Question III:
Fiscal dominance refers to a situation in which the monetary authority is re- quired, or in the future might plausibly be required, to finance spending by the fiscal authority that cannot be covered by non-inflationary sources of finance.

1.Explain how the perception of “fiscal dominance” alters the monetary au- thority’s capacity to manage inflation.

2.In the lecture, we discussed “unpleasant monetarist arithmetic”. What does this mean, and what was the counter-intuitive result from the dis- cussion about the relationship between monetary growth and inflation?

3.A fiscal consolidation, for example an increase in taxes, that puts the fiscal authority on a sound financial footing could eliminate the government’s reliance upon inflationary finance and the problem of “fiscal dominance”. Explain what we mean by the following statement: “A tax increase that is implemented as part of an inflation stabilization should be viewed as a change in the form of the tax structure, not an increase in the overall tax burden. As such, contractionary “Keynesian” effects of the tax hike would not apply.

Question IV:
The key elements of a modern “Phillips curve” analysis of inflation are expecta- tions, inertia, demand, and “supply shocks” (such as a commodity price shock or an abrupt exchange rate depreciation that raises the cost of imported inter- mediate and final goods.)

1.Explain what we mean by “expectations” and “inertia” in the inflation process. Explain why it matters whether inflation is mainly driven by ex- pectations or inertia. You may use the problem of disinflation to illustrate the difference.

3.If expectations are an important driver of inflation, then the credibility of a government’s monetary policy may play an important role. How does weak credibility affect the monetary authority’s ability to reduce inflation?

6.What does Olivier Blanchard mean by the phrase “Back to the 1960s”?

Question III: Fiscal dominance refers to a situation in which the...