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Monetary Economics (Quiz 2A)

Lahore School of Economics

Monetary Economics

Winter Term, 2012

Quiz 2A: B.Sc. III B

Instructions: Answer all questions in the spaces provided below. For full marks, make sure
you write all relevant points and do all necessary calculations. Pencils, pens, rulers, etc.
cannot be shared and cell phones cannot be used during the session. Total points: 65

Question 1

Compare the general equilibrium excess demand functions of barter economy and monetary
economy. (7 points)

Excess demand function in a barter set up is D S; whereby Di is a function of relative prices and
total endowment value.
2 3 ( 1)
= , ,, ,
1 1 1 1

There are n 2 prices of n 1 goods. To find the price of each good, it is divided by a superior
good, Good 1 in this case. In a GE framework, each term within the bracket of the equation
above would be a numeric value, for example, P2/P1 = 2 would indicate that unit of Good 1
can be bought with 1 unit of Good 2. Similarly, relative price of the goods is given in terms of
one specific good chosen to be a reference against which everything else takes its value. It
could be priced in terms of gold. In a barter set up, ED = 0 by the end of a working day because
Says Law is a must.

In a monetary economy set up, excess demand function is the same as barter system, except
for the fact that each good is priced against absolute price level (or price of money)

1 2 (1)
= ( , , , , = 1 )

If goods are exchanged with the use of money, then EDG = ESM and ESG = EDM. This is how
monetary and real sectors are inter-related. It also indicates that Says Law is not a necessity.
Changes in absolute price level do not change relative prices or the function of excess demand
because it affects all the relative prices equally through the denominator. This characteristic is
known as homogeneity postulate. Absolute price level can be thought of a constant which, if

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Monetary Economics (Quiz 2A)
taken out of the excess demand function, can be given a degree of 0. This would not change
the meaning of the equation and excess demand would still be a function of goods own money
price and total endowment value. It should be noted that relative price levels are not important
in a monetary set up, but they are a key feature of barter set up.

Question 2

The 'classical' theoretical system has a dichotomous structure (monetary aspects are
separated from real aspects) in which, according to the quantity theory of money, the money
supply has the sole function of determining the absolute level of prices, remaining neutral
with regard to the real economy. Explain this statement of the Classical Theory of Money (8

Real sector can work with ant level of absolute prices, which are determined in quantity theory
of money. Money is acting as medium of exchange of goods and services but if it wasnt there,
exchange of goods would still have taken place. Hence, classical economists, including Pigou
(1941) elaborated that money is acting as a veil. Money market ALONE is worthless if Real
Goods Market vanishes! But market for real goods can survive even if money market is not
there. Money is thus neutral

The other way through which money neutrality was explained is the DIRECT effect of monetary
policy transmission mechanism. Refer to the following graph:

Lower money supply shifts the MS curve backwards. As MS falls, people expect the prices to fall
as QTM is assumed to be a valid theory in this economy. It shifts the MD curve backwards too
as people demand less cash (as prices are expected to fall). Immediately as MS curve shifts
backwards, there is excess demand of money in the economy ESG in goods market Prices
fall continuously in direct proportion to the decrease in MS (as less money is chasing same

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Monetary Economics (Quiz 2A)
amount of goods at full employment level). Hence, lower money supply wont change the
output; it will only reduce prices.


Question 3

Using the loss function stated by Svensson (targeting), answer the following questions

(A) What is the optimal inflation rate? (10 points)

2 2
= () ( ) + ( )
2 2

If we derivate this, dL/d = b / (a + f) + fT/(a + f). Derivation should be shown to get

full credit.

