Comment on the ability of a credible nominal anchor to allow ...

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Comment on the ability of a credible nominal anchor to allow policy makers to exploit a short-run trade-off between unemployment and inflation.
 
  What will be an ideal response?

Question 2

In the text, the equivalence of the goods market equilibrium in the IS model to the equilibrium in which desired investment equals desired saving is demonstrated, assuming that both government purchases and net exports are zero.
 
  Demonstrate the equivalence when both G and NX are non-zero.

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Answer to Question 1

In the wake of a negative supply shock, policy makers may wish to implement expansionary policy to reverse the decline in economic activity. If this is understood as a temporary, emergency measure, rather than an abandonment of a commitment to price stability, expected inflation may decline even as aggregate demand is rising. However, under normal circumstances, any attempt to reduce unemployment and tolerate an increase in inflation will not be supported by credibility. On the contrary, such a policy must signal a lack of commitment to price stability; the loss of credibility confirms the illusory nature of the trade-off.

Answer to Question 2

In terms of output and expenditures, the equilibrium condition is Y = C + I + G + NX. Rearranging terms, Y - C - G = I + NX. For households, saving is Y - T - C. Government saving is T - G. National saving S = Y - T - C + T - G = Y - C - G. Substituting into the equilibrium equation, S = I + NX. Now, the combined saving by households and the government may be greater or less than investment, with the difference made up by a capital outflow (NX > 0 ) or capital inflow (NX < 0 ), respectively.

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