Analysis of the Effects of Fiscal Policies, Real Interest Rates, and Monetary Policy Procedures on t

Introduction and Background

Please read the article “The ECB’s lack of credibility could hamstring Europe’s recovery” from the Economist, September 19th 2020.

https://www.economist.com/leaders/2020/09/19/the-ecbs-lack-of-credibility-could-hamstring-europes-recovery (register to the website for free)

Answer to the following questions employing the models you studied during the course. The grade will take into account the precision and the completeness of your answers. Write about three (maximum four) pages.

1) The article talks about “a fiscal response to the pandemic”. One fiscal action was to increase transfers.

a) Describe, employing the Keynesian income-expenditure model, the effects of this policy action on real activity. (3 points)

b) Compare the effects of this policy action to those caused by an increase (of the same amount) of public expenditures. Which of the two fiscal tools would be more effective on output? Provide a graphical, an analytical and an economic intuition for that. (5 points)

2) The article stresses the danger of depressed inflation expectations since they keep real interest rates higher than they otherwise would be. Explain why high real rates would be a problem. (Hint: think to the relationship between real rates and economic activity.) (3 points)

3) “So concerned is America’s Federal Reserve about inflation expectations that it has promised to allow inflation to overshoot its target temporarily to make up for shortfalls, ensuring that inflation averages 2% over the long term.”

Explain this new strategy. Do you know other recent changes to the Fed’s monetary policy procedure? (4 points)

4) “The ecb …insists that it could cut interest rates below today’s level of -0.5%”. Explain what interest rate the author is referring to and which are the other two interest rates that form the ECB corridor?

Describe the corridor. (4 points)

5) “Peraphs Ms Lagarde, not for the first time, gave too hawkish an impression. In a seemingly corrective blog post the next day, Philip Lane, the bank’s chief economist, struck a more doveish tone.”

Briefly explain the terms “hawkish” and “dovish” (2 points)

6) “If the practical effect of budgetary loosening is to let the central bank take a breather, the chances are that the exchange rate will appreciate, offsetting some or all of the stimulus. The monetary taps must stay fully open for the extra fiscal stimulus to have the desired effect. That is what is happening in America.”Employing the Mundell-Fleming model with flexible exchange rates and perfect capital mobility, explain:

a) the first part of the sentence, providing economic intuition and a graphical analysis. (Hint: following a budgetary loosening, imagine that governments in Europe increase transfers and discuss the effects on real economic activity and the exchange rate). (5 points)

b) The second part of the sentence, providing economic intuition and a graphical analysis. (Hint: think about what “The monetary taps must stay fully open” implies in terms of the model’s curves). (5 points)