+ 2
Other equation: = ( ) ( )

Derivate this equation w.r.t. inflation rate and the answer would be b/(a + f). (Again,
derivation should be shown)

(B) Why is this loss function better than the previous loss functions? Use the concepts of
inflation bias and time-consistent policy to explain the answer (10 points)
Despite any shortcomings, this function is better because:

1) The inflation bias has been reduced

2) The target level of inflation is announced. Authorities dont need to monitor central
banks as it would sooner or later be realized how different actual inflation is from
the target level
3) Since higher inflation rate and deviation from target is more costly for the society, it
is in the best interests of the authority that the inflation rate announced is
maintained. There is a greater incentive for a time-consistent policy

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Monetary Economics (Quiz 2A)
Question 4

Rogoff stated that L = a/2 ()2 c( e). Explain this function and critically evaluate the
findings. How did Cukierman and Lohmann (1992) modified this loss function? (10 points)

As inflation increases, losses of the central bank reduce by c and increase by a/2 but as
inflation keeps on increasing, losses (measured by a/2) exceed the benefits (measured by c) as
function is quadratic in inflation. Relative weight given FOR inflation has been reduced to c
from b (it was b in the original Barro and Gordons loss function). Rogoff advocated this
because he believed that a central bank is a conservative institution whose preferences are
lower and stable inflation rates. Hence, benefits of inflation reduce from b to c in the central
banks loss function.

Optimal inflation rate = c/a which is less than b/a.

Criticisms of the approach include:

There is still imperfect information on the CBs being a conservative institution

How does a CB commit to announcements in a more credible way than government?
If government was untrustworthy (in terms of committing to a rule) because of which
the responsibility was delegated to CB, should CB also delegate it further to a more
conservative body?
CBs conservative attitude is not important. More significant is the institutional
structure! Cost of cheating = Loss of reputation and if this loss is considered to be huge,
institutions would not cheat. So, strong moral attitude is better than a conservative

Cukierman (1992) said that it depends on a CBs degree of independence before Rogoffs
approach can work.
= 2 ( ) ( )
= + (1 )
= degree of CB independence
If = 1, then d = c and = c/a (Rogoffs)
If = 0, then d = b and = b/a (Barro and Gordon)

Lohmann (1992) said that in addition to central bank independence and conservative
preferences, optimal policy making should include threat of government of ending CBs
independence. This would kill any incentive to cheat on the CBs part

Question 5

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Monetary Economics (Quiz 2A)
When Svensson explained inflation targeting, he said that it can be stated as a Taylor Rule:

Explain how the target, T should be set, i.e. explain the significance of and partial-
adjustment towards the target over-time. (10 points)

Svensson said that inflation targets are not targets for today but targets for tomorrow since
todays interest rate policy will not affect inflation today, it will effect inflation after a lag of 1.5
to 2 years. Thus authorities should use forecast of future inflation as a flexible targeting rule.
Once future target is set, short run intermediate targets are derived.

The solution indicates that two year ahead inflation forecast:

+2 = + ( +1 )

Whereby, = weight that quantifies how expected value of inflation in time period two is
different from the target value with respect to the difference between expected inflation in
time period one and the target value. There will be discrepancies between expected inflation
and target inflation rates and these differences will minimize (that is, will be less than one) as
future target inflation is achieved after many time periods, that is, there will be partial
adjustment towards the target.

The equation shown in the question is the Taylor rule. It states that if in time period 1, inflation
is higher than the intermediate target level (of period 1), then interest rates have to increase by
so that intermediate target is achieved. The inflation forecast is a function of short term
interest rate and therefore changes to the instrument will drive the intermediate variable
(expected inflation in time period 2) and ultimately the goal variable (inflation in time period 2)
towards the target inflation.

Question 6

If central bank pegs the interest rate in the money market, how would a cash shortage
(higher demand for reserves) be eliminated? (10 points)

The diagram below elaborates the money market with different reserve regimes.

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Monetary Economics (Quiz 2A)

The relevant reserve regime is known as interest rate targeting or pegged interest rates at r1. The
supply of reserves is perfectly elastic, S1 and the demand curve is the same as before. As demand
curve shifts rightwards to resolve any liquidity shortage, central bank intervenes and supply the
extra reserves needed (by open market operations) in the banking system. Borrowing is not done as
central bank supplies reserves to take care of the excess demand.

Pegged Interest Rates

In this case, if the interest rates

are pegged at rf, then higher
demand for cash reserves (from
demand 1 to demand 2) would
force the monetary authorities to
supply more reserves such that
interest rates remain at rf.
Reserves would increase to R2
from R*

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