Chapter 25 - Macroeconomic policy. In this chapter you will consider whether policymakers should try to stabilize the economy, consider whether monetary policy should be made by rule rather than by discretion, consider whether the central bank should aim for zero inflation, consider whether fiscal policymakers should reduce the government debt, consider whether the tax laws should be reformed to encourage saving. | Macroeconomic Policy Chapter 25 McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved. Learning Objectives Discuss the policy options available to the central bank in response to demand shocks and inflation shocks Explain the roles played by the anchored inflationary expectations and central bank credibility in keeping inflation low Describe how fiscal policy can affect both aggregate demand and aggregate supply Address why macroeconomic policy is as much art as a science Stabilization Policy and Demand Shocks Output Y AD1 Y 1 Inflation rate e AD2 Y* 1 AS2 Responding to Aggregate Inflation Shocks The economy begins in long-run equilibrium at Y1, 1 Adverse inflation shock shifts aggregate supply to AS2 Central bank follows its monetary policy rule and raises interest rates Recessionary gap at Y2 with higher inflation, 2 The central bank chooses Close the recessionary gap Restore target inflation rate LRAS Output (Y) 1 AD1 Y 1 Inflation ( ) AS1 Y2 2 AS2 Accommodating an Aggregate Inflation Shock Suppose the central bank moves to close the recessionary gap Eases monetary policy, lowering interest rates at 2 Resets target inflation rate to 3 Lower interest rates stimulate consumption and investment spending AD shifts to AD2 Long-run equilibrium is now at Y1 and 3 Aggregate inflation shock leads to higher long-run inflation LRAS Output (Y) 1 AD1 Y 1 Inflation ( ) AS1 3 Y2 2 AD2 AS2 Responding to An Aggregate Inflation Shock Suppose the central bank decides to maintain inflation at 1 Inflation is 2, above expected inflation of 1 The central bank raises interest rates Along AS2, expected inflation is 3 When the central bank fails to respond with looser monetary policy, expected inflation decreases AS2 shifts back to AS1 Original long-run equilibrium is restored LRAS Output (Y) 1 AD1 Y 1 Inflation ( ) AS1 Y2 2 AS2 3 Anchored Inflationary Expectations Anchored inflationary expectations means peoples expectations . | Macroeconomic Policy Chapter 25 McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved. Learning Objectives Discuss the policy options available to the central bank in response to demand shocks and inflation shocks Explain the roles played by the anchored inflationary expectations and central bank credibility in keeping inflation low Describe how fiscal policy can affect both aggregate demand and aggregate supply Address why macroeconomic policy is as much art as a science Stabilization Policy and Demand Shocks Output Y AD1 Y 1 Inflation rate e AD2 Y* 1 AS2 Responding to Aggregate Inflation Shocks The economy begins in long-run equilibrium at Y1, 1 Adverse inflation shock shifts aggregate supply to AS2 Central bank follows its monetary policy rule and raises interest rates Recessionary gap at Y2 with higher inflation, 2 The central bank chooses Close the recessionary gap Restore target inflation rate LRAS Output (Y) 1 AD1 Y 1 Inflation ( ) AS1 Y2
