• What can we interpret about the central bank’s preferences from this loss function (Equation 13.1)?

• Briefly explain how this loss function compares to the standard loss function and a loss function with y^T> ye.
• Find the inflation bias for a central bank with this loss function (Equation 13.1).

5. The insider-outsider model

Consult Chapter 15 to answer the following questions.

• How can the insider-outsider model explain persistently high levels of unemployment?

• Can this form of hysteresis be mitigated by increasing aggregate demand?

6. Financial crisis

Assume an economy with lump-sum taxes is hit by a large negative demand shock (e.g. financial crisis). In response, the government introduces a large fiscal stimulus package to try and boost economic activity and help stabilize the economy. Assess whether the policy will be successful in each of the following cases:

• In the 3-equation model, when stimulus is financed through borrowing

• In the 3-equation model, when the stimulus is financed by raising taxes (i.e. a balanced budget expansion)

• In the RE − PIH model, when the stimulus is financed through borrowing.

In which case will output expand the most? Justify your answer.