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Examiners’ commentaries 2011


115 Monetary economics

Important note

This commentary reflects the examination and assessment arrangements for this course in theacademic year 2010–11. 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).

Specific comments on questions – Zone A

Candidates should answer ELEVEN of the following SEVENTEEN questions: EIGHT fromSection A (5 marks each) and THREE from Section B (20 marks each). Candidates arestrongly advised to divide their time accordingly.

Section A

Answer EIGHT questions from this section (5 marks each).

Consider the following statements, say whether they are true, false or uncertain, and give a briefreasoned explanation for their answer. Marks will not be awarded for answers unsupported by areasoned explanation.

Question 1

A criticism of Tobin’s portfolio selection model of money demand is that it suggestsindividuals are ‘all-or-nothing’ holders of money or bonds.

Reading for the question

Subject guide, Chapter 2.

Goodhart, C.A.E. Money Information and Uncertainty. (London: MacMillan, 1989) Chapter 3.

Lewis, M.K. and P.D. Mizen Monetary Economics (New York: Oxford University Press, 2000)Chapters 5 and 6.

Approaching the question

The statement is false. The answer is straightforward and a nice discussion is provided in thesubject guide. Baumol and Tobin’s model of transactions demand suggests the saw-toothbehaviour in respect of money and bonds. Tobin’s portfolio selection model explains whyindividuals might hold a combination of money and bonds as determined by the riskiness ofbonds and individual preferences.

Comments on answers

This question was frequently answered, generally very well.

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Question 2

An increase in the mandatory reserve requirement will cause a fall in the aggregatemoney supply.



Goodhart, C.A.E. Money Information and Uncertainty. (London: MacMillan, 1989) Chapter 6.


The simple answer is that the statement is true. See the subject guide or Goodhart for a gooddiscussion. Where a central bank is able to control bank reserves, changes in reserverequirements will translate into changes in the aggregate money supply. Basically one can relatethis to the definitions of money supply and monetary base where money supply is defined as:

M = D + C; (1)

M is money supply, D is deposits and C notes and coins held by the public. In the same way wecan define monetary base as:

H = C +R, (2)

where R is bank reserves.

Dividing (1) and (2) by D and then diving one by the other we find:

M = H

1 +C

DC

D+R

D

. (3)

The term in parenthesis is the money multiplier and depends on the cash and reservescoefficicients. There is obviously an inverse relationship between the reserves coefficicient and themoney supply. A good answer would have highlighted the importance of the requirement beingmandatory.

Comments on answers

This question was frequently answered, and most got the answer right but very few highlightedthe importance of the requirement being mandatory.

Question 3

A positive relationship between the nominal interest rate and anticipated inflationimplies that the rate of growth of money has no effect on the real economy.



Walsh, C.E Monetary Theory and Policy. (MIT press, 2003) second edition, Chapters 2 and 3.

Barro, Robert J. ‘Inflation and Economic Growth’, Bank of England Quarterly Bulletin (May),1995, pp. 39–52.

Barro, Robert J. ‘Inflation and Growth’, Federal Reserve Bank of St. Louis Review 78 (3) (May),1996, pp. 153–169.

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The statement is uncertain. The question was designed to test the candidate’s knowledge ofsuperneutrality of money i.e. a situation where the steady state values of real variables (likeconsumption, capital) are independent of the rate of growth of nominal money or inflation rate.This is a property of some of the general equilibrium models with money e.g. the Sidrauskimoney-in-the-utility function (MIU) model or the deterministic cash-in-advance (CIA) models.For super-neutrality the relation between the nominal rate and anticipated inflation must, via theFisher equation, be one-for-one. Perhaps the most important reason superneutrality will fail inactual economies is the presence of taxes that are not indexed to inflation; for instance, beinglevied on nominal capital gains (rather than real capital gains) so that effective tax rates willdepend on the inflation rate, generating real effects on capital accumulation and consumption asinflation varies. An excellent discussion is in Walsh (2003). Empirical evidence from Barro (1995,1996) finds that the estimated effects of inflation on growth and investment are significantlynegative under some plausible statistical procedures; a finding which is inconsistent withsuperneutrality. Barro’s results indicate that an increase in average inflation of ten percentagepoints per annum reduces the growth rate of real per capita GDP by 0.2–0.3 percentage pointsand lowers the ratio of investment to GDP by 0.4–0.6 percentage points; the long-term effects onthe standards of living can be substantial in his analysis.

