Question

a. Consider an economy that is characterised by the following Phillips curve:

? = ?^- − ?(? − ?^e ),

where ? is unemployment, ?^- is the natural rate of unemployment, ? is inflation, ?^e is inflation expectations

and ? > 0 is a parameter. Suppose that the loss function of the central bank is given by:

?(?, ?) = ? + 3/2 ?²

Agents are assumed to be rational. Compute inflation and unemployment (i) if the central bank commits to ? = 0 and is believed by the public; (ii) if the central bank acts under discretion

b. Explain what is meant by deficit bias and state three reasons for why it may arise.

c. Use the national income identity to derive an expression showing how aggregate saving and investment are related in a small open economy.

d. According to economic theory , how is the nominal exchange rate determined in the short run?

a. According to economic theory , how is the nominal exchange rate determined in the long run?

Answer 1

b) We demonstrate that nominal exchange rates in the long run are determined by both monetary and real factors,

The simplest long run theory of the long run determinants of nominal exchange rates is the theory of purchasing power parity. This theory predicts that in the long run exchange rates tend to move so as to restore purchasing power parity between countries, in the sense of equating their price levels, when they are expressed in a common currency. Purchasing power parity essentially asserts that the long run real exchange rate is constant and equal to one.

When combined with a monetary theory of the determination of national price levels, purchasing power parity theory becomes a simple monetary theory of the long run determinants of nominal exchange rates, asserting that long run nominal exchange rates depend on the long run evolution of the money supply and money demand of one country relative to those of another country. Thus, the combination of purchasing power parity theory with long run equilibrium in the money market, attributes the long run evolution of nominal exchange rates only to monetary factors.

The long run real exchange rate depends on all the factors that determine the relative demand and supply of a country’s output. Such factors are real factors including as a country’s relative total factor productivity, consumer preferences, government expenditure and taxes, market structure etc.

Combined with the monetary theory of the determination of national price levels, this more general theory of the determination of real exchange rates becomes a theory of the long run determinants of nominal exchange rates as well. It asserts that long run nominal exchange rates depend on the real determinants of long run real exchange rates, plus the monetary determinants of the long run evolution of the money supply and money demand of one country relative to those of another country. Thus, both monetary and real factors can account for the long run evolution of nominal exchange rates.

c) In the short run, movements of currency respond to short run differences in interest rates so that short run rates of return are equalized across borders.

d) Deficit bias: The tendency of governments to allow deficit and public debt levels to increase.

Causes:

•Insufficient understanding of long-run constraints

     - lack of understanding of intertemporal budget

       constraint

    - overoptimism

     - overconfidence

•Politicians acting in their own interest – rent-seeking behaviour

    - lack of fiscal transparency

    - political business cycles

•Short-sightedness

    - higher discount rate for politicians than for the

      electorate

•Time inconsistency

     - optimal policy depends on the expectations of the

       public

     - time-inconsistent preferences: more impatience

       associated with short-run than long-run trade-offs

•Common-pool problems

    - concentrated benefits, dispersed costs

    - wars of attrition