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Professor Salyer, Economics 137, Spring 2001
Final Examination
Directions: Answer all questions. Point totals for each question are given in parentheses. To
receive credit, you must provide explanations for your answers. Relax and enjoy the summer you have deserved it.
1.(15) Over the summer, you visit the Minneapolis Federal Reserve Bank and have lunch with
Edward Prescott. Professor Prescott, a very famous economist, does not believe that monetary
policy has much impact on the economy. Using your historical knowledge of Fed actions and the
characteristics of business cycles, you present a most persuasive argument otherwise. This consists
of….
A correct answer will discuss the C. Romer article - how there is indeed strong evidence that monetary policy matters.
The more you discuss the particulars of the Romer article and the evidence she presents, the better the answer.
2. (15) Consider the following IS-LM model:
Y  a0  a1r
IS
M  b0  b1Y  b2 r
curve
LM
curve
Express the model in reduced form under the assumption that the money supply is the instrument
of monetary policy.
The reduced form model is:
 b  a0 b1  

1
  
 M
r   0
 a1b1  b2   a1b1  b2 
 a b  a1b0 
a1
 
Y   0 2
M
 a1b1  b2  a1b1  b2
A correct answer will get the algebra right - but a partially correct answer will define a reduced form model and say what
the endogenous and exogenous variables are.
3. (20) “The Lucas aggregate supply curve is based on the assumptions that agents have imperfect
information and form expectations rationally. Since both of these assumptions involve variables
which are unobserved, the theory can not be tested.” Do you agree with this statement?
No - I don’t agree. As was discussed on the midterm, the slope of the AS curve is determined by the volatility of
inflation - this was what Lucas tested: to see if economies with high variance of inflation had steeper slope vis-à-vis low
variance economies. Students may talk about the properties of optimal forecasts - this is OK but a better answer will talk
about the signal extraction problem and the implications for the slope.
4. (15) Give three reasons for why a central bank should adopt inflation targeting.
1. - In the long run, inflation is the only macroeconomic variable that monetary policy can affect. (A really good answer
would talk about the Death of the Phillips Curve - the interpretation of a stable policy tradeoff between output
(unemployment) and inflation). 2. The cost of even moderate inflation is high (again - more examples are better) and 3.
An explicit and announced target makes monetary policy more transparent - which helps build a reputation and
credibility (this reduces the time inconsistency problem).
5. (20) In Euroland, businessmen are prone to waves of skepticism and optimism which translates
into their investment decisions. Based upon Poole’s analysis, should the European Central Bank
Professor Salyer, Economics 137, Spring 2001
target the money supply, inflation, nominal GDP, or interest rates? Use graphs to support your
answer.
This is the Poole anlysis with shocks to the IS curve - the ECB should target the money supply. A full answer needs to
use the appropriate figure from Poole
6. (15) What is the Taylor rule? If the Fed is trying to stabilize inflation, why do we expect the
coefficients in the Taylor rule to be positive?
We know what the Taylor rule is. The coefficients should be positive because the Fed is trying to stabilize the economy hence when output is above full employment the nominal interest rate must be increased. When inflation is above the
target, the nominal interest rate must be increased by more than the change in inflation so that the real rate increases. It is
important that they make the link between real interest rates and economic activity.
7. (15) Give three NON-ECONOMIC examples of dynamic inconsistency.
Have fun with this one!!!
8. (20) The Walsh model consists of the two structural equations:
1
 t   e  axt  et
2
k
xt   a  t   T   ut

Equation (1) is the Phillips Curve while eq. (2) represents the Monetary Policy rule.
a. Explain the intuition behind both equations – what do the parameters represent?
The Phillips curve is straightforward - it represents the tradeoff in the economy between inflation (deviations from
expected) and output. The MPR represents the optimal setting for output given the deviation of inflation from the
inflation target. A good answer represents that inflation above the target implies that x is negative - a recession. This
stems from the policymaker’s preferences in which output and inflation fluctuations are “bads”. The two parameters are
k = the weight on inflation fluctuations and  = the weight on output fluctuations.
b. Derive the reduced form of the model.
You will want to do the algebra to check, but I get the following (with


)
ka
 1  T
 1 
  
e
xt  
     
et  
u t
  a 
  a 
  a 
   T
  
 a 
e
t   T  
     
et  
u t
  a 
  a 
  a 
c. Using the reduced from solution, what are the long run equilibrium values for output deviations
and inflation? Interpret your answer.
Set   
of alpha.
T
e
and solve. You need to interpret in terms of the New Policy Tradeoff as described in Taylor and the role