# Suppose firms expect future output to be lower and future interest rates to be lower. Given this information, how will firms alter investment in the current period?

Theory section:

Question one:

Suppose firms expect future output to be lower and future interest rates to be lower. Given this information, how will firms alter investment in the current period? Explain. (about 50-100 words)

Question two:

Explain why current consumption is likely to respond less than one for one to changes in current income. (about 50 words)

Question three:

Explain why the multiplier in an open economy is different from the multiplier in a closed economy. (about 50 words)

Question Four:

Suppose a country’s output is below the policy makers’ desired level of output and is experiencing a trade surplus. Assume that the policy makers’ goals are to achieve the desired level of output (i.e., full employment output) and balanced trade. Given this information, what type of exchange rate and/or fiscal policy can be used to achieve simultaneously these two goals? Explain. (about 50 words)

Question five:

Explain what can occur to cause an increase in the debt ratio. (about 50-100 words)

Applied Section one:

The scenario

Scenario

Suppose the New Zealand economy is in recession. The unemployment rate is 7% and the Reserve Bank of New Zealand (RBNZ) is considering using monetary policy to expand output. Assume the RBNZ knows, with certainty, that:

i. absent changes in monetary policy, unemployment will still be 7% next year;

ii. the natural rate of unemployment is 5%;

iii. from Okun’s law, 1% more output growth for a year leads to a 0.4% reduction in the unemployment rate.

Also assume the RBNZ can effectively use monetary policy to increase output growth rates as desired, i.e., the interest rate is sufficiently far away from the zero lower bound. However, the RBNZ is uncertain about the effect that changes in its policy rate, the Official Cash Rate (OCR), have on output growth. To inform its decisions, the monetary policy committee summons the research department to produce predictions of the one-year response of NZ output growth to a decrease of 1% in the OCR. The research department, using three different macroeconometric models, presents the results from three different models:

Model (a): output growth is predicted to increase by 1.0% (moderate monetary transmission channel)

Model (b): output growth is predicted to increase by 0.6% (weak monetary transmission channel)

Model (c): output growth is predicted to increase by 2.0% (strong monetary transmission channel)

The research department further informs that each model prediction is equally likely, and that effects for OCR changes different than -1% are proportional to these predictions, e.g.: a decrease of 2% in the OCR is predicted to increase output growth by 2% according to model (a), 1.2% according to model (b), and 4% according to model (c), and so on.

Using the scenario information above answer the following questions.

Note: for the numerical questions, please provide a numerical answer in percentage points, e.g., 1 for 1%, -2 for -2%, etc.

Question one:

1. What is the output growth rate needed to lower the unemployment rate to the natural rate of unemployment?

Question two:

2a. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (a).

Question 3:

2b. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (b).

Question 4:

2c. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (c).

Question5:

2d. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Models’ average.

Question6:

3a. Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

(note the above statement is equal across the next 5 questions)

Calculate the potential effects of this policy on output growth according to the prediction of Model (a).

Question7:

3b. Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on output growth according to the prediction of Model (b).

Question8:

3c. Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on output growth according to the prediction of Model (c).

Question 9:

3d. Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on unemployment according to the prediction of Model (a).

Please answer with the resulting unemployment rate, not the change.

Question10:

3e. Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on unemployment according to the prediction of Model (b).

Please answer with the resulting unemployment rate, not the change

Question11:

3f. Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on unemployment according to the prediction of Model (c).

Please answer with the resulting unemployment rate, not the change.

Question12:

4a. What is the risk of creating inflationary pressures in the economy by following the average of model predictions? (about 50-100 words)

Question13:

4b. What should the RBNZ do to avoid any risk of increasing inflation? Should the OCR be decreased by more or less than the change implied by the average of model predictions? (about 50 words)

Question 14:

5. Discuss the implications of a higher degree of uncertainty about the effects of monetary policy on output. What would happen if the range of model predictions increased? (about 50-100 words)

Applied Section two:

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Macroeconomic Shocks, Identification, and Data Revisions

Go to Stats NZ website (https://www.stats.govt.nz/) and find out by how much New Zealand’s Consumer Price Index (CPI) and Gross Domestic Product (GDP) changed in the first and the second quarters of 2020 (March and June 2020 quarter) relative to their corresponding previous quarters (i.e., look for the quarterly rates of change).

Use these data to answer the following questions.

Note: for the numerical questions, please provide a numerical answer in percentage points, e.g., 1 for 1%, -2 for -2%, etc.

Question 1:

1a. In March 2020, New Zealand’s CPI changed by:

Question2:

1b. In March 2020, New Zealand’s GDP changed by:

Question3:

1c. In June 2020, New Zealand’s CPI changed by:

Question4:

1d. In June 2020, New Zealand’s GDP changed by:

Question5:

2c. Discuss the meaning of the shocks identified above. Do they make sense with how Covid-19 affected the New Zealand economy? (about 100 words)

Question6:

3a. Considering the New Zealand GDP revision statistics, based on the vintages from 29/06/2001 to 22/09/2011 from the RBNZ real-time database for GDP, calculate the expected revised GDP growth rates for the figures you collected above for the first and the second quarters of 2020. Use the revision statistics on the first versus the last estimates in that real-time dataset, and assume the revisions will follow a normal distribution, i.e., 95% of revisions are expected to lie between +- 2 standard deviations from the mean. (Hint: see the Applied Macro Exercise 6)

Using average revision statistics, what is the expected mean of the revised GDP growth rate for the first quarter of 2020?

Question7:

3b. Using average revision statistics, what is the expected mean of the revised GDP growth rate for the second quarter of 2020?

Question8:

3c. Using the standard deviation of revision statistics, what is the 95% lower bound on the revised GDP growth rate for the first quarter of 2020?

Question9:

3d. Using the standard deviation of revision statistics, what is the 95% upper bound on the revised GDP growth rate for the first quarter of 2020?

Question10:

3e. Using the standard deviation of revision statistics, what is the 95% lower bound on the revised GDP growth rate for the second quarter of 2020?

Question11:

3f. Using the standard deviation of revision statistics, what is the 95% upper bound on the revised GDP growth rate for the second quarter of 2020?

Question12:

4. Considering your answer to the previous questions, how likely it is that your identification of the macroeconomic shocks affecting the New Zealand economy in the first and second quarters of 2020 may be affected by future data revisions? Discuss how data revisions could change your shocks identification, and whether such identification change is more or less likely to happen for one of these two quarters than the other. (about 100 words)