PART A

PART A

Question 1:
(a) Explain mathematically and conceptually the difference between firmly and partially
anchored expectations.
(10 marks)

The Phillips curve now takes the following form:

π t =¿

E T
Where π t = χ π + ( 1− χ ) π t −1 and χ is a parameter indicating central bank credibility

χ =1: Firmly anchored expectations

0< χ <1: Partially anchored expectations

(b) Use the 3-equation model to illustrate the effect of a deflationary shock on the
economy in the case of firmly anchored expectations.
(10 mark
A deflationary shock has the opposite effect as in the diagram above. The PC curve shifts
down for one period but then shifts back in the next period.

(c) Use the 3-equation model to illustrate the effect of a deflationary shock on the
economy in the case of partially anchored expectations.
(10 marks)

A deflationary shock has the opposite effect as in the diagram above. The PC curve shifts
down and the CB needs to go through an adjustment process of first lowering the interest
rate and then gradually increasing it after.

(d) Explain how your answer in part (c) differs from that in part (b) and from the case of
fully unanchored expectations.
(10 marks)

χ =0: Fully unanchored expectations:

  After a deflationary shock the central bank needs to lower the interest rate. There are
some periods during which y t > y e and the adjustment to equilibrium is costly.

χ =1: Firmly anchored expectations:

 The effect of a deflationary shock only lasts one period. In period two, the PC reverts
E T
back to the PC with π t =π . The central bank does not need to change the interest

rate and disinflation is costless, meaning y t = y e.

0< χ <1: Partially anchored expectations:

 After a deflationary shock the central bank needs to lower the interest rate but to a
lesser extent as in the fully unanchored case of χ =0. The rise in output is lower and
the adjustment is quicker than in the fully unanchored case.

PART B

Question 2
(a) Outline the central bank loss function and the Phillips curve and mathematically
derive the MR.
(10 marks)

The central bank loss function is given by the following:

2 T 2
L=( y t − y e ) + β (π t−π )

The higher the loss L, the worse it is for the CB. The central bank is worse off the further
inflation π t is away from its target level π T and the further output y t is away from its
equilibrium level y e . β reflects the relative