EC3115
Monetary Economics
Section A
Answer all EIGHT questions from this section.
Indicate whether the following statements are true or false, or uncertain and give a short explanation. Points are only given for a well reasoned answer.
1. An advantage of indirect barter over fiat money is that indirect barter does not require trust between individuals.
2. The Baumol-Tobin model cannot realistically explain the demand for money.
3. Under the assumption of neutrality of money, fully anticipated inflation has no welfare costs.
4. In Lucas’ misperceptions model, unanticipated monetary policy shocks have real effects due to asymmetrical information.
5. Monetary policy makers only care about inflation.
6. The Bretton Woods exchange rate mechanism can be thought of as a gold exchange standard.
7. When in a liquidity trap, it is difficult for a country to affect the exchange rate using monetary policy.
8. The Lucas critique implies that monetary policy is influential in all circumstances.
Section B
Answer THREE out of FIVE questions from this section.
9. Suppose that the economy of Krugmania is characterised by the following Phillips Curve
and the IS Curve
where y is the real output, π is the rate of inflation, i is the short term interest rate set by the Central Bank and are i.i.d. shocks with The Central Bank of Krugmania is aiming to stabilise inflation around a target inflation π* of 0 percent. The quadratic loss function of the Central Bank (which aims to minimise this loss function) takes the following form.
(a) Solve for the optimal interest rate under these conditions. (7 points)
(b) Now suppose that there is parameter uncertainty, i.e. parameters a and b are time varying. The policymaker knows from which distribution these parameters are drawn. To capture this let and Now solve for the optimal interest rate setting rule.(7 points)
(c) Compare your results in (b) with those in (a), highlighting the main effects of parameter uncertainty. (6 points)
10. In an economy with n households, assume a household’s utility depends on the quantity of goods consumed, X, and on real money balances, M/P.
Let the household have initial endowments X0 of goods and M0 of nominal money balances. The budget constraint faced by the household is then, in nominal terms:
(a) What is a potential justification of the inclusion of money in the utility function? (7 points)
(b) Is money neutral in this economy? Discuss analytically. (7 points)
(c) If the economy was characterised by limited participation in financial markets would your results change? Provide intuition without deriving the model. (6 points)
11. Consider the yield curve depicted in Figure 1, where the maturity of a range of bonds, expressed in years, is given on the x-axis and their respective redemption yields on the y-axis.
Figure 1: Yield curve
Assume that term premia are present and take the form. k1 = 0, k2 = 0.5%, k3 = 1%, k4 =1.25%, and k5 = 1.5%, where ki represents the term premium (per annum) for a bond with a maturity of i years.
(a) Calculate the implied expected 1-year interest rates for the next 5 years. (5 points)
(b) Explain how the yield curve can be used to extract information about expected inflation. Outline the assumptions you would need to make. (5 points)
(c) Assume expected 1-year real interest rates will be constant at 1.5% and calculate expected inflation. (5 points)
(d) Explain what the economic interpretation is of a sudden inversion of the yield curve. (5 points)
12. (a) Briefly explain the real business cycle (RBC) model. In particular discuss the type of shocks that drive business cycles and how these shocks propagate through the economy. (7 points)
(b) Discuss to what extent the RBC model is able to explain the stylised facts of the macro economy and the business cycle. (7 points)
(c) Contrast and compare the predictions of the RBC model regarding monetary policy and cyclicality of wages and prices to those of the Keynesian model with sticky nominal wages. (6 points)
13. In answering this question use the AA-DD model of the open economy. Assume the Central Bank is committed to maintaining full employment and natural output.
(a) When there is a temporary increase in the domestic propensity to consume explain
(i) how Output and the exchange rates are affected by the shock. (3 points)
(ii) how monetary policy can be used to restore output to its original equilibrium. (3 points)
(iii) whether monetary policy is the optimal policy to restore equilibrium for this shock. (2 points)
(b) When there is a temporary decrease in the foreign interest rate explain
(i) how output and the exchange rates are affected by the shock. (3 points)
(ii) how monetary policy can be used to restore output to its original equilibrium. (3 points)
(iii) whether monetary policy is the optimal policy to restore equilibrium for this shock. (2 points)
.
(c) Explain how temporary monetary policy is different from permanent monetary poli-cy in the AA-DD model; provide a diagrammatic analysis to support your argument. (4 points)