# 2. Fiscal consolidation revisited. Suppose inflation at

2. Fiscal consolidation revisited.
Suppose inflation at time t is given by n = n°; + m + z - aut, and inflationary expectations are
given by n°; = 0 T-1+ (1-0) T, where 0<0 <1, and n is a constant.
i.
For what values of 0 do we obtain the original Phillips curve relation?
ii.
For what values of 0 do we obtain the new Phillips curve relation?
Suppose the economy is initially at a medium-run equilibrium (defined by Yn, Un, and rn).
Consider the case where the government decides to reduce government expenditure (G) to
decrease the deficit (holding taxes constant). Additionally, suppose the value of 0 is
consistent with the original Phillips curve relation.
ii.
Demonstrate the effect of a reduction in government expenditure on the IS
curve and the PC in the short run.
iv.
If the central bank only cares about the level of inflation, how should it respond
to the fiscal consolidation? What happens to unemployment?
If the central bank only cares about the inflation growth rate, how should it
V.
respond to the fiscal consolidation?
If the central bank only cares about the level of output, how should it respond
to the fiscal consolidation? What happens to unemployment?
vi.
vii.
Suppose the central bank adjusts the real interest rate to return the economy to
a medium-run equilibrium consistent with a zero output gap. How does the level
of inflation compare to its level before the fiscal consolidation?
Now suppose the value of 0 is consistent with the new Phillips curve relation.
viii.
Demonstrate the effect of a reduction in government expenditure on the IS
curve and the PC in the short run.
ix.
Suppose the central bank adjusts the real interest rate to return the economy to
a medium-run equilibrium consistent with a zero output gap. How does the level
of inflation compare to its level before the fiscal consolidation?
х.
What will occur if the real interest rate corresponding to the zero lower bound
is greater than the new natural rate of interest, rn'? Illustrate this situation using
the IS-LM-PC model.