Question 1. In the wake of the Great Recession, the U.S. Federal Government ran large budget deficits, primarily because federal income tax revenues fell as GDP declined. In addition, the Federal Reserve engaged in several emergency lending programs that, as was well documented in class, caused reserves held in the banking system to grow from $40B to $2.5T in six years. Many observers predicted at the time that large budget deficits and the "huge" increase in bank reserves would cause runaway inflation. Yet no inflation materialized.

Using your knowledge of (a) the process of creating money (M1), (b) the relationship between money growth and inflation, and (c) the conditions that are required to create a hyperinflation, explain why these predictions of high inflation did not pan out.

In developing your answer, draw on the central bank balance sheet, the quantity theory, the money multiplier and other macro relationships as needed. You may also refer to relevant case studies and data from class notes. Use complete, carefully worded sentences that focus on providing a cogent, tightly focused and sophisticated analysis.

Question 2. You are the head of the central bank of country Q. Your country has experienced a severe draught that has increased the natural or "full-employment" rate of unemployment, denoted as Un, from 5 percent to 8 percent. The higher natural rate is expected to last from 2016 through 2021. In response to the rise in unemployment, many in Q's Parliament are demanding the central bank act to lower unemployment. You, of course, are well aware that the central bank of Q must operate under the so-called "dual mandate" (which, in fact, was modeled after the Federal Reserve Act) in which the central bank's goals must be to (a) promote "low unemployment" and (b) maintain "low inflation".

Assume that you can set inflation in any year to exactly what you want. Also assume that the economy of country Q has the Phillips Curve , U = Un - .5(π - π(e)), where U is the unemployment rate, π is inflation, π(e ) is expected inflation which is equal to last year's actual inflation ( i.e. π(e ) = π(-1)).

Choose the inflation target for each year and calculate the resulting unemployment rate.

Choose a set of annual inflation rate targets for each year 2016 thru 2021 that you think will satisfy the dual mandate. Assume everyone knows that Un has gone from 5 percent to 8 percent. Explain how your policy satisfies the dual mandate!

Use complete sentences to defend your policy choice in a way that will be convincing to skeptical parliamentarians.

Question 3. Two think tank policymakers, A and B, are on a Sunday morning talk show debating the impact of government budget deficits on the economy. Policymaker A says that budget deficits are bad because they lower national savings that would otherwise be available for investment. Policymaker B says, no, the way that government spending is financed (either by taxes or deficits) is not the relevant issue. Instead he says that it's really the level of government consumption itself that is the critical variable in reducing savings and investment. Which of these policymakers, A or B, is correct? Use equations and explain them.

Question 4. From an actual radio show interview in 2013:

STUART VARNEY: -- but if we do something dramatic vis-a-vis China, isn't there a danger that we would just ignite a trade war at a very difficult time for the world economy?

TRUMP: Well, I would love to have a trade war with China.

VARNEY: Really?

TRUMP: Because, if we did no business with China, frankly, we will save a lot of money.

Question 5. A recent techno-thriller book, Ghost Fleet - P.J Singer and August Coles, envisaged an armed conflict between China and the U.S. (Spoiler Alert: China does not win.) While this scenario is unlikely, perhaps a trade war triggered by outrage over Chinese currency manipulation could occur. If such a thing happened our trade deficit with China would shrink as Chinese goods would not be able to enter the U.S.

Suppose that as a result of a quasi-trade war with China our total trade deficit shrinks immediately from $550B to $300B in 2017 and stays at $300B through 2021.

You are to use the calibrated model of the U.S economy that you previously used in Assignment 1 (found in the Assignments Folder) to estimate the impact of this deficit reduction on the U.S. economy through 2021. The trade reduction should start in 2017. (The trade deficit is in cell C40 in the model and is now set at -550.)