Comments on answers

This question was answered infrequently. Only a very small number of answers emphasised theneed for a one-for-one relationship.

Question 4

Persistent high inflation can help explain a breakdown of the observed relationshipbetween inflation and unemployment.

Reading for this question


Friedman, M. ‘The role of monetary policy’, American Economic Review, 58 (1), 1968, pp. 1–17.

Phelps, E.S. Microeconomic Foundation of Employment and Inflation Theory (New York:Norton, 1970).

Approaching this question

The statement is true. The subject guide has a nice discussion. Friedman and Phelps claimedthat agents cared not about their nominal wage but about their real wage which led to theexpectations augmented Phillips curve; see, for instance, equations (7.3) and (7.4) in the subjectguide. This expectations augmented Phillips curve explained the breakdown of the observedrelationship between inflation and unemployment. Changes in expected inflation led to shifts ofthe Phillips curve and the in long run there was no trade-off between unemployment andinflation. Through the high inflation 1970s, workers revised upwards their expectations ofinflation and this meant the Phillips curve could no longer be used to explain the relationshipbetween inflation and unemployment. To get high credit, candidates had to describe the intuitionwell.

Comments on answers

Answers to this question were mixed for what should have been a relatively straightforwarddiscussion of the augmented Phillips curve.

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Question 5

Baseline Real Business Cycle theory predicts a negative correlation between outputand prices.



Backus, D. and P. Kehoe ‘International Evidence on the Historical Properties of BusinessCycles’, American Economic Review, 81, 1992, pp. 864–888.

Long, J. and C. Plosser ‘Real Business Cycles’, Journal of Political Economy 91(1), 1983, pp.39–69.


The straightforward answer is that the statement is true. The Real Business Cycle modelemphasises real shocks to the economy as the primary cause of business cycles e.g. shocks to theproduction function. Suppose there is an adverse shock to aggregate supply which shifts theaggregate supply curve. This causes a fall in output and a rise in prices. Hence, adverse shocksto aggregate supply contract output at the same time as increasing prices. A good answer shouldhave been supported with a diagram and an explanation of the mechanism involved. An excellentanswer might note that evidence on the cyclicality of prices can be mixed but generally pricesappear to be procyclical.

Comments on answers

Some candidates could answer this question fully, but many did not emphasise the simplemechanism at hand.

Question 6

In a Keynesian model of sticky wages, expansionary monetary policy causes animmediate increase in prices and output, but no effect in the long run.



Phelps, E.S. (1994) ‘Phillips curve’, in Newman, P., M. Milgate and J. Eatwell (eds.) The NewPalgrave Dictionary of Money and Finance (London: MacMillan, 1994).

Friedman, M. ‘The role of monetary policy’, American Economic Review, 58 (1), 1968, pp. 1–17.


The statement is false. This was a straightforward question and there is a good discussion in thesubject guide. Although there are short-run effects to both output and prices, in the long run thelabour market clears which means there no long-run change in output but higher wages andprices are part of a new equilibrium in the long run.

Comments on answers

This question was frequently answered well; many answered ‘True’ based on interpreting along-run change in nominal prices as no change (thinking that the question asked whether therewere any real effects).

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Question 7

The policy ineffectiveness proposition holds for all rational expectations models.



Lewis, M.K. and P.D. Mizen Monetary Economics (New York: Oxford University Press, 2000)Chapter 9.

Romer, D. Advanced Macroeconomics (McGraw-Hill, 2006) third edition, Chapter 6.


The statement is false since the proposition does not necessarily hold in all rational expectationsmodels. A simple example is given in Chapter 8 of the subject guide where systematic changes tomonetary policy can affect output. Romer (2006) presents the Fischer model where prices arepre-determined for two periods and here again anticipated changes in monetary policy can havereal effects in the short run. An implication is that policy changes can stabilise the economy.Romer contains a very detailed discussion of the topic.

