I n t h I s c h a p t e r y o u w I l L

r
):
r
2% 
π
1/2 (
y
y*
)/
y*
1/2 (
π
π
*
),
where 
π
is the average of the inflation rate over the
past year, 
y
is real GDP as recently measured, 
y*
is an
estimate of the natural rate of output, and 
π
*
is the Fed’s
goal for inflation.
a.
Explain the logic that might lie behind this rule for
setting interest rates. Would you support the Fed’s
use of this rule?
b.
Some economists advocate such a rule for monetary
policy but believe 
π
and 
y
should be the 
forecasts
of
future values of inflation and output. What are the
advantages of using forecasts instead of actual
values? What are the disadvantages?
5. The problem of time inconsistency applies to fiscal
policy as well as to monetary policy. Suppose the
P r o b l e m s a n d A p p l i c a t i o n s

---

C H A P T E R 3 4
F I V E D E B AT E S O V E R M A C R O E C O N O M I C P O L I C Y
8 0 9
government announced a reduction in taxes on income
from capital investments, like new factories.
a.
If investors believed that capital taxes would
remain low, how would the government’s action
affect the level of investment?
b.
After investors have responded to the announced
tax reduction, does the government have an
incentive to renege on its policy? Explain.
c.
Given your answer to part (b), would investors
believe the government’s announcement? What
can the government do to increase the credibility
of announced policy changes?
d.
Explain why this situation is similar to the time
inconsistency problem faced by monetary
policymakers.
6. Chapter 2 explains the difference between positive
analysis and normative analysis. In the debate about
whether the central bank should aim for zero inflation,
which areas of disagreement involve positive statements
and which involve normative judgments?
7. Why are the benefits of reducing inflation permanent
and the costs temporary? Why are the costs of
increasing inflation permanent and the benefits
temporary? Use Phillips-curve diagrams in your
answer.
8. Suppose the federal government cuts taxes and
increases spending, raising the budget deficit to
12 percent of GDP. If nominal GDP is rising 7 percent
per year, are such budget deficits sustainable forever?
Explain. If budget deficits of this size are maintained for
20 years, what is likely to happen to your taxes and your
children’s taxes in the future? Can you do something
today to offset this future effect?
9. Explain how each of the following policies redistributes
income across generations. Is the redistribution from
young to old, or from old to young?
a.
an increase in the budget deficit
b.
more generous subsidies for education loans
c.
greater investments in highways and bridges
d.
indexation of Social Security benefits to inflation
10. Surveys suggest that most people are opposed to budget
deficits, but these same people elected representatives
who in the 1980s and 1990s passed budgets with
significant deficits. Why might the opposition to budget
deficits be stronger in principle than in practice?
11. The chapter says that budget deficits reduce the income
of future generations, but can boost output and income
during a recession. Explain how both of these
statements can be true.
12. What is the fundamental tradeoff that society faces if it
chooses to save more?
13. Suppose the government reduced the tax rate on income
from savings.
a.
Who would benefit from this tax reduction most
directly?
b.
What would happen to the capital stock over time?
What would happen to the capital available to each
worker? What would happen to productivity?
What would happen to wages?
c.
In light of your answer to part (b), who might
benefit from this tax reduction in the long run?

---

---