EC3115

Summer 2020 online assessment guidance

EC3115 Monetary Economics
The assessment will be an open-book take-home online assessment within a 24-
hour window. The requirements for this assessment remain the same as the
originally planned closed-book exam, with an expected time/effort of 3 hours and 15
minutes (inclusive of fifteen minutes reading time).

Candidates should answer ELEVEN of the following THIRTEEN questions: all

EIGHT from Section A (5 marks each) and any THREE from Section B (20 marks
each). Candidates are strongly advised to divide their time accordingly. If more than
eleven questions are answered, only the first questions attempted will be counted.

You should complete your assessment using pen and paper. Please use BLACK
ink only.

Handwritten work then needs to be scanned, converted to PDF and then uploaded to
the VLE as ONE individual file including the coversheet. Each scanned sheet
should have your candidate number written clearly at the top. Please do not write
your name anywhere on any sheet.

The paper will be available at 12.00 pm (BST) on Friday 10 July 2020.

You have until 12.00 pm (BST) on Saturday 11 July 2020 to upload your file into
the VLE submission portal. However, you are advised not to leave your submission
to the last minute. We will deduct 5 marks if your submission is up to one hour late,
10 marks if your submission is more than one hour late but less than two hours late
(etc.).

The assessment has been designed with a duration of 24 hours to provide a more
flexible window in which to complete the assessment and to appropriately test the
course learning outcomes. As an open-book assessment, the expected amount of
effort required to complete all questions and upload your answers during this window
is no more than 3 hours and 15 minutes. Organise your time well and avoid working
all night.

You may use any calculator for any appropriate calculations, but you may not use
any computer software to obtain solutions. Credit will only be given if all workings are
shown.

You are assured that there will be no benefit in you going beyond the expected 3
hours and 15 minutes of effort. Your assessment has been carefully designed to help
you show what you have learned in the hours allocated.

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This is an open-book assessment and as such you may have access to additional
materials including but not limited to subject guides and any recommended reading.
But the work you submit is expected to be 100% your own. Therefore, unless
instructed otherwise, you must not collaborate or confer with anyone during the
assessment. The University of London will carry out checks to ensure the academic
integrity of your work. Many students that break the University of London’s
assessment regulations did not intend to cheat but did not properly understand the
University of London’s regulations on referencing and plagiarism. The University of
London considers all forms of plagiarism, whether deliberate or otherwise, a very
serious matter and can apply severe penalties that might impact on your award. The
University of London 2019-20 Procedure for the Consideration of Allegations of
Assessment Offences is available online at:
https://london.ac.uk/sites/default/files/governance/assessment-offence-procedure-
year-2019-2020.pdf

The University of London’s Rules for Taking Online Timed Assessments have been
included in an update to the University of London General Regulations and are
available at:
https://london.ac.uk/sites/default/files/regulations/progregs-general-2019-2020.pdf

© University of London 2020

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Section A
Answer all EIGHT questions from this section. Each question is worth 5 marks.

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.

1. Money is typically a good store of value.

2. Money demand is higher when there is a lot of uncertainty.

3. A doubling of the velocity of circulation results in the price level doubling.

4. The Phillips curve provides a justification for the relevance of monetary policy in the
short run.

5. US monetary aggregates have lost their informational content for inflation and real
output in recent times.

6. Empirical evidence suggests that money is super-neutral.

7. In Lucas’ misperceptions model real effects of monetary policy persist in the long-run.

8. Under the segmentation hypothesis, the yield curve can be used to make predictions
about expected inflation.

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 Section B
Answer THREE out of FIVE questions from this section. Each question is worth 20
marks.

9. Consider the Cagan(1956) model of hyperinflation. Let the money demand function be

mt − pt = αy − βRt ,

and the Fisher equation is given as

Rt = r + (pet+1 − pt ),

where mt is the log of money, pt and pet+1 are the current and expected log price levels;
Rt is the nominal interest rate. Log output, y, and the real interest rate, r, can be
assumed constant. Define the growth rate of money as ∆mt = µ.
(a) (5 points) Derive, mathematically, the inflation rate, given some level of µ.
(b) (5 points) Explain how hyperinflation can arise in this model and how it affects the
demand for money.
(c) (5 points) Explain why a government may wish to engage in money creation and
how this can lead to hyperinflation.
(d) (5 points) A more recent phenomenon is the widespread experience of a very rapid,
but non-explosive inflation as a result of a continuing government deficit, see for
example the experience of Argentina and some other Latin American countries.
Explain how this can be a stable equilibrium outcome; you may wish to show
graphically.

