Solution To Tutorial 7

Introductory Macroeconomics, ECON10003
Semester 2, 2020
Solution to Tutorial 7
1. (a) In the short run a more aggressive response to inflation implies that the policy reaction
function will shift upwards. This shift upwards in the policy reaction function will lead
to a shift inwards of the AD curve. The short run equilibrium outcome is that output
and the inflation rate will decline. The effect of the change in policy upon the AD curve
is depicted in Figure 1. We can illustrate the outcome of this shift in the AD curve in
Figure 2.
(b) In the aftermath of the short run we see that inflation expectations are above the actual
rate of inflation. As a result, inflation expectations will begin to shift downwards. This
decline in inflation expectations is shown as a gradual shift down in the AS curve that
continues until inflation equals expected at the natural rate of output. This is depicted
in Figure 3. I have focused upon the short run equilibrium at point B and the long run
equilibrium at point C. In the transition there would be a gradual move from B to C
as expectations adjust gradually.
(c) We discussed in an earlier Section of this course what the costs of inflation were. By
reducing inflation from close to 10 per cent to closer to 2.5 per cent the RBA has
reduced these costs. This reduction in the costs of inflation has been the benefit. The
cost associated with the reduction in inflation is that there was a significant increase
in unemployment rate required to bring down inflation to 2.5 per cent. In Australia,
unemployment exceeded 10 per cent in the early 1990s.
(d) There are a number of structural features that may help reduce the costs associated with
brining inflation downwards:
i. How quickly do inflation expectations adjust to new circumstances? In general, the
more rapid the adjustment the lower will be the rise in unemployment.
ii. How quickly do prices adjust? If prices are able to adjust very quickly, then we may
able to return to our long run equilibrium very quickly.
iii. Some features of the labour market may affect the cost of adjustment. For example,
as output declines by how much does unemployment rise? This may depend upon
labour market institutions. In many countries, a reduction in hours worked in the
aggregate economy occurs with only a small reduction in hours per worker but a
large reduction in number of workers. In some countries, a reduction in hours worked
occurs with only a small reduction in employment and a relatively large reduction
in hours per worker. It is likely that the second case will lead to lower costs.
2. There is no direct role of the financial sector in the AD-AS model. In the model we talk about
households, firms, the government and the overseas sector and we make assumptions regarding
how these different sectors of the economy behave. Implicitly, in those assumptions there is
some assumed ability regarding how the financial sector operates - for example, firms are able
to finance investment to some degree and that households are able to borrow to consume.
But this is for the most part kept to the background. If we wanted to incorporate shocks to
the financial sector to the AD-AS model we would have to say that events in the financial
sector lead to some sort of change in the behaviour of households or firms, or potentially
other sectors of the economy. For example, the failure of financial intermediaries may lead to
a reduction in exogenous investment by firms if firms have difficulty in finding finance.
One of the criticisms of the AD-AS model would be that the way in which financial markets
is incorporated into the model is arbitrary. This makes it hard to know what effects shocks to
financial intermediaries will have upon endogenous variables or how different policy responses
1
Υ Y
r PRF(new) PAE
PRF(original) PAE(original)
PAE(new)
π Y1 Y0
Y
AD(original)
AD(new)
Y1 Y0 Y
Figure 1: Effect of change in monetary policy upon AD curve.
will impact upon economic outcomes. For example, in the financial crisis in the USA there
were proposals to bail out the banks and proposals to help households that could not repay
their housing loans. It is difficult in this AD-AS model to compare these different polices.
A frequent critique of macroeconomics after the crisis was that economists had not paid any
attention to the importance of financial factors in understanding the macroeconomy. Perhaps
this area was understudied, but many scholars, perhaps most notably Ben Bernanke, had
studied the interaction between the financial sector and the real economy.
3. There is no correct answer to this question. It’s rather to point out that it is difficult to esti-
mate potential output and the natural rate of unemployment in practice. To remind you, the
level of potential output is defined as the level of output produced when factors of production
(capital and labour) are used at their normal rates. The natural rate of unemployment is the
level of unemployment that corresponds to structural and frictional unemployment. These
concepts are quite vague and unable to be measured directly using data that the Australian
Bureau of Statistics would collect.
It is hard for us to have an idea of what the level of potential output is during a pandemic
since there is very little recent historical evidence to guide us. If we view the normal rates of
usage of factors as corresponding to rates in which transmission of Covid-19 is not too rapid,
then surely potential output has fallen by a large amount. It is a bit hard to tell if actual
output has fallen by a greater amount than potential output during this recession. Although
this problem is particularly salient during this recession, I think similar issues occur during
other downturns as well as during booms. As an example, during the internet boom in the
late 1990s, there was debate regarding what was the new capacity of the economy due to
enhanced productivity growth.
Also note, that at least in the theory that we have presented in lectures, potential output and
the natural rate of unemployment are key measures that the government needs to estimate
to have an idea of whether expansionary or contractionary policy is called for.
2
Inflation
AS
π0
π1
AD (initial)
AD (new)
Y1 Y0
Output
Figure 2: AD-AS due to change in monetary policy.
Inflation AS(initial)
AS(final)
A
π0
π1 B
AD (initial)
AD (final)
Y1 Y0=Yn
Output
Figure 3: Long run effect of a change in monetary policy

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Introductory Macroeconomics, ECON10003

Figure 1: Effect of change in monetary policy upon AD curve.

Figure 2: AD-AS due to change in monetary policy.

Figure 3: Long run effect of a change in monetary policy

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