Exam 2015, questions and answers PDF

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Examiners’ commentaries 2015

Examiners’ commentaries 2015 EC3115 Monetary economics Important note This commentary reflects the examination and assessment arrangements for this course in the academic year 2014–15. The format and structure of the examination may change in future years, and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading references Unless otherwise stated, all cross-references will be to the 2011 edition of the subject guide. You should always attempt to use the most recent edition of any Essential reading textbook, even if the commentary and/or online reading list and/or subject guide refer to an earlier edition. If different editions of Essential reading are listed, please check the VLE for reading supplements – if none are available, please use the contents list and index of the new edition to find the relevant section. Important note: In the 2015–16 academic year,the new edition of the subject guide for EC3115 Monetary economics will form the basis of the examination.

General remarks Learning outcomes At the end of this course, and having completed the Essential reading and activities, you should be able to: •

explain and discuss why people hold money and why it is used in the trading process

•

solve macroeconomic models and assess the role and efficacy of monetary policy for various types of models in both the Classical and Keynesian set-ups

•

describe and explain the main channels of the monetary transmission mechanism, through which monetary policy can have real effects on the economy

•

discuss the merits and disadvantages of different monetary policies used by Central Banks

•

evaluate the effects of monetary policy in different exchange rate regimes

•

discuss the differences between fixed and flexible exchange rates and the consequences on the workings of monetary policy.

Format of the examination This course is intended to take an analytical approach to monetary economics. Candidates are expected to have mastered the main principles, in the form of a number of key theoretical models. They should be able to use these flexibly, as tools to analyse economic issues and data. They are also expected to have some knowledge of the empirical evidence on these models.

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EC3115 Monetary economics

The paper contains 13 questions in total with eight in Section A and five in Section B. The format of Section A now requires candidates to answer all eight questions from this section. These questions are intended to test your knowledge of important concepts and understanding of key analytical points. A brief answer is expected, and candidates need to be selective in order to focus their answers on the most important points, since, for some of these questions, a very long answer could be given. Section B consists of five questions, three of which must be answered by the candidate. The questions in Section B can be of three different types. They are intended to test the candidate’s ability to understand and interpret empirical data and relate them to relevant theories where possible. Some general knowledge of recent economic events is sometimes helpful in answering these questions. The sub-sections of this type of question will typically relate to a single concept or model. The second type of question that can appear in Section B will require the candidate to carry out calculations and problem solving in relation to specific models. Finally, the third type of question can be essay-type questions that test the candidate’s ability to discriminate and evaluate; these will be intended to test whether the candidate has done further reading beyond the core text/subject guide. All the question types in Section B will typically relate to a single concept or model. The subject guide contains brief notes on the main topics in the syllabus, and gives recommendations on textbooks and other readings. It is very important that candidates study widely, using textbooks and other readings, particularly those items marked Essential reading. The subject guide alone is not sufficient – it is not intended as a textbook, but as a guide to the relevant literature. Candidates should aim to understand the key analytical principles with enough confidence to be able to use them as a set of tools to apply to a wide range of economic questions. General knowledge of recent events relating to macroeconomics is valuable, particularly when commenting on economic data in Section B of the examination.

Planning your time in the examination The examination is divided into two parts. As mentioned above, Section A requires answers to all eight questions and Section B requires answers to three out of five questions. Candidates should allow ten minutes for careful reading to ensure that they understand the questions and make appropriate choices in Section B. Each question in Section A is worth five marks, and candidates should plan to spend ten minutes on each question, one hour and 20 minutes on the section. Each question in Section B is worth 20 marks and 30 minutes should be allowed for each, or 90 minutes for the whole section. Planning your time in an examination like this, where there are different sections and questions of different lengths, is important. It is easy for candidates to spend too long on Section A, and to have to skimp on Section B. Section A answers must be brief and to the point.

What are the Examiners looking for? The examiners are looking for answers that show an understanding and ability to apply economic principles, combined, where appropriate, with factual knowledge. The use of diagrams to illustrate points is welcomed by the examiners. Candidates are expected to show independent critical judgement, for example, in Section A where the statements given may be true or false or somewhere in-between. Candidates should be able to distinguish between true and false, or partially true and partially false, claims. In the data-based questions in Section B, the examiners are looking for comments based on a close examination of the data provided. Candidates’ comments should reflect appropriate economic principles and theoretical ideas. Comments should, where this is relevant, be supported by some knowledge of other facts and circumstances beyond those shown in the question paper. It is not expected that candidates will have studied in detail the data for the countries, the variables, or the time period that are mentioned in the question. But it is expected that they will have some general knowledge of a wide range of recent economic events. The essay-type questions in Section B are intended to test whether the candidate has done further reading beyond the core text/subject guide.