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10. Consider a Real Business Cycle model with money in the utility. The representative
agent derives utility from consumption goods, Ct , and real money balances, Mt /Pt , but
also from leisure, defined as (1 − lt ) where lt is labour supplied. Utility is obtained
from these variables not only today but into the future, discounted at rate β. Assume a
lifetime utility function of the form:
∞  
X
t Mt
U= β ln Ct + ζ ln + γ ln(1 − lt )
t=0
Pt

where ζ and γ are constant preference parameters. The individual maximises utility
subject to a budget constraint given in real terms.
Mt Bt+1 Wt Bt Mt−1
Ct + + = lt + (1 + Rt−1 ) + .
Pt Pt Pt Pt Pt
The left-hand side comprises of consumption, Ct , real money balances, Mt /Pt , and sav-
ings, Bt+1 /Pt . The right-hand side comprises of real wage income, W t
Pt t
l , capital income
Bt
,(1+rt−1 ) Pt —where Rt−1 is the nominal rate of return on savings, (Bt ), from the previous
period—and real money balances, MPt−1 t
, carried over from the previous period.
(a) (4 points) Write down the dynamic Lagrangian.
(b) (5 points) Solve for the optimal consumption in t as a function of consumption in
t + 1, rate of return rt and discount rate β. Comment.
(c) (5 points) Solve for optimal labour supply lt as a function real wages W
Pt
t
and con-
sumption Ct . Comment. Would your results change if the consumer would not
derive utility from real money balances?
(d) (6 points) Solve for the real money demand Mt /Pt as a function of Ct and Rt .
Comment.

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11. Consider a classical Patinkin economy where a representative household utility is a func-
tion of consumption, C, and real money balances, M/P , such that

Ut = Ctα (Mt /Pt )1−α ,

and the household is subject to a budget constraint given by

Ct + Mt /Pt ≤ Yt + Mt−1 /Pt .

Yt is the endowment and Mt−1 are the money balances accrued in the previous period.
(a) (6 points) What is the justification of adding money balances to the utility func-
tion?
(b) (8 points) Calculate optimal goods and money demand. Provide intuition. If ele-
ments in the utility function were additive of the form,

Ut = Ctα + (Mt /Pt )1−α ,

instead of multiplicative, would your results change qualitatively? Discuss briefly

using the new first order conditions?
(c) (6 points) Is there a role for monetary policy in this setting? What happens when
the economy faces a money supply increase? Show graphically and provide intuition.

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12. Consider a McCallum economy with sticky prices where the aggregate demand expression
given as:
yt = β0 + β1 (mt − pt ) + β2 Et−1 [pt+1 − pt ] + νt ,
where yt , mt and pt are the logs of real output, nominal money balances and the price level
respectively at date t, νt is an i.i.d. normal aggregate demand shock with νt ∼ (0, σν2 ),
β0 , β1 , β2 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 p∗t ;

(ii) the prices are set by firms at t − 1 and will only be effective in t; furthermore prices
are equal to the expected to be market clearing price at time t, i.e. pt = Et−1 [p∗t ];
(iii) real output consistent with natural rate of unemployment, (y ∗ ), is determined by
the following law of motion

yt∗ = δ0 + δ1 t + δ2 yt−1
∗
+ ut

where t being time trend, δ0 , δ1 , δ2 positive parameters and ut is an i.i.d. normal

aggregate supply shock with ut ∼ (0, σu2 );
(iv) the monetary policy is characterized by the expression

mt = µ0 + µ1 mt−1 + et

where et is an i.i.d. normal money supply shock with et ∼ (0, σe2 ).

(a) (5 points) Solve for the output gap, i.e. deviations of real output from the market
clearing level.
(b) (5 points) Are unanticipated monetary policy changes effective? Show analytically
and provide intuition.
(c) (5 points) Are anticipated monetary policy changes effective? Show analytically
and provide intuition.
(d) (5 points) Can Quantitative Easing (QE) programmes be effective if the model
described above is indeed reflecting the reality? If yes, explain. If no, when can QE
policies be effective policy tools?

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13. Consider the aggregate supply curve

yt = y ∗ + α (πt − Et−1 [πt ]) + t .

where y ∗ is the market clearing level of output, πt is inflation rate and t is a productivity
shock term where its mean is set equal to zero. Suppose that the monetary authority
chooses the inflation rate directly and tries to minimise the following loss function:

L = πt2 + λ(yt − ky ∗ )2 where k > 1.

λ shows the authority’s preference for output fluctuations relative to inflation fluctua-
tions. Assume that k > 1 so that a level of output greater than the market clearing level
is desired reflecting political biases towards higher output.
(a) (5 points) Show graphically that in this environment the monetary authority with-
out inflation commitment has an inflation bias. Discuss.
(b) (5 points) Show analytically the size of the inflation bias.
(c) (5 points) Discuss three elements that determine the level of inflation bias.
(d) (5 points) Suppose that the central banker would be penalised, by way of reduced
salary, for allowing any inflation above the socially desired level, set in this case at
zero. Suppose Ψ parameter reflects this penalty in the contract. The loss function
that would be minimised would then be:

LContract = πt2 + λ(yt − ky ∗ )2 + Ψπt .

So that the central bank’s loss depends on the level of inflation through the Ψ
parameter as well as squared inflation and squared output deviations. Show the
size of the Ψ that would reduce the inflation bias to zero.

END OF PAPER

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