MN2140 Macro-Finance 2019
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MN2140 Macro-Finance
2019
Answer to Question 1
a) i) True, ii) False, iii) False, iv) True.
b) i) In this case, β > 1.
ii) No, it will become flatter. The slope of the of the Monetary Rule (MR) curve is 
1
. Thus, if both α and β increase, the absolute value of the slope becomes smaller which implies that the MR curve becomes flatter.
c) Because it takes some time to build houses (1 to 2 years), in the short- run the supply of houses is perfectly inelastic and an unexpected increase in demand would lead to an increase in prices in the short- run. However, as there is abundant space for building new houses, after the initial increases in prices more houses will be built (increase in supply) which will reduce house prices. If there is also no scarcity of workers and raw materials, the long-run supply of houses will be perfectly elastic and the new long-run equilibrium house prices will be the same as (or close to) those prevailing before the increase in the
demand for houses. The students may also mention the possibility of a bubble in which prises are expected to increase and exactly because of these beliefs prices indeed increase (self-fulfilling prophesy).
Answer to Question 2
a) The graph is below.
Sequence of Events
Inflation shock → Inflation rate increases →
CB raises the interest rate to put the economy on the MR curve
→ AD, output and inflation fall (PC shifts downwards) →
CB gradually reduces the interest rate →
AD and output gradually rise and inflation gradually falls to target → ……→ Medium-run equilibrium with 
= 
, 
= 
and 
= 
.
b) The impulse response functions for output, inflation and the interest rate are given in graph below.
c) Under rational expectations, the new equilibrium levels of output, inflation and the interest rate will be the same as under adaptive expectations. However, under rational expectations, the adjustment path will be different and the adjustment period will be much shorter. (The students are not expected to describe the adjustment path but only to mention that the adjustment period will be shorter).
Answer to Question 3
a) The leverage of the investment bank is F
e . Using the demand function for financial assets, we have:
1
Leverage = z 
(1
r 
rP 
P)
So, leverage is clearly decreasing in the policy interest rate rate rp .
b) i) In period 0, the investment bank leverage is 10 and its holdings of financial assets 100 units.
ii) In period 1, the investment bank leverage increases to 25 and its holdings of financial assets increase to 250 units.
iii) In period 2, the capital gain on the initial holdings of financial assets the investment bank marks to market is (1.02 – 1) x 100 = 2. So, its equity increases to 12 (10 + 2). As a result, the investment bank will increase its holdings of financial assets to 12 x 25 = 300 units at the end of period 2.
iv) In period 3, the investment bank incurs a capital of (1.02 – 0.96) x 300 = 18. This loss exceeds its equity value and so it becomes insolvent.
v) Because the maximum allowed leverage is 20, in period 1, the investment bank will buy 100 units and hold 200 units instead of 250. The capital gains from the initial 100 units is still 2 and so, at the end of period, the equity value will still be 12 but the holdings of financial assets will be 240 instead of 300 units. In period 3, the bank will incur a loss of 14.4 instead of 18. However, 14.4 exceeds 12 and so the bank is insolvent. Therefore, a stricter leverage limit would be required for the bank to avoid insolvency.
2022-05-10