Comments on answers

This question was generally answered well with good detail, but many avoided it.

Question 8

The expectations hypothesis is able to explain empirical evidence on the relativevolatility of long term bond yields.



Shiller, R.J. ‘The volatility of long-term interest rates and expectations models of the termstructure’, Journal of Political Economy 87 (5), 1979, pp. 1190–1219.

Goodhart, C.A.E. Money Information and Uncertainty (London: MacMillan, 1989) Chapter 4.

Mishkin, F.S. ‘The Economics of Money’, Banking and Financial Markets (London: Pearson,2009) ninth edition, Chapter 6.


The statement is false. The expectations hypothesis states that the interest rate on a long-termbond is an average of the short-term interest rates that people expect to occur during the life ofthe long-term bond; bonds are perfect substitutes. As a result the hypothesis would suggest thatlong rates are smoother because they are an average of current and future expected rates.Empirically, long rates are as volatile as short rates. Mishkin and the subject guide has a gooddiscussion on the topic.

Comments on answers

This was generally answered reasonably well, though often candidates took the opportunity tounload all they knew about term structures. A surprising number of candidates argued thatexpectations hypothesis had nothing to say about volatility.

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Question 9

Increases in long-term nominal interest rates can signal an increase in expectedinflation.



Goodhart, C.A.E. Money Information and Uncertainty, (London: MacMillan, 1989) Chapter 4.

Walsh, Carl E. Monetary Theory and Policy (MIT Press, 2003) second edition, Chapter 10.


The simple answer is that the statement is true. Under the expectations hypothesis, highernominal short-term rates in the future will be reflected in higher nominal rates on long term debttoday. For a given real rate, a higher nominal interest rate can signal an increase in expectedinflation via the Fisher equation. There is empirical evidence supporting this view as well. SeeWalsh (2003), Chapter 10.3, for a good discussion.

Comments on answers

This was a difficult question, but was not generally avoided. Candidates answered with a rangeof different ideas, and only a few really provided the right intuition.

Question 10

A depreciation of the domestic currency will raise the domestic price level in theshort run.



Krugman, P.R. and M. Obstfeld International Economics: Theory and Policy (London: AddisonWesley, 2008) Chapter 12.


This was a simple straightforward question and the statement is true. A depreciation of thedomestic currency will make exports cheaper but imports will be more expensive, and assumingthe basket of domestic consumption still includes imported goods, the domestic price level willincrease. A good answer would have been straight and to the point.

Comments on answers

Candidates tended to over-complicate answers to this question, mainly by considering long-runeffects rather than focusing on the short run.

Question 11

Country A and Country B are part of a currency union and an investor faces achoice between a project in A and a project in B. Expected returns on the CountryA project are two percentage points higher than the Country B project. Theinvestor should invest in Country A.


Subject guide, Chapters 12 and 14.

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Krugman, P.R. and M. Obstfeld International Economics: Theory and Policy (London, PearsonInternational, 2008) Chapter 20.


The statement is uncertain. Though there is no exchange rate risk, there are things to considerin addition to the expected returns. In particular if the investor is risk averse then the relativerisks involved in the projects might make the two point difference in expected returns insufficientto choose country A. Transaction costs can also have the same effect.

Comments on answers

Answers to this question were mixed; either candidates got the answer clearly or else discussed arange of irrelevant issues that did not approach the correct answer.

Question 12

Fiscal synchronisation is necessary for a currency union to be sustainable.



Krugman, P.R. and M. Obstfeld International Economics: Theory and Policy (London: PearsonInternational, 2008) Chapter 20.


The statement is uncertain. This was meant to be an open-ended question which requiredcandidates to use their critical thinking. With stable exchange rates and convergent inflationrates, convergence of interest rates is also important or else capital flows would put pressure onthe exchange rate. One can relate this to convergence on the size of the budget deficit and theratio of public sector debt to GDP since these affect the rate of interest. With too much debt,governments might find it difficult to redeem their debt. There was obviously room for debate inthe answer, but it could consider the consequences of imbalances caused by different fiscalpositions across a currency union. Answers could have included reference to current events in theEuro area.

