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Chapter 24: Q. 5 (page 655)

Why does the divine coincidence simplify the job of policymakers?

Short Answer

Expert verified

When monetary policy achieves the dual goals of price stability and economic activity stability in the economy, it is referred to as a divine coincidence. This simplifies the job of policymakers.

Step by step solution

01

Step 1. Introduction

The framework established by the central bank in order to accomplish economic growth and stabilise the country's economy is known as monetary policy.

02

Step 2. Explanation

When monetary policy achieves the dual goals of price stability and economic activity stability in the economy, it is called divine coincidence. This indicates that there is no conflict between monetary policymakers' intentions, and the economy is free of both transient and permanent aggregate demand and supply shocks. As a result, policymakers' jobs get easier.

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Most popular questions from this chapter

Suppose the current administration decides to decrease government expenditures as a means of cutting the existing government budget deficit.

  1. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.
  2. What will be the effect on the real interest rate, the inflation rate, and the output level if the Federal Reserve decides to stabilize the inflation rate?

Suppose that f is determined by two factors: financial panic and asset purchases.

  1. Using an MP curve and an AS/AD graph, show how a sufficiently large financial panic can pull the economy below the zero lower bound and into a destabilizing deflationary spiral.
  2. Using an MP curve and an AS/AD graph, show how a sufficient amount of asset purchases can reverse the effects of the financial panic depicted in part (a).

For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a longrun equilibrium.

a. Consumers reduce autonomous consumption.

b. Financial frictions decrease.

c. Government spending increases.

d. Taxes increase.

e. The domestic currency appreciates.

In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a 鈥渟oft patch鈥� in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.

  1. How might fears of a zero lower bound justify such a policy, even if the economy was not actually in a recession?
  2. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

For aggregate demand shocks and permanent supply shocks, the price stability and economic activity stability objectives are consistent: Stabilizing inflation stabilizes economic activity, even in the short run. For temporary supply shocks, however, there is a trade-off between stabilizing inflation and stabilizing economic activity in the short run. In the long run, however, there is no conflict between stabilizing inflation and stabilizing economic activity.
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