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Examiners’ commentaries 2015

Key steps to improvement In general, in the examination scripts for the 2015 examinations, many candidates did not set out their answers in as much depth as the examiners expect for a final year optional course that forms part of a degree programme. Candidates are encouraged to use diagrams to illustrate their arguments where appropriate. They are also expected to explain in words the economic significance of algebraic derivations. A significant group of candidates, of course, performed very well, and wrote lucid, detailed, well-illustrated answers that showed good technical skills, understanding of the economic principles and good knowledge of relevant recent economic events. Key steps for improvement then include: •

Allow yourself time to read the questions and carefully manage your time in the examination.

•

Answer the question on the paper directly. Do not make use of set piece answers to other, possibly similar, questions. Do not write irrelevant material just for the sake of lengthening your answers.

•

Make full use of diagrams where possible.

•

Combine manipulations of algebraic models with explanations in words of relevant economic principles.

Examination revision strategy Many candidates are disappointed to find that their examination performance is poorer than they expected. This may be due to a number of reasons. The Examiners’ commentaries suggest ways of addressing common problems and improving your performance. One particular failing is ‘question spotting’, that is, confining your examination preparation to a few questions and/or topics which have come up in past papers for the course. This can have serious consequences. We recognise that candidates may not cover all topics in the syllabus in the same depth, but you need to be aware that examiners are free to set questions on any aspect of the syllabus. This means that you need to study enough of the syllabus to enable you to answer the required number of examination questions. The syllabus can be found in the Course information sheet in the section of the VLE dedicated to each course. You should read the syllabus carefully and ensure that you cover sufficient material in preparation for the examination. Examiners will vary the topics and questions from year to year and may well set questions that have not appeared in past papers. Examination papers may legitimately include questions on any topic in the syllabus. So, although past papers can be helpful during your revision, you cannot assume that topics or specific questions that have come up in past examinations will occur again. If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties when you sit the examination. We strongly advise you not to adopt this strategy.

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EC3115 Monetary economics

Examiners’ commentaries 2015 EC3115 Monetary economics Important note This commentary reflects the examination and assessment arrangements for this course in the academic year 2014–15. The format and structure of the examination may change in future years, and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading references Unless otherwise stated, all cross-references will be to the 2011 edition of the subject guide. You should always attempt to use the most recent edition of any Essential reading textbook, even if the commentary and/or online reading list and/or subject guide refer to an earlier edition. If different editions of Essential reading are listed, please check the VLE for reading supplements – if none are available, please use the contents list and index of the new edition to find the relevant section. Important note: In the 2015–16 academic year,the new edition of the subject guide for EC3115 Monetary economics will form the basis of the examination.

Comments on specific questions – Zone A 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. Section A Answer all EIGHT questions from this section. 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. Question 1 An advantage of indirect barter over fiat money is that indirect barter does not require trust between individuals.

Reading for this question The subject guide, Chapter 1. Kiyotaki, N. and J. Moore, ‘Evil is the root of all money’, The American Economic Review 92(2) 2002, Papers and Proceedings, pp.62–66.

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Examiners’ commentaries 2015

Approaching the question False. Only direct barter does not require trust between individuals. The problem of trust in indirect barter is known as the Wicksell problem: as agents accept barter not only for consumption but also for further trade, the system can collapse into autarky without commitment. See p.16 of the subject guide for a worked-out example.

Question 2 The Baumol–Tobin model cannot realistically explain the demand for money.

Reading for this question The subject guide, Chapter 2. Baumol, W. ‘The transactions demand for cash: an inventory theoretic approach’, Journal of Econometrics 66, November, 1952, pp.545–56. Tobin, J. ‘The interest elasticity of transactions demand for cash’, The Review of Economics and Statistics 38(3) 1956, pp.241–47. Tobin, J. ‘Liquidity preference as behaviour towards risk’, Review of Economic Studies 25(1) 1958, pp.65–86. Approaching the question True. The subject guide provides a description of the Baumol–Tobin model; the model vastly underestimates the empirical amount of money held by firms and individuals as it fails to take into account institutional factors and only focuses on the need of money for transactions.

Question 3 Under the assumption of neutrality of money, fully anticipated inflation has no welfare costs.

Reading for this question The subject guide, Chapter 5. Approaching the question False. Candidates are expected to provide a discussion on the difference between the superneutrality and neutrality of money; Figures 5.1a and 5.1c of the subject guide highlight the difference between the two assumptions. Under the assumption of superneutrality, real money demand is not impacted on by anticipated inflation, so there are no welfare costs. Under neutrality (but non-superneutrality) real money demand is reduced by higher inflation (see Figure 5.2b of the subject guide), leading to welfare costs.

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EC3115 Monetary economics

Question 4 In Lucas’ misperceptions model, unanticipated monetary policy shocks have real effects due to asymmetrical information. Reading for this question The subject guide, Chapter 6. Lucas, R.E. Jr. ‘Some international evidence on output-inflation trade-offs’, American Economic Review 66(5) 1976, p.985. Lucas, R.E. Jr. ‘Nobel lecture: monetary neutrality’, Journal of Political Economy 104(3) 1996, pp.661–82. Approaching the question True. The asymmetric information causes the agents to confuse monetary shocks with demand shocks and thus respond to monetary shocks by changing their consumption by a fraction of the observed (but unidentified) shock. In the long run, agents find out about the true nature of the shock and the effect reverses. If information is symmetric, monetary policy would be ineffective in the Lucas’ misperceptions model.

