Chapter 17, Expectations, Output and Policy Video Solutions, Macroeconomics Australasian Edition

Problem 1

Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly.
a. Changes in the current one-year real interest rate are likely to have a much larger effect on spending than changes in expected future one-year real interest rates.
b. The introduction of expectations in the goods market model makes the IS curve flatter, although it is still downward sloping.
c. Current money demand depends on current and expected future nominal interest rates.
d. The rational expectations assumption implies that consumers must take into account the effects of future fiscal policy on output.
e. Expected future fiscal policy affects expected future economic activity but not current economic activity.
f. Depending on its effect on expectations, a fiscal contraction may actually lead to an economic expansion.
g. Ireland's experience with deficit reduction programs in 1982 and 1987 provides strong evidence against the hypothesis that deficit reduction can lead to an output expansion.

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Problem 2

During the late 1990 s, many observers claimed that the economies of many rich countries had transformed into a New Economy (a high-tech economy), and that this justified the very high values for stock prices observed at the time.a. Discuss how the belief in the New Economy, combined with the increase in stock prices, affected consumption spending.
b. Stock prices subsequently decreased. Discuss how this might have affected consumption.

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Problem 3

For each of the following, determine whether the IS curve, the LM curve, both curves or neither curve shifts. In each case, assume that expected current inflation and future inflation are equal to zero, and that no other exogenous variable is changing.
a. A decrease in the expected future real interest rate.
b. A decrease in the current short-term nominal interest rate.
c. An increase in expected future taxes.
d. A decrease in expected future income.

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01:07

Problem 4

. Consider the following statement: 'The rational expectations assumption is unrealistic because, essentially, it amounts to the assumption that every consumer has perfect knowledge of the economy.' Discuss.

Kaylee Mcclellan

Numerade Educator

01:05

Problem 5

A new prime minister, who promised during the campaign that she would cut taxes, has just been elected. People trust that she will keep her promise, but that the tax cuts will be implemented only in the future. Determine the impact of the election on current output, the current interest rate and current private spending, under each of the following assumptions. (In each case, indicate what you think will happen to $Y^*, r^{\prime e}$ and $T^e$, and then how these changes in expectations affect output today.)
a. The RBA decides not to change the interest rate.
b. The RBA decides to prevent any change in future output.
c. The RBA decides to prevent any increase in the future interest rate.
d. The RBA acts very strongly to keep inflation at its target rate.

Christopher Dzorkpata

Numerade Educator

Problem 6

In 1992 the US deficit was US\$290 billion. During the US presidential campaign, the large deficit emerged as a major issue. So, when President Clinton won the election, deficit reduction was the first item on the new administration's agenda.
a. What does deficit reduction imply for the medium run and the long run? What are the advantages of reducing the deficit?
In the final version passed by Congress in August 1993, the deficit reduction package included a reduction of US\$20 billion in its first year, increasing gradually to US\$131 billion four years later.
b. Why was the deficit reduction package backloaded? Are there any advantages or disadvantages to this approach ?
In February 1993 President Clinton presented the budget in his State of the Union address. He asked Alan Greenspan, the Fed chairman, to sit next to First Lady Hillary Clinton during the delivery of the address.
c. What was the purpose of this symbolic gesture? How can the Fed's decision to use expansionary monetary policy in the future affect the short-run response of the economy?

