~~EC3115 ZA d0

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

EC3115 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route

Monetary Economics

Wednesday, 22 May 2013 : 10.00am to 1.00pm

Candidates should answer ELEVEN of the following EIGHTEEN questions: 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.

PLEASE TURN OVER

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Section A
Answer EIGHT questions from this section.
Indicate whether the following statements are true, false, or uncertain and give a short
explanation. Points are only given for a well reasoned answer.
1. Indirect barter cannot solve the Wicksell problem when all individuals are self-sucient.
2. The classical dichotomy refers to a case where money demand and money supply
should be analyzed separately.
3. Non-superneutrality of money describes the situation when price changes always aect
real variables.
4. Friedmans rule of constant money growth is an artefact of monetary neutrality arguments.
5. In Lucas misperceptions model symmetric information leads to real eects of unanticipated monetary policy shocks.
6. The concept of time inconsistency of policy refers to implementation lags of monetary
policy.
7. The baseline Real Business Cycle model predicts a negative association between prices
and real output in the case of technology shocks.
8. In a Keynesian model with sticky wages, monetary policy shocks lead to countercyclical
wages.
9. Parameter uncertainty in the Brainard model implies more aggressive scal policy action.
10. The preferred habitat hypothesis of interest rates can realistically explain term premia.
11. According to the Balassa-Samuelson theory, a productivity increase in US non-traded
goods will lead to a real appreciation of the US dollar.
12. The Law of One Price (LoOP) states that all commodities or goods should be sold at
the same price when converted in the same currency.
13. Labour market exibility serves as a buer in a monetary union: It allows countries to
deal better with idiosyncratic shocks.

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Section B
Answer THREE questions from this section.
14. (a) Show how exchange rates are determined under a gold standard. Explain how a
gold standard would, in theory, stabilize balance of payment imbalances.
(b) In the run up to the Euro, the countries that were part of the Exchange Rate
Mechanism (ERM) signed up to the Maastricht treaty, that imposes a number of
economic conditions on those countries. Amongst other things it limits a countrys
budget decit to 3% of GDP and its national debt to 60% of GDP. Discuss the
importance of such conditions on the success of a monetary union.
An Optimal Currency Area (OCA) can be dened as a geographical region in which it
would maximize economics eciency to have the entire region share a single currency.
(c) Consider the following statement: In the light of the current nancial crisis it is
clear that the eurozone is not an optimal currency union and the member states
should return to their original currencies.
Write an essay arguing either in favor or against the above statement. In your essay
you should discuss both sides of the argument.

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15. Assume that the banking sector is described as follows:

D = d0 d1 (i iD )
L = l0 l1 (i iL ),
where L stands for bank loans, D stands for bank deposits, iL the loan rate, iD deposit
rate and i is the market interest rate. Assume that banks do not have operating costs
or are not required to hold reserves.
(a) Calculate the competitive equilibrium. Show graphically. How do your results
change when the government sets deposit rates equal to iD = a, with a < iL .?
Provide intuition.
(b) Now suppose that government introduces a mandatory reserve ratio, r , such that
R = r D. How do your results change? What are the implications of such a reserve
ratio policy on prices and quantities? Provide intuition.
(c) Sometimes, it is suggested that the reserve ratio policy can be an alternative to
targeting interest rates or monetary aggregates. Can this be an eective policy to
stabilize output and ination uctuations?

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16. Suppose that the economy of Uncertainia is well approximated by the following reduced
form relationship between interest rates (i), output gap (y), ination () and an exogenous disturbance term ():

t = yt + at1
yt = bit + t ,
where the error term is i.i.d. normal with t (0, 2 ). Suppose also that the expected
loss function (Le ) of the central bank takes the following quadratic form
Et L = Et (t )2 ,
where represents the target ination. Assume that Central Bank of Uncertainia sets
the target ination rate equal to 0.
(a) Solve for the optimal interest setting when there is no parameter uncertainty.
(b) Now suppose that there is parameter uncertainty, i.e. parameters a and b are time
varying. Assume also that the policymaker knows from which distribution these
parameters are drawn. To capture this, specify b (b, b2 ) and a (
a, a2 ). Now
solve for the optimal interest rate setting rule. How do your results change with
respect to data uncertainty case?
(c) Show graphically the problem with parameter uncertainty.
(d) Now suppose that the Central Bank of Uncertainia sets the target ination as being
2% under parameter uncertainty. How do your results change? Explain your answer
and give intuition for your result

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17. Consider a McCallum economy with sticky prices where the aggregate demand expression
given as:
yt = 0 + 1 (mt pt ) + 2 Et1 [pt+1 pt ] + t ,
where yt , mt and pt are the logs of real output, nominal money balances and the price level
respectively at date t, t is an i.i.d. normal aggregate demand shock with t (0, 2 ),
0 , 1 , 2 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 pt ;
(ii) the prices are set by rms at t 1 and will only be eective in t; furthermore prices
are equal to the expected to be market clearing price at time t, i.e. pt = Et1 [pt ];
(iii) real output consistent with natural rate of unemployment, (y ), is determined by
the following law of motion that captures hysteresis

yt = 0 + 1 t + 2 yt1
+ ut

where t being time trend, 0 , 1 , 2 positive parameters and ut is an i.i.d. normal

aggregate supply shock with ut (0, u2 );
(iv) the monetary policy is characterized by the expression
mt = 0 + 1 mt1 + et
where et is an i.i.d. normal money supply shock with et (0, e2 ).
(a) Solve for the output gap, i.e. deviations of real output from the market clearing
level.
(b) Are unanticipated monetary policy changes eective? Show analytically and provide
intuition.
(c) Are anticipated monetary policy changes eective? Show analytically and provide
intuition.
(d) Can recently announced Quantitative Easing (QE) programmes be eective if the
model described above is indeed reecting the reality ? If yes, explain. If no, when
can QE policies can be eective policy tools?

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18. (a) Consider a two country world. Prove that if both Uncovered Interest Parity (UIP)
and relative Purchasing Power Parity (PPP) hold, real interest rates will be equal
in both countries.
Parts (b) and (c):
Consider the following data
Variable

Value

Current Spot Rate

Forecasted next years Spot Rate
Forward Rate (1 year maturity)
Pound interest rate

1.59
1.65
1.61
1.1%

Where the exchange rate is dened as dollars per pound.

(b) All else equal, calculate the dollar interest rate for which CIP would hold in the
above example.
(c) Assume the actual dollar interest rate is 3.2%. Calculate a trading strategy that
yields a risk free payo now of 100 dollars. Explain your answer.

END OF PAPER

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