Question 5 Monetary policy makers only care about inflation. Reading for this question The subject guide, Chapter 8. Barro, R.J. and D.B. Gordon ‘A positive theory of monetary policy in a natural rate model’, Journal of Political Economy 91(3) 1983, pp.589–610. Goodhart, C.A.E. ‘What should Central Banks do? What should be their macroeconomic objectives and operations?’, Economic Journal 104(427) 1994, pp.1424–36. Approaching the question False. Candidates are expected to answer this question by providing a brief discussion of the inflation bias (the political bias towards a higher output); excellent answers would also include a discussion on potential ways to resolve this tension.

Question 6 The Bretton Woods exchange rate mechanism can be thought of as a gold exchange standard. Reading for this question The subject guide, Chapter 14.

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Examiners’ commentaries 2015

Krugman, P. and M. Obstfeld, International economics: theory and policy. (Pearson, 2008) 8th edition [ISBN 9780321488831] Chapter 19. Approaching the question True. Under the Bretton Woods exchange rate system, all countries pegged their currencies to the dollar, which in turn was convertible into gold at a fixed dollar price. In principle this gave the Bretton Woods system many of the advantages of a pure Gold standard, while being more flexible in its operations. In the end, it turned out that the Bretton Woods system was still too rigid and became eventually undone in favour of floating exchange rates and free movement of capital.

Question 7 When in a liquidity trap, it is difficult for a country to affect the exchange rate using monetary policy.

Reading for this question The subject guide, Chapter 13. Krugman and Obstfeld (2008), Chapter 16. Approaching the question True. In a liquidity trap, the central bank cannot further lower interest rates as they have hit the lower bound. As Krugman and Obstfeld Figure 16–19 ‘A low-output liquidity trap’ shows, this leads to a horizontal segment of the AA curve in which temporary monetary policy is impotent in changing either output or the exchange rate. Note that it may still be possible to affect output and the exchange rate using unconventional monetary policy, such as QE.

Question 8 The Lucas critique implies that monetary policy is influential in all circumstances.

Reading for this question The subject guide, Chapter 8. Lucas, R.E. ‘Econometric policy evaluation: a critique’, in Brunner, K. and A.H. Meltzer (eds) The Phillips curve and labor markets. (Amsterdam; Oxford: North-Holland, 1976) [ISBN 9780444110077]. Approaching the question False. Lucas critique implies the opposite. If policymakers attempt to take advantage of statistical relationships, expectations adjust such that the statistical relationship collapses.

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EC3115 Monetary economics

Section B Answer THREE out of FIVE questions from this section. Question 9 Suppose that the economy of Krugmania is characterised by the following Phillips Curve πt = yt + aπt−1 and the IS Curve yt = −bit + ǫt where y is the real output, π is the rate of inflation, i is the short term interest rate set by the Central Bank and ǫ are i.i.d. shocks with ǫ ∼ N (0, σǫ2). The Central Bank of Krugmania is aiming to stabilise inflation around a target inflation π ∗ of 0 percent. The quadratic loss function of the Central Bank (which aims to minimize this loss function) takes the following form: L = Et (πt − π ∗ )2 (a) Solve for the optimal interest rate under these conditions. (7 points) (b) Now suppose that there is parameter uncertainty, i.e. parameters a and b are time varying. The policymaker knows from which distribution these parameters are drawn. To capture this let a ∼ N (a, σa2) and b ∼ N (b, σb2 ). Now solve for the optimal interest rate setting rule. (7 points) (c) Compare your results in (b) with those in (a), highlighting the main effects of parameter uncertainty. (6 points) Reading for this question The subject guide, Chapter 8. Approaching the question The problem has essentially two parts: candidates need to solve for cases with and without parameter uncertainty and discuss implications of such uncertainties. Case without parameter uncertainty: Substitute the perceived structure of the economy into the objective function of the central bank. Le

=

2

E (aπt−1 − bit + εt − π ∗ )

or: Le

=

  2 a2 πt−1 + b2 i2t + E ε2 + π ∗2 − 2aπt−1 bit + 2aπt−1 E(εt ) | {z } | {z } 0

σε2

−2aπt−1 π ∗ − 2bit E(εt ) + 2bit π ∗ − 2E(εt ) π ∗ . | {z } | {z } 0

0

The job is to minimise the loss with the use of the monetary policy instrument it , so:

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∂Le ∂it

=

2b2 it + 2bπ ∗ − 2aπt−1 b = 0

it

=

−π ∗ + aπt−1 . b

Examiners’ commentaries 2015

That is the certainty equivalence result a la Brainard. That means additive shocks do not affect the way monetary policy is conducted. The best the policymaker can do is to ignore them. Case with parameter uncertainty: Now, include a bit of complication. The economic environment is the same except that the parameters of the structural equations exhibit some uncertainty. Specifically, πt

=

yt + aπt−1

yt<...