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ECON1002 Introductory Macroeconomics, Semester 2 2024

TUTORIAL 8

(Week beginning Sept. 23)

Reading Guide: Review Week 8 Lecture 7 and Textbook Chapters 11 and 12 to prepare for this tutorial.

Key Concepts: Policy Reaction Function; the Taylor Rule; Aggregate demand-aggregate supply diagram; Sources of inflation, Disinflation, Inflation targeting.

REVIEW OF CONCEPTUAL UNDERSTANDING

1. What do you understand by the policy reaction function?

2. How has the way monetary policy is conducted in Australia evolved since 1990? Why?

3. What do you understand by inflation targeting? How does it help conduct of monetary policy?

4. What do you understand by the concept of disinflation? How does a policy of disinflation affect the economy in the short run, and in the medium or long run?

5. Can the AD-AS model be used to analyse the short-run and long-run effects of fiscal and monetary policy?

6. Why did policy mistakes occur in the 1970s? What were the consequences? Can we explain the policy mistakes using the AD-AS model?

PROBLEMS

THERE ARE TWO PROBLEMS (1 AND 3) WITH AN ASTERISK FOR STUDENT PRESENTATIONS.

*1. Assume the following monetary policy reaction function.

r = 0.02 + 0.5(π – πT)

,where r is the interest rate, is the inflation, and is the inflation target.

(a) Assume that the inflation target is 3% or 0.03. Represent the reaction function graphically.

(b) Now assume that the inflation target has been lowered to 1% or 0.01. Represent the reaction function under the new inflation target graphically.

(c) How would you draw the reaction function if the inflation target is higher, say. at 5% or 0.05?

(d) How would the changes in the inflation target affect the aggregate demand relation in the economy?

2. This problem asks you to trace out the adjustment of inflation when the economy starts with an output gap. Suppose that the economy’s aggregate demand curve is:

y = 1000 – 1000π

where y is short-run equilibrium output and π is the inflation rate, measured as a decimal. Potential output, y*, equals 950 and the initial inflation rate is 10 per cent (π = 0.10).

(a) Find output and inflation for this economy in short-run equilibrium and in long-run equilibrium.

(b) Suppose that, each quarter, inflation adjusts according to the following rule: This quarter’s inflation = last quarter’s inflation minus 0.0004 (y* – y). Starting from the initial value of 10 per cent for inflation, find the value of inflation for each of the next five quarters. Does inflation come close to its long-run value?

*3. For each of following, use an AD–AS diagram to show the short-run and long-run effects on output and inflation. Assume the economy starts in long-run equilibrium.

(a) An increase in consumer confidence that leads to higher consumption spending

(b) A reduction in taxes

a. perceived as temporary

b. perceived as permanent

(c) An easing of monetary policy by the Reserve Bank with a higher inflation target

(d) A sharp drop in oil prices raising short-run costs of production

(e) A war that raises government purchases

4. Planned aggregate expenditure in Lotusland depends on real GDP and the real interest rate according to the following equation:

PAE = 3000 + 0.8y – 2000r

The Bank of Lotusland, the central bank, has announced that it will set the real interest rate according to the following policy reaction function:

Rate of Inflation, π                   Real Interest Rate, r

0.0                                                0.02

0.01                                               0.03

0.02                                               0.04

0.03                                                0.05

0.04                                                0.06

For the rates of inflation given, find exogenous expenditure and short-run equilibrium output in Lotusland. Graph the AD curve.

5. Suppose that a permanent increase in oil prices creates an inflationary shock and reduces potential output. Use an AD-AS diagram to show the effects of the oil price increase on output and inflation in the short-run and the long-run, assuming that there is no policy response. What happens if the Reserve Bank responds to the oil price increase by tightening monetary policy?

6. Explain how a disinflationary macroeconomic policy (e.g. a contractionary monetary policy) can successfully reduce the inflation rate to a permanently lower level. Use the AD-AS model to describe the initial policy actions, a short run equilibrium, adjustment process toward a new long run equilibrium.