Question 1 (10 marks)

You are a ministerial advisor within the Ministry of Finance in your country. The Finance Minister has a few minutes to have a quick chat with you before going into an unscripted television interview on the matter of monetary policy. She has a query which she puts to you, and she seeks your response.

The background to her query is explained here. The economy had previously been at an equilibrium level of output and price acceptable to the government and the independent central bank (indeed the output level was at long-run output [Y*]), such that the price level = P₀ and output level (Y₀) = Y*. EP refers to expected price, which in period 0 is equal to price P₀.

Suddenly there is a huge spike in oil prices that induce a sizeable negative shock to aggregate supply moving it from AS₀(EP₀) to AS₀'(EP₀), creating a negative output gap (aggregate demand AD₀ remains unchanged) as output falls to Y₁ and inflation as prices rise to P₁. Price level P₁ is within the comfort zone of the central bank as the inflation level is still within its target band, but it is at the very upper bound of the target.

The government has no fiscal policy space to react to this negative shock as its budgetary situation is precarious and so it has decided not to act, hoping that the independent central bank with use expansionary monetary policy instead to shift the aggregate demand curve upwards.

1. The minister wishes to tell the interviewer that she is confident that the actions of the central bank will lead to an improvement in output (Y) in the short-term as it will lower interest rates (i.e. increase the money supply in the economy). You need to tell the minister whether you agree or disagree with her assertion, and explain why this is so. You should explain your response both in words and graphically as to why you agree or disagree with the minister. (6 marks)
2. The minister also wishes to state that, in general (so not necessarily based on the situation above), that the price level has no influence on output in the short-term. Using your knowledge of rational expectations, inform the minister whether or not you agree with her and explain why this is so. (4 marks)

Question 2 (10 marks)

You are a political economist working for a political party and your team has been tasked with working out permutations regarding steps governments may take with respect to maximising their utility but also to account for how the public will react, assuming the public behave in a manner described within the rational expectations paradigm.

The aggregate supply curve in your country is equal to: Y = Y* + P - EP (1)

Where Y* is the long-term equilibrium level of output, P is the price level and EP is the expected price level.

The government's utility function is: U_G = -0.75P² + Y - Y* (2)

The public's utility function is: U_P = -(P-EP)² (3)

1. Your political party is attempting to decipher the appropriate price level that a government would prefer to see in place in the economy. If the government ignores the public's expectation of prices, what price level would maximise its utility, the options being P=0, P=1, P=2 and P=3? Show your workings and explain why you chose the value of price that you did. (3 marks)
2. The political party is however, well-aware that to be successful in the long-run, the pricing policy must leave the public better-off, or at least no worse off in terms of the public's utility. As the public is rational, what expected price would the public form given their knowledge of the government preference? What would the public's level of utility be, and is this level of utility going to leave the public at least no worse off in terms of their utility? (3 marks)
3. If the government commits to set the price level at P=2, is this commitment dynamically consistent from the point of view of the public? Explain your answer. (2 marks)
4. Looking back at (c), now assume that adaptive expectations apply and the government has, in the past set P=2. Is the government's statement to set the price level at P=2 credible in the eyes of the public? Explain your answer. (2 marks)

Question 3 (10 marks)

You are an economist at the finance ministry of Asiaca, and your supervisor is asking you to work on the country's stock of debt to GDP ratio, as borrowings have increased dramatically due to lockdowns during the COVID-19 pandemic. You have been presented with information for 2020 (time period t) and 2019 (time period t-1) as follows:

Expenditure for purchase of goods and services (G) in 2020	$60 bn
Average tax rate (