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Free response question

Macroeconomics · Hard · 30 marks

IEO past paper: 2025 International Economics Olympiad, open questions

Open Question 5. After-COVID Inflation Country AA implemented COVID-19 lockdown support by increasing subsidies, offering loans to businesses, and distributing funds to citizens. These measures aimed to support household and business incomes during a time when production was significantly reduced. The government financed this support by increasing public debt, issuing and selling more government bonds, including to foreign investors. If no other policies are introduced, this government support during COVID-19 would increase inflation in Country AA.

(a)To counteract inflation, the central bank of Country AA raises its policy interest rate. How does this increase affect the interest rates that consumers and businesses face, such as on credit cards or business loans? Pay close attention to the exact transmission mechanism.[8](b)What are the most likely short-term effects of this interest rate increase on the economy? Consider consumption, production, and the labour market.[7](c)If investors expect that the central bank's policy will cause a recession, and that the central bank will later lower interest rates to stimulate the economy, what will likely happen to long-term interest rates (e.g. 30-year bonds or mortgages) and why? (4 points) What does this imply about the shape of the yield curve? (1 point)[5](d)If investors believe the current policy will control inflation without causing a recession, and expect stable growth and neutral monetary policy in the future, how will long-term interest rates compare to short-term rates? (4 points) What does this imply about the yield curve? (1 point)[5](e)Based on the discussion above about the role of expectations, how should the central bank design its monetary policy to effectively reduce current inflation?[5]

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