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EC3115

Monetary Economics

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 advantage of using fiat money vs. a barter economy is that fiat money no longer requires trust between transaction partners.

2. The demand of money is positively related to the price uncertainty of assets.

3. Under the preferred habitat theory the slope of the yield curve tells us nothing about the expected inflation.

4. Countries with low national savings rates must also have low investment rates.

5. Assume country A and country B have equal interest rates. Uncovered Interest Parity implies that if country A increases its interest rate, its exchange rate is expected to depreciate over time.

6. The quantity theory of money states that the total value of all monetary transactions must be equal to the real value of goods and services it buys.

7. According to the standard real business cycle (RBC) theory, money is not neutral.

8. Recessions are best dealt with by conservative central bankers.

Section B

Answer THREE out of FIVE questions from this section. (20 marks each)

9. Consider a classical-Patinkin economy where a representative household utility is a func-tion of consumption (C) and real money balances (M/P) such that:

and the household is subject to a budget constraint given by:

where Y stands initial endowment of goods, M0 stands for initial money balances.

(a) Calculate optimal goods and money demand. Provide intuition. Would your results change qualitatively if elements (that are real money balances and consumption) in the utility function were additive, instead of multiplicative?

(b) Is there a role for monetary policy in this setting? What happens when the economy faces a money supply increase? Show graphically and provide intuition.

(c) Is the classical theory convincing? Are you aware of alternative macro theories where monetary policy can be an effective output stabilisation tool? Discuss ana-lytically one such model.

10. Consider a McCallum economy with sticky prices where the aggregate demand expression given as:

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 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

(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.

(iii) real output consistent with natural rate of unemployment, (y*), is determined by the following law of motion that captures hysteresis

where t being time trend, δ0, δ1, δ2 positive parameters and ut is an i.i.d. normal aggregate supply shock with

(iv) the monetary policy is characterised by the expression

where et is an i.i.d. normal money supply shock with

(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.

11. Suppose that the economy of Pool-land is characterised by the following IS schedule

and the following LM schedule

where Y represents the real output, R the short term interest rate, M the real money balances, coefficients a, b, c, d are positive constants. The economy is subject to additive shocks. ε and η are IS and LM shocks with the following properties and 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.

12. A treasurer has to manage the cash position of a small London college. At the beginning of the year the college receives £5 million in tuition fees. The college is expected to spend all of that money in the year, at an approximately constant daily rate. The treasurer can either hold the financial wealth of the college in bonds, yielding an interest rate of 4% or in cash, which is assumed to not receive any interest. The accrued interest on the bond holdings is received at the end of the year and is not compounded inbetween. The brokerage fees of exchanging bonds for money are £1,000 per transaction. Note that the first transaction takes place at the beginning of the year, when the treasurer buys bonds, the transactions during the rest of the year will compose of selling bond holdings. The treasurer wants to minimize the costs of cash management, C, which are composed of the interest foregone on the cash holdings and the brokerage fees.

(a) Draw the time profile of the college’s holdings of cash and bonds.

(b) Set up the cost minimization problem for the treasurer and calculate the how much money, Z, should be transferred each time the treasurer sells off bonds.

(c) Calculate the interest elasticity of money.

(d) The problem outlined above is based on the Baumol-Tobin inventory theoretic mod-el. State and discuss two criticisms of the inventory theoretic model.

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.