Download EC3115 ZB d1 - University of London International Programmes

~~EC3115 ZA d0
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON
EC3115 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route
Monetary Economics
Tuesday, 6 May 2014 : 14:30 to 17:30
Candidates should answer ELEVEN of the following THIRTEEN questions: all EIGHT
from Section A (5 marks each) and THREE from Section B (20 marks each).
Candidates are strongly advised to divide their time accordingly.
If more questions are answered than requested, only the first answers attempted will be
counted.
PLEASE TURN OVER
© University of London 2014
UL14/0184
Page 1 of 7
D1
Section A
Answer ALL EIGHT questions from this section. (5 marks each)
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. The use of commodity money does not generate seignorage profits.
2. The demand for money is positively related to the expected payoff of assets.
3. Under the segmentation hypothesis, the slope of the yield curve tells us nothing about
the expected inflation.
4. The United States runs a balance of payments deficit in most years.
5. Assume country A and country B have equal interest rates. Covered Interest Parity
implies that if country A increases its interest rate, its spot exchange rate is expected to
depreciate over time.
6. A fully anticipated inflation has welfare costs.
7. Central banks’ main role in an economy is to manage maturity transformation.
8. Parameter uncertainty in the Brainard model implies interest rate smoothing.
Page 2
UL14/0184
Page 2 of 7
D1
Section B
Answer THREE out of FIVE questions from this section. (20 marks each)
9. In the economy of Manana, prices are perfectly flexible and output is always at its full
employment level, Y . The stock of money, M , growing at a constant rate, µ. Aggregate
demand is given by Y d = a − b(R − π e ), where R is the nominal rate of interest and π e
is the expected rate of inflation; a and b are positive constants.
(a) Imagine that the quantity theory of money applies, with the velocity of circulation
of money constant.
i. What is the inflation rate, π, in Manana?
ii. If the inhabitants of Manana have perfect foresight, what is the effect of increasing the growth rate of the money supply on real and nominal interest
rates?
iii. Is the stock of real money balances affected by the rate of growth of the money
supply?
iv. Is money neutral and/or superneutral in Manana under this situation?
(b) Imagine now, that instead of the quantity theory of money, the demand of real
money balances is determined by (in logs) m − p = h − kR, with h and k two
positive constants. How do your answers in part (a) change?
Page 3
UL14/0184
Page 3 of 7
D1
10. Consider a McCallum economy with sticky prices where the aggregate demand expression
given as:
yt = β0 + β1 (mt − pt ) + β2 Et−1 [pt+1 − pt ] + νt ,
where yt , mt and pt are the logs of real output, nominal money balances and the price level
respectively at date t, νt is an i.i.d. normal aggregate demand shock with νt ∼ (0, σν2 ).
β0 , β1 , β2 are positive parameters and E is the expectations operator. To construct the
aggregate supply assume the following:
(i) the market clearing price is denoted by p∗t ;
(ii) the prices are set by firms at t − 1 and are only effective in t. These are expected
to be the market clearing price in t, i.e. pt = Et−1 [p∗t ];
(iii) real output consistent with natural rate of unemployment, (y ∗ ), is determined by
the following law of motion that captures hysteresis
∗
yt∗ = δ0 + δ1 t + δ2 yt−1
+ ut
where t being time trend, δ0 , δ1 , δ2 positive parameters and ut is an i.i.d. normal
aggregate supply shock with ut ∼ (0, σu2 );
(iv) the monetary policy is characterised by the expression
mt = µ0 + µ1 mt−1 + et
where et is an i.i.d. normal money supply shock with et ∼ (0, σe2 ).
(a) Solve for the output gap, i.e. deviations of real output from the market clearing
level.
(b) Are unanticipated monetary policy changes effective? Show analytically and provide
intuition.
(c) Are anticipated monetary policy changes effective? Show analytically and provide
intuition.
(d) What is the Lucas critique? Evaluate the critique based on the output gap equation
you have derived above.
Page 4
UL14/0184
Page 4 of 7
D1
11. Suppose that the economy of Pool-land is characterised by the following IS schedule
Y = a − bR + ε
and the following LM schedule
M = c − dR + eY + η
where Y represents the real output, R the short term interest rate, M the real money
balances, and where coefficients a, b, c, d are positive parameters. The economy is subject
to additive shocks. ε and η are IS and LM shocks with the following properties ε ∼ i.i.d.
2
2
(0, σε ) and η ∼ i.i.d. (0, ση ). Note that the uncertainty arises only due to additive
shocks.
Suppose that the monetary authority goal is to minimise the variance of output.
(a) Is it better to use short term interest rates instead of real money balances to stabilise
the economy when the economy is subject to IS shocks only? Show analytically.
(b) Is it better to use short term interest rates instead of real money balances to stabilise
the economy when the economy is subject to LM shocks only? Show analytically.
(c) Now consider the case of multiplicative uncertainty, where parameters of the model,
a,b,c,d are subject to uncertainty. Would this model modification affect your policy
results? Discuss verbally.
Page 5
UL14/0184
Page 5 of 7
D1
12. A student takes £20,000 net over the course of a year, at an approximately constant
daily rate. He is saving to buy a car at the end of the year, which costs £6,000; all the
rest of his takings he spends, also at an approximately constant daily rate. He can hold
his savings in a deposit account in a bank paying 3% per annum, with costless deposits
and withdrawals, or he can purchase bonds paying a known yield of 8%. Interest on the
bond and the deposit account is paid at the end of the year and compounded annually.
The brokerage fee in purchasing or selling bonds is £4 per transaction. Assume the
student makes his transactions optimally by making n transactions, n − 1 of these being
purchases of bonds spaced equally through the year, and the nth transaction being the
sale of bonds at the end of the year to pay for the car. The interest earnings he intends
to spend on extras for the car.
(a) Draw the time profile of the student’s holdings of deposits and bonds.
(b) Find an expression of the student’s average bond holding as a function of n?
(c) What is the optimal value of n?
(d) The problem above is based on the Baumol-Tobin inventory theoretic approach.
Tobin’s model of portfolio selection also deals with money demand. Explain how
Tobin’s model of portfolio selection explains how agents decide how much bonds
and money to hold.
Page 6
UL14/0184
Page 6 of 7
D1
13. A small open Asian economy wants to stimulate the economy by making its export
products to Japan, its main trading partner, more competitive. In order to do so, the
central bank has decided on a permanent increase of the domestic money supply.
Show graphically what the effect of the permanent increase of the money supply will
be on the exchange rate and output under the following two scenarios. Explain your
answers and make sure in each case to discuss both the short run and long run effects.
(a) Japan does not change its monetary policy.
(b) Japan retaliates by also increasing its money supply.
Now consider the case where the small Asian economy decides to unilaterally engage in
a permanent fiscal expansion, say by funding a new space program.
(c) Show graphically what the effect of the fiscal expansion will be on the exchange
rate and output. Explain your answer.
END OF PAPER
Page 7
UL14/0184
Page 7 of 7
D1