Monetary Economics (Quiz 3A)

Lahore School of Economics

Monetary Economics

Winter Term, 2012

Quiz 3A: B.Sc. III Suggested Solutions

Instructions:

Answer all questions in the spaces provided below. For full marks, make sure you write all
relevant points and do all necessary calculations. Pencils, pens, rulers, etc. cannot be shared
and cell phones cannot be used during the session.

Exchange of quiz versions will not be tolerated at any cost and any ONE exchange caught
would lead to cancelation of ALL the quizzes. The case would immediately be reported to the
disciplinary committee.

Total points for the quiz: 50

Question 1

Assume a hypothetical economy is currently at Y* and an unanticipated negative demand

shock takes place, i.e. inflation rates fall. How would that affect the Friedmans expectation-
oriented Phillips Curve? (15 points)

We begin from full employment level of Y*

consistent with U*. As aggregate demand
decreases, output decreases and there is
less room for employment in the economy.
Lower employment decreases the
recruitment of workers and the nominal
wages fall. This is shown in the movement
from Point E to Point F. People expect both
lower output and lower wages consistent
with the existing level of prices = p0.
However, when the negative AD shock takes
place, prices fall to p1 but workers dont
adjust their expectations immediately about
the price level. They are in money illusion
whereby it is perceived that prices are high
at p0 and nominal wages are falling thus real wages MUST be falling. Since there is excess capacity in the
economy below Y* (or above U*, Point F in the graph), the actual price level comes out to be lower at p1.

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 Monetary Economics (Quiz 3A)
Thus, when higher or constant real wages are realized/observed at Point F, the expectations are revised
and adjusted. Higher real wages and lower nominal wages lower the expected cost of production of the
employers. Consequently, more employment takes place and economy steadily returns to its original
level of employment, which is the natural rate of unemployment, U*. This shifts the Phillips Curve at U*
(Point G) from Point F at the same level of current lower nominal wages. In the above graph, movement
from E to F (money illusion) is in the short run while movement from F to G is in the long run.

Question 2

If people have imperfect information or partial information sets, a systematic monetary

policy can be effective. Is this true or false? Explain. (10 points)

This statement is true. If people have imperfect information sets, or data sets with errors and
missing values, even if they fully adjust their expectations according to given information (i.e.
the value of = 1) and there are no unexpected shocks, Y would still not be equal to Y* as a
wrong policy is predicted. This wrong prediction is not because people are irrational but
because an information shock has taken place. There is gap between full information (t) and
given information (t (z)) or the full information is not revealed properly.

Because there are rooms for errors as data is not continuously available and is partially
extracted from given information sets, systematic policies can operate and policies can be
affective.

Question 3

Using IS/PC/MR model, explain the effects of a positive shock in IS curve on output, inflation
and real interest rate in the following scenarios:

A) The IS curve is flatter

B) The IS curve is steeper

Note that the procedures will be the same in both parts but the proportionate effects on
variables would differ. Your answer should focus on that and obviously, it can be best
explained through graphs and equations. No derivation required!! (15 points)

Part A:

It is important to note that PC = +1 = + (+1 ) and MR-AD Eq: +1 =

(+1 )

If there is a recessionary gap, inflation levels would fall by and PC curve will shift downwards in the
long run while inflationary gap will raise the inflation by and shift the PC curve upward in the long run

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 Monetary Economics (Quiz 3A)
Refer to the diagram shown. This is a
combination of IS/PC/MR model with a
relatively flat IS curve. Currently, the
economy is at Y*, target inflation level
and stable level of interest rates at rS.

When IS curve shifts rightwards, income

level increases to Y0. Inflationary gap
shifts the PC Curve upwards and
economy settles at Y* and 4% inflation
level in the long run.

If the policymaker is inflation inverse,

he/shell increase the interest rates to r1
whereby MR intersects PC (4%) in the
lower panel (Point B)

As per the MR, a recessionary gap will be introduced (Y1 < Y*) and inflationary expectations will move
downwards to 3%. After that, policy maker will keep on decreasing the interest rates to remove
recessionary gap and inflationary expectations will move in the downward direction so long as Y < Y*.
This will keep on shifting PC curve downwards and each curve consistently will intersect MR curve (such
as the green curve whereby inflation = 3%). This process will end when inflation = 2% and the new stable
level of interest rates are rIS.

Part B:

The relevant diagram for Part B is on the left

side. The procedure is exactly the same as Part A
but since the output responds less to a change in
interest rates, a larger change in interest rates
(from rS to r1) is made by the policymaker to
bring a recessionary gap and get towards the
inflation target of 2%. In the end, the economy
faces a larger change in stable level of real
interest rates (compare rsI in both diagrams).

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 Monetary Economics (Quiz 3A)
Question 4

Discuss why the interest rates on bonds in the asset markets are important for the monetary
authorities. For this question, please emphasize only on the importance of interest rate
movements, NOT the asset prices changes. Any irrelevant information will be NEGATIVELY
marked. (10 points)

Interest rates are perceived as yields of the financial assets. As yields fall, perceived risk of
holding a financial asset falls. Thus, lower yields indicate lower risk or favorable economic
conditions. During economic booms, interest rates on corporate sector bonds fall relative to
government bonds while during economic downturns, interest rate on corporate sector bonds
rise relative to government bonds. Thus, the interest rate spread can reflect the economic
conditions and guide an appropriate change in the monetary policy.

Secondly, higher expected yields also indicate that people are expecting higher inflation, ceteris
paribus. This would obviously be of importance to a central bank.

Thirdly, financial asset markets can be used to judge credibility of the central bank and CB can
look for evidence of their performance. If market agents can generally anticipate a fall in short-
term interest rates, the prices and yields of short term assets would show little response on the
day of the announcement as most of the market agents would already have shifted towards
bonds. This information and reaction from the market would test the credibility of the CBs
announcements.

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