Comments on answers

This question in general was not answered very often, and few could relate it to the right issue.

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Section B

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

Question 13

There are three figures below related to monetary variables in the US for the periodJanuary 1999 to May 2009. Figure 1 presents the evolution of M1, M2,andmonetary base; Figure 2 the evolution of the money multipliers; and Figure 3 theevolution of the cash and reserves coefficients i.e. the currency-deposit ratio and thereserve-deposit ratio respectively.

Figure 1: M1, M2 and monetary base in the US, January 1999-May 2009 (Jan 1999=100). Source:Von Hagen, J. ‘The Monetary Mechanics of the Crisis’, Bruegel Policy Contribution, Issue 2009/08,August.

Figure 2: Figure 2: Money multipliers in the US, January 1999-May 2009 (Jan 1999=100). Source:Von Hagen, J. ‘The Monetary Mechanics of the Crisis’, Bruegel Policy Contribution, Issue 2009/08,August.

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Figure 3: Figure 3: Cash and reserves coefficients in the US, January 1999-May 2009. Source:Von Hagen, J. ‘The Monetary Mechanics of the Crisis’, Bruegel Policy Contribution, Issue 2009/08,August.

(a) Explain the link between the monetary base and the money supply M1.





In this question, candidates were expected to derive the money multiplier and explain theintuition behind it. Goodhart is an excellent reference. A good answer would have beensomething like the following.

Base money, also known as high-powered money is the monetary liabilities of the Central Bank.This consists of notes and coins, and the deposits and reserves of banks with the Central Bank.If the monetary authorities increased the monetary base by printing money and giving it toprivate individuals, those individuals will probably deposit a fraction of it with their bank. Thebank will not want to keep all of these deposits in the form of liquid assets, as this strategy willnot earn the bank the most money. Instead it will keep a fraction of it in liquid form but lendout the rest in order to earn a higher return. The funds given out as loans will be spent andsubsequently deposited at the bank of whoever sold the goods to the initial borrower. The bankwill again lend out a fraction of these new deposits and the process continues. In equilibrium thetotal increase in the money stock, the liabilities of the government (notes and coins) and theliabilities of banks (deposits) will be a multiple of the increase in the high-powered money. Let usdefine money supply as:

M = D + C, (1)

where M is money supply, D is deposits and C notes and coins held by the public. In the sameway we can define monetary base as:

H = C +R, (2)

where R is bank reserves.

Dividing (1) and (2) by D and then diving one by the other we find:

M = H

1 +C

DC

D+R

D

. (3)

The term in brackets is the money multiplier and depends on the cash an reserves coefficients. Ifthese coefficients are relatively stable, it is easier for the central bank to control money supply.

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Comments on answers

Most candidates were able to derive the money multiplier. However, only a few managed toprovide the intuition behind.

(b) Explain the behaviour of the money multiplier m1 in Figure 2 from that of thebehaviour of the cash and reserve coefficients in Figure 3.




Von Hagen, J. ‘The Monetary Mechanics of the Crisis’, Bruegel Policy Contribution, Issue2009/08, August.


Candidates were expected to interpret the data presented in the figures using their knowledgeabout the money multiplier. A good answer would have been something like the following.

An increase in both the cash and reserves coefficients produces a reduction in the moneymultiplier m1. We can observe in Figure 3 that the cash coefficient in the US has been slowlyincreasing since 1999 while the reserves coefficient has remained relatively constant. As a resultm1 has been falling moderately. We observed this behaviour until May 2008. At this time, thereis a jump in the reserves coefficient due to the credit crunch; and even though the cash coefficientis falling, the net effect of these two forces is a severe drop in the value of m1. An excellentanswer would have related the behaviour of the multiplier carefully to the events during thefinancial crisis. Von Hagen is an excellent reference on the topic.

Comments on answers

Most candidates were aware of the events in the US during the last financial crisis. Candidateswith a good grasp of the impact of the cash and reserves coefficients in the money multiplier wereable to provide a very good interpretation of the data.

(c) The money supply M1, M2 go up even as the money multipliers m1, m2 fall towardsthe end of the period. What does this tell you about Federal Reserve policy at thetime?