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Problem 7

Suppose that the governor of the RBA unexpectedly announces that he will retire in one year. At the same time, the treasurer announces his nominee to replace the retiring RBA governor. Financial market participants expect the nominee to be confirmed by parliament. They also believe that the nominee will conduct a more contractionary monetary policy in the future. In other words, market participants expect the interest rate to rise in the future.
a. Consider the present to be the last year of the current RBA governor's term and the future to be the time after that. Given that monetary policy will be more contractionary in the future, what will happen to future interest rates and future output (at least for a while, before output returns to potential (GDP)> Given that these changes in future output and future interest rates are predicted,
what will happen to output and the interest rate in the present? What will happen to the yield curve on the day of the announcement that the current RBA governor will retire in a year?
Now suppose that, instead of making an unexpected announcement, the RBA governor is required by law to retire in one year (there are limits on the term of the RBA governor), and financial market participants have been aware of this for some time. Suppose, as in part (a), that the treasurer nominates a replacement who is expected to conduct a more contractionary monetary policy than the current RBA governor.
b. Suppose that financial market participants are not surprised by the treasurer's choice. In other words, market participants had correctly predicted who the treasurer would choose as the nominee. Under these circumstances, is the announcement of the nominee likely to have any effect on the yield curve?
c. Suppose instead that the identity of the nominee is a surprise and that financial market participants had expected the nominee to be someone who favoured an even more contractionary policy than the actual nominee. Under these circumstances, what is likely to happen to the yield curve on the day of the announcement? (Hint: Be careful. Compared with what was expected, is the actual nominee expected to follow a more contractionary policy or a more expansionary policy?)
d. On 1 August 2006, Glenn Stevens was nominated to succeed lan Macfarlane as RBA governor. Do an Internet search and try to learn what happened in financial markets on the day the nomination was announced. Were financial market participants surprised by the choice? If so, was Stevens believed to favour policies that would lead to higher or lower interest rates (as compared with the expected nominee) over the next three to five years? (You may also do a yield curve analysis for the period around Stevens' nomination. If you do this, use six-month yields on overnight indexed swaps and five-year Treasury bond interest rates.)

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Problem 8

Deficits urul interest rutes
The dramatic change in the US budget position after 2000 (from a surplus to a large and continuing deficit) reinvigorated the debate about the effect of fiscal policy on interest rates. This problem asks you to review theory and evidence on this topic.
a. Review what theory predicts about fiscal policy and interest rates. Suppose there is an increase in government spending and a decrease in taxes. Use an IS-LM diagram to show what will happen to the nominal interest rate in the short run and in the medium run (assuming the Fed is following an interest rate rule and has an implicit inflation target). Assuming that there is no change in monetary policy, what does the IS-LM model predict will happen to the yield curve immediately after an increase in government spending and a decrease in taxes?During the first term of the G. W. Bush administration, the actual and projected federal budget deficits increased dramatically. Part of the increase in the deficit can be attributed to the recession of 2001. However, deficits and projected deficits contimued to increase even after the recession had ended. The following table provides budget projections produced by the Congressional Budget Office (CBO) over the period August 2002 to January 2004. These projections are for the total federal budget deficit, so they include Social Security, which was running a surplus over the period. In addition, each projection assumes that current policy (as of the date of the forecast) continues into the future.$$
\begin{array}{|lc|}
\hline \text { Date of forecast } & \text { Projected five-year deficit as per cent of five-year GDP } \\
\hline \text { August } 2002 & -0.4 \\
\hline \text { January } 2003 & -0.2 \\
\hline \text { August } 2003 & -2.3 \\
\hline \text { January } 2004 & -2.3 \\
\hline
\end{array}
$$
b. Go to the website of the Federal Reserve Bank of St Louis, (http://research.stlouisfed.org/fred2), and follow the links to 'FRED Economic Data, then 'Categories', under Interest Rates' and then Treasury Constant Maturity', obtain the data for '3-Month Constant Maturity Treasury Rate' and '5-Year Constant Maturity Treasury Rate' for each of the months in the table shown here. For each month, subtract the three-month yield from the five-year yield to obtain the interest rate spread. What happened to the interest rate spread as the budget picture worsened over the sample period? Is this result consistent with your answer to part (a)?
The analysis you carried out in this problem is an extension of work by William C. Gale and Peter R. Orszag. See 'The economic effects of long-term fiscal discipline', Brookings Institution, 17 December 2002. Figure 5 in this paper relates interest rate spreads to CBO five-year projected budget deficits from 1982 to 2002.

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