Unit 5 Part 2

4/11/16

Ex. Assume that the US economy is in long-run equilibrium with an expected inflation rate of 6% and unemployment rate of 5% Then nominal interest rate is 8%

(a.) Using correctly labeled graph with both the short-run and long-run Phillip curves and the relevant numbers from above. Show current long-run equilibrium as Point A.

(b.) Calculate the real interest rate in the long-run equilibrium.

i%=n%-π%

    =8%-6%=2%

(c.) Assume now that the Federal Reserve decides to target an inflation rate of 3% What open-market operation should the Federal Reserve undertake?

Lower discount rate, buy bonds and decrease RR ratio

Inflation- general rise in the price level

Deflation- general decline in the price level

Disinflation- decrease in the rate of inflation over time

Stagflation- unemployment and inflation increasing at the same time

Supply-Side Economics AKA Reaganomics

-          Changes AS and not AD

-          Determines the level of inflation, unemployment rates & economic growths

Supply-Side Economists:

-          support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, save, innovate and undertake entrepreneurial ventures

Lower Marginal Tax Rates:

-          induce more work thus causing AS to increase

-          also make leisure more expensive and work more attractive

Incentive to Save & Invest:

1.      High Marginal Tax Rates: reduce the rewards for saving and investing

2.      Consumption might be increasing but investing depends on saving

3.      Lower marginal tax rates encourage saving and investing

Laffer Curve

-          There is a theoretical relationship between tax rates and government spending revenue

-          As tax rates increase from zero, government revenues increase from zero to some maximum level and then decline

Criticisms

1.      Research suggests that the impact on tax rates on incentives to work, save and invest are small

2.      Tax cuts also increase demand, which fuels inflation and demand may exceed supply

3.      Where the economy is actually located on the curve is difficult to determine