Von Hagen, J. ‘The Monetary Mechanics of the Crisis’, Bruegel Policy Contribution, Issue2009/08, August.


Candidates were expected to interpret the data presented in the figures and a good answer wouldhave been something like the following.

The Fed has managed to keep M1 and M2 constant by offsetting the fall in the money multipliersby increasing monetary base. This has been achieved by combining conventional monetary policyinstruments and non-conventional ones such as Quantitative Easing. As was indicated in part(b), the money multipliers have fallen mainly due to the severe increase in reserves held by banksdue to the credit crunch. An excellent answer would have displayed knowledge of theseimportant events in discussing the multiplier.

Comments on answers

Some candidates failed to identify the instruments over which a central bank has control (i.e.,monetary base) and the factors that depend on the agents’ behaviour (i.e., cash and reservescoefficients).

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Question 14

During the 1980s and 1990s many Latin American countries experienced episodes ofhigh inflation which in some cases resulted in a process of hyperinflation. Figures 4and 5 below present information on the evolution of the annual inflation inArgentina and Bolivia respectively for the period 1981–2001.

Figure 4: Figure 4: Annual inflation in Argentina 1981–2001. (Source: World Bank.)

Figure 5: Figure 5: Annual inflation in Bolivia 1981–2001. (Source: World Bank.)

(a) Explain the concept of seignorage.



Walsh, C.E Monetary Theory and Policy (MIT press, 2003) second edition, Chapter 4.

Scott and Freeman, Modeling Monetary Economies (Cambridge: Cambridge University Press)Chapter 3.


To explain the concept of seignorage candidates were supposed to use the key insight fromFriedman’s price theoretic approach that the area under the demand curve measures the utilityderived by individuals from holding money balances. A good answer would have been somethinglike the following.

The opportunity cost to individuals of holding money balances is measured by the nominal rateof interest, R. The consumers’ surplus enjoyed by individuals from holding money balances, thatis, the excess of the utility they derive over the opportunity cost they incur, is thus measured bythe area A in Figure 6.

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Figure 6: Seigniorage and the inflation tax.

Suppose that, initially, there is no inflation, so that the nominal interest rate in Figure 6 is equalto the real interest rate (R0 = r). Given this interest rate, the total stock of money balances,which individuals wish to hold, is denoted (M/P )0. The area B measures the annual incomestream the government as issuer of money is able to acquire by the once and for all purchase ofproductive assets with the money it issues. (In a static economy with no inflation, the stock ofmoney outstanding is constant, but the government was able to acquire real assets with it at thetime it was introduced.) But if the money is fiat money, the cost of production is approximatelyzero, so the government is essentially able to acquire real assets ‘for free’ by virtue of itsmonopoly position on the money issue. This is known as ‘seigniorage’, and it represents atransfer of resources from money holders (households and firms) to the government. Seigniorageis essentially a form of taxation, and the area C in Figure 6 is the excess burden or deadweightloss associated with this tax.

Comments on answers

Candidates in general were quite good at answering this question. However, a common confusionwas between the concepts of seignorage and inflation tax.

(b) Is it possible to establish when a very rapid and continuing inflationary processbecomes a hyperinflation?



Cagan, P. ‘The monetary dynamics of hyperinflation’, in Friedman, M. (ed.) Studies in theQuantity Theory of Money (Chicago: University of Chicago Press, 1956).



Candidates were supposed to discuss when a process of high inflation is explosive and when it isnot. A good answer would have been something like the following.

Generally it is very difficult to determine when a rapid and continuing inflationary processbecomes a hyperinflation. Cagan (1956) in his classic article argues that a country suffers ahyperinflation if the the monthly inflation is 50% or more which translates into an annual rate ofmore than 12,000%. In Latin America some countries such as Argentina and Brazil haveexperienced annual levels of inflation greater than 100% for many years; however the process hasnot necessarily been explosive.

Comments on answers

Some candidates were aware of Cagan’s rule of thumb for identifying a hyperinflation while othersmade up their own rules of thumb. A 100% inflation per month was a popular rule in this answer.

