Monetary Theory and Policy

| June 2, 2016

Final exam

Instructions: This is a take-home exam consisting of three questions. Some important reminders:

· You are free to consult notes, readings, and other materials in formulating your answers. BUT (a) it is expected that your answers will reflect your own ideas and that material will not be directly copied from other sources without attribution, and (b) collaboration is not permitted.Violations will be prosecuted.

· While there is no space limit for the exam, the quality of your answers matters more than their length. Writing excessively does not help your grade.

· Strong answers are accurate, insightful, thorough, and clearly expressed. They should also demonstrate strong command of key ideas, theories, research findings, and policy debates covered in this class.

· Assuming you are well prepared, it is not expected that writing this exam will take more than the class period.

Your completed exam must be emailed to me — by 6:00 am Tuesday morning, Dec. 18thth, as a Word or .pdf file.

* * *

1. Time inconsistency

a) When is a policy said to be time inconsistent?

b) Describe Barro and Gordon’s model of central bank decision making, writing down its

key equations. Making reference to these equations, explain why the central bank will

behave in a time-inconsistent way.

c) Show mathematically why an “inflation bias” arises in this model. What accounts for its

magnitude? What will the actual rate of inflation be?

d) Does the inflation bias lead to higher growth? Explain why or why not.

e) Define inflation targeting. Why is IT thought to represent a good solution to the time

consistency problem?

f) Based on material covered in this course, comment intelligently on the following: “If the

U.K., the European Central Bank and the U.S. Federal Reserve think 2% is the correct

value of inflation to target, then inflation-targeting emerging-market countries like Brazil,

Colombia, South Africa, and Chile should also aim to reduce their inflation targets to 2%.”

2. Short answers

a) In the view of Geanaopolos, could the Fed have prevented the Great Recession by adhering to the Taylor rule in its interest rate decisions in the 2001-2007 expansion? Explain his reasoning, and speculate intelligently on whether he would agree that the types of ‘unconventional monetary policies’ that the Fed has pursued since fall of 2008 had potential to promote a robust recovery from the 2007-09 recession.

b) Based on material covered in this course, comment intelligently on the following: “According to the IMF’s current projections, China will overtake the U.S. as the world’s largest economy in 2017. Consequently we can expect the Chinese currency, the Renminbi, to displace the U.S. dollar as the world’s dominant international currency around that time.”

3. Monetary policy at the zero bound

a) Why is it said that monetary policy becomes ineffective if the central bank lowers the policy interest rate to zero – and is this actually right? Explain, using the forward-solution to current output as a function of future expected interest rates to illustrate your argument.

b) Discuss what three means the central bank can use to try to affect the public’s expectations of future real costs of borrowing, even if the nominal interest is already at the zero bound. Is there any evidence that any of this unconventional monetary policy ‘works’?

c) Last week the Federal Open Market Committee (FOMC) of the Federal Reserve System announced that it decided to

“keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

Explain why the FOMC opted to include language about the specific level of unemployment it wants before it might consider possibly increasing the Federal Funds rate. What is the expected benefit, and what might be the cost?

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