Part R. Anabyical QuestionsDeflation poses serious economic risks, including increased real debt burdens, postponed consumption and investment, and an elevated likelihood of prolonged recessions.
In response to the threat of deflation during the 2007-2010 financial crisis, some economists questioned whether the Federal Reserve’s 2 percent inflation target was sufficient. They argued for a higher target-such as 3 percent-to provide greater room for real interest rates to adjust, especially when nominal rates approach the zero lower bound. Using the Aggregate Demand-Aggregate Supply (AD/AS) framework, analyze the potential impact of increasing the inflation target from 2 percent to 3 percent. Begin your analysis at long-run equilibrium and explain the short-run effects on output and employment, as well as the long-run consequences for inflation and expectations.
Assume the government follows a strict rule that prohibits monetizing the debt-that is, it cannot print money to finance budget deficits. Under this constraint, can the government still run persistent budget deficits? Use the intertemporal government budget constraint to explain the conditions under which persistent deficits are sustainable.
Explain how budget deficits can lead to crowding out using the national income identity. Evaluate whether empirical evidence or historical episodes-such as the U.S. in the 1980s or post-2008 fiscal expansions – support or contradict the crowding-out hypothesis.
Using the open-economy short-run macroeconomic model, examine the effects of a global increase in savings – such as a sustained rise in household and corporate savings in Chinathat lowers the world interest rate. Use the IS/MP framework to illustrate the impact on domestic investment, output, and real interest rates. Then, apply the AD/AS model to describe the short-run and long-run implications for inflation and aggregate output. Finally, assess the policy implications for China. Can a country like China simultaneously maintain an independent monetary policy, a fixed exchange rate, and free capital flows? Why or why not?
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