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(c) Which models might best describe the situation of Argentina and Bolivia? Explainyour answer.



Cagan, P. ‘The monetary dynamics of hyperinflation’, in Friedman, M. (ed.) Studies in theQuantity Theory of Money (Chicago: University of Chicago Press, 1956).


Dornbusch, R. ‘Lessons from experience with high inflation’, The World Bank Economic Review,6, 1992, pp. 13–31.


Bolivia has suffered a hyperinflation. We can clearly observe a peak in 1985 of nearly 12,000%.We can use the model by Cagan (1956) to describe how a hyperinflation produces the collapse ofmoney demand. Argentina, in contrast, has not experienced such an increase in the level ofprices, but has battled with high inflation throughout the 1980s. The best model to describe theArgentinian case is the model by Dornbusch (1992) of very rapid and continuing, butnon-explosive, inflation. An excellent answer would have explained the models presented in thesubject guide.

Comments on answers

In general, few candidates could match the Bolivian and Argentinian experiences with the Cagan(1956) and Dornbusch (1992) models respectively. A common answer was to use the Dornbuschmodel to explain the experiences of both countries. Only a few candidates were able to derive themodels explicitly.

Question 15

Figure 7: Monthly per cent changes in the dollarpound ($/£) exchange rate and monthly inflationdifferentials between the US and the UK (1973–2005). Source: Pilbeam, K. International Finance(London: Palgrave MacMillan, 2006)

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Figure 7 presents information on the monthly per cent change in the dollar-poundexchange rate and monthly inflation differentials between the US and the UK forthe period 1973–2005.

(a) How accurate is Purchasing Power Parity as a theory to explain exchange ratemovements?



Pilbeam, K. International Finance (London: Palgrave MacMillan, 2006) Chapter 6.


Candidates were expected to evaluate the suitability of PPP as a theory to explain exchange ratefluctuations. The theory of purchasing power parity makes a number of strict assumptions.Violation of any of these assumptions can result in the failure of PPP to describe exchange ratemovements. Such violations include the assumption of no transport costs and other barriers totrade, the existence of perfect competition, the idea that there is a homogenous price levelmeasure across countries, and that non-traded goods can be ignored. In addition, by looking atFigure 7 we can see that PPP fails in the short run to explain the movement of exchange rates.The percent change in the dollar-pound exchange rate is lower than the inflation differential,suggesting that relative PPP is not holding between the UK and the US.

Comments on answers

In general, candidates responded very well to this question, demonstrating good knowledge ofPurchasing Power Parity theory.

(b) Explain why the exchange rate seems to be more volatile than inflation.





In this question candidates were expected to explain why the exchange rate seems to be morevolatile than inflation. One explanation is that prices are sticky in the short run, while exchangerates adjust very quickly. This situation can be explained by the Dornbusch overshooting model.An excellent answer would have provided a good discussion of this model.

Comments on answers

The great majority of answers pointed out that prices are less volatile than exchange rates.However, relatively few candidates provided an explanation related to the Dornbuschovershooting model.

Question 16

Consider a world in which PPP holds only for traded goods:

PT = SP ?T , (1)

where S is the exchange rate, PT is the price of traded goods in the domesticcountry, and P ?

T is the price of traded goods in the foreign country.

In addition, it is assumed that an aggregate price index for the domestic economy Pis constructed as the weighted average of the price levels of traded and non-tradedgoods in the domestic economy. In the same way, an aggregate price index for theforeign country P ? is calculated as the weighted average of traded and non-tradedgoods in the foreign economy:

P = αPN + (1− α)PT , α ∈ (0, 1) (2)

P ? = βP ?N + (1− β)P ?

T , β ∈ (0, 1) (3)

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(a) Calculate the exchange rate as a function of the relative prices of non-traded withrespect to traded goods.




General comments

Pilbeam (2006), Chapter 6, is an excellent source for this question. This question is anillustration of the second type of question that can appear in Section B (with the new examformat) which requires the candidate to carry out calculations and problem solving.


We start by dividing equation (2) by (3):

P

P ?=αPN + (1 − α)PT

βP ?N + (1 − β)P ?

T

. (4)

Then we divide the numerator by and the denominator by, which are equal by equation (1):

P

P ?= S ×

αPN

PT+ (1 − α)

βP ?N

P ?T

+ (1 − β)

. (5)

Rearranging:

S =P

P ?×

βP ?N

P ?T

+ (1 − β)

αPN

PT+ (1 − α)

. (6)

Comments on answers

Some candidates were not able to derive the exchange rate as a function of the relative prices ofnon-traded with respect to traded goods. Most answers started well by dividing (2) by (3) butfailed to use equation (1).

(b) Using your answer to (a) explain why, or why not, Purchasing Power Parity holds interms of aggregate price indices.





PPP does not hold in terms of aggregate price indices. The reason is that the relative price ofnon-traded with respect to traded goods influences the exchange rate. This can be easily seen bylooking at the term in parenthesis in expression (6) derived in (a).

Comments on answers

This part of the question was straightforward for those who managed to compute the rightexpression in (a); others obviously found it difficult.

(c) Calculate the real exchange rate, Q, and discuss the effects of an increase inproductivity in the traded goods sector in the domestic economy.



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Rearranging (6) we have:

Q =SP ?

P=

βP ?N

P ?T

+ (1 − β)

αPN

PT+ (1 − α)

.An increase in productivity in the tradable sector in the home country will decrease the price ofdomestic traded goods. This will not only produce an appreciation of the domestic currency butalso cause the real exchange rate to fall (real appreciation). This means that fewer consumptionbundles have to be given up by the home country in order to purchase a consumption bundle inthe foreign country. One unit of domestic currency will buy more goods abroad.

Comments on answers

This part of the question was challenging and required a good knowledge of some of the mainconcepts in open economy macroeconomics. Some candidates who were able to derive the correctexpression in (a) failed to derive the corresponding expression for the real exchange rate fromthat answer.

Question 17

(a) Using a suitable model, demonstrate the inflation bias of discretionary monetarypolicy.

(b) Explain how an anti-inflation reputation of the central banker can reduce thisinflation bias of discretionary monetary policy.



Walsh, C.E Monetary Theory and Policy (MIT press, 2003) second edition, Chapter 8.

Rogoff K. ‘The Optimal Degree of Commitment to an Intermediate Monetary Target’, QuarterlyJournal of Economics 100, 1985, pp. 1169–1190.

Alesina, A. and L.H. Summers ‘Central Bank Independence and Macroeconomic Performance:Some Comparative Evidence’, Journal of Money, Credit and Banking, Vol. 25, No. 2, 1993, pp.151–162.

Clarida, R., J. Gali and M. Gertler ‘The Science of Monetary Policy: A New KeynesianPerspective’, Journal of Economic Literature XXXVII(4), 1999, pp. 1661–1707.


This is an example of an essay type question that candidates can expect in Section B with thenew exam format. Candidates were supposed to explain the basic inflation bias problem ofdiscretionary monetary policy using an aggregate supply function and a loss function for thecentral bank. They needed to explain the various equations and intuition behind the result.They could have used the quadratic loss function of the central bank which penalises deviationsof inflation and output around target levels. An excellent source for this question which discussesthe models in detail is Walsh (2003), Chapter 8. An anti-inflation reputation of the central bankwould mean a higher weight attached to fighting inflation in the loss function of the central bank.A higher weight would reduce the inflation bias (see Rogoff (1985)). A good answer would haveindicated that there is a potential distortion to stabilisation policy as a result: while averageinflation may be low, there is a potential cost in terms of higher output volatility. See Walsh(2003), Section 8.3.2, for a good theoretical discussion and Alesina and Summers (1993) for anempirical test of this proposition. Clarida, Gali and Gertler (1999) is an excellent recent sourcefor the inflation bias in the context of the recent micro-founded models that are in use today; see

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also Walsh (2003), Chapter 11. An excellent answer would have demonstrated knowledge wellbeyond the material in the subject guide.

Comments on answers

This question was not frequently attempted. The answers were very heterogeneous in terms ofquality. Some candidates provided a very detailed analysis while others simply tried to explainthe intuition without using an explicit model.

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