Monetary Economics (Quiz 3B)

Lahore School of Economics

Monetary Economics

Winter Term, 2012

Quiz 3B: 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

Elaborate in detail the New Keynesian Aggregate Supply Curve. How does that refute the
claim of New Classical economics that anticipated policies are ineffective? (10 points)

It begins from the assumption of a fixed 2-year contract of the employed workers. Half of the
labor force is recruited in Year t (they negotiate the nominal wages based on information till
t-1) and the other half is recruited in year t+1 (they negotiate the nominal wages based on
information till t). As contracts expire after two years respectively for both groups, there is an
overlapping of contracts in the Year t+1. Nominal wages in Year t+1 are equal to wages of
ALL the labor force (hired in t and t+1).

Wt+1 = ( t-1Wt + tWt+1) read as wages of the group hired in Year t who negotiated wage
contract using information in t-1 PLUS wages of the group hired in Year t+1 who negotiated
wage contract using information in t

And to determine real wages, expected price level for Year t+1 is predicted in respective time
periods by both groups separately:

t-1Wt = Et-1 Pt+1 expectations about Year t+1 price level is made in Year t-1 by those hired in
year t

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 Monetary Economics (Quiz 3B)
tWt+1 = Et Pt+1 expectations about Year t+1 price level is made in Year t by those hired in
Year t+1

Hence, nominal wages become a function of price level: Wt+1 = (Et-1 Pt+1 + Et Pt+1)

Aggregate supply is a function of real wages. New Keynesian Supply Curve says that if the real
wage is zero (i.e. W P = 0), Y = Y*. If real wage increases (W > P), firms cost of production rises
and that reduces Y from Y* by the factor of . Similarly, lower real wages (W < P) would
increase output from Y* by the same parameter.

Yt+1 = Y* (Wt+1 Pt+1)

The equation of Wt+1 is substituted in the AS curve and simplified version shows that:
(derivation not required):

Yt+1 = Y*+ /2 (Pt+1 Et-1 Pt+1) + /2 (Pt+1 Et Pt+1)

If an anticipated monetary policy shock occurs in Year t, Pt+1 would be different than Et-1 Pt+1 (in
red font). Group of workers recruited in Year t despite being rational individuals cant do
anything about it as they have a fixed contract till Year t+1. Although they accurately predict
that because of a shock in Year t, price level in Year t+1 would come out to be different than
expected price level as only the information till Year t-1 was incorporated while negotiating
the contract and shock occurred in next year, they cant ask for a different nominal wage right
after the shock has occurred. Any anticipated shock in Year t would thus cause a disturbance
in the real wage, Wt+1 Pt+1 0 for workers hired in Year t. However, the workers hired in Year
t+1 would update their expectations after the anticipated shock in Year t and formulate an
efficient contract which would equate actual and predicted price levels in Year t+1 or P t+1 = Et
Pt+1 and real wage, Wt+1 Pt+1 = 0.

Thus, it can be concluded that so long as contracts of half of the workforce are fixed,
anticipated monetary policy can work for some time and are not always ineffective.

Question 2

Mathematically and intuitively explain the IS/PC/MR models equations. How would the real
sector work if IS curve faces a NEGATIVE shock? Explain the effects on real interest rates,
output and inflation levels. (20 points)

IS: +1 = Y is inversely related to r and changes after a lag of a year

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 Monetary Economics (Quiz 3B)
PC = +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

MR-AD Eq: +1 = (+1 )

if inflation exceeds the target level, policy
maker intervenes and creates a recessionary
gap by a factor of by increasing the
interest rates.

Refer to the diagram shown. This is a

combination of IS/PC/MR model. Currently,
the economy is at Y*, target inflation level
and stable level of interest rates at rS.

When IS curve shifts leftwards, income level

decreases to Y0. Recessionary gap shifts the
PC Curve downwards (in red) and economy
settles at Y* and 1% inflation level in the
long run.

To get back to targeted level of inflation, the policymaker decreases the interest rates to r1 whereby MR
intersects PC (1%) in the lower panel (Point B)

As per the MR, an inflationary gap will be introduced (Y1 > Y*) and inflationary expectations will move
upwards to between 1% and 2% shifting the PC curve upwards (in green). After that, policy maker will
keep on increasing the interest rates to get rid of inflationary gap and inflationary expectations will
move in the upward direction so long as Y > Y*. This will keep on shifting PC curve upwards and each
curve consistently will intersect MR curve (such as the green curve whereby inflation is close to 2%). This
process will end when inflation = 2% and the new stable level of interest rates are rIS.

Question 3

Explain in detail the transmission mechanism of a fall in interest rates via investment channel
only. (10 points)

Students need to focus on the following channel and will be given points on how well theyve
explained.

If interest rates fall market interest rates also follow the change, that is they fall asset
prices rise increasing the collateral power of financial assets, cost of borrowing falls, retained

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 Monetary Economics (Quiz 3B)
profits are re-invested rather than saved as there is lower opportunity cost of investment
thus investment rises AD rises inflation increases with a time lag of almost 2 years

On the other hand, lower interest rates reduces the interest income from interest-earning
assets and firms who are net savers face adverse wealth effect leading to lower investment.
This can also lead to cash constraints low investment low AD and inflation

The final effect on AD and inflation depends on the magnitudes of both transmission
mechanisms.

Question 4

If higher asset prices can affect inflation through aggregate supply channel, how would the
monetary authorities react? Focus on the authorities concerns and reaction only. Please
formulate a consistent answer and avoid irrelevant information as it would be negatively
marked for this question. (10 points)

Scarcity in real assets of the economy such as agricultural products or energy related products
can lead to higher prices. This can threat the inflation targets set by the authorities through
aggregate supply channel. As asset prices rise, value of CPI (consumer price index) rises and
although the second term in the following PC equation is not affected as that measures AD
pressures, the rising inflation levels are picked up by first term in the equation, t

PC +1 = + (+1 )

Authorities can set a high interest rate to curtail inflationary pressures. The increasing inflation
level is thus unavoidable.

However, if the rise in asset prices is artificial or goods are hoarded or rationed to deliberately
increase the prices and profits, then the authorities can avoid rising inflation levels by looking
for the sources of distortions. If thats not politically possible, then interest rates have to be
increased to restrict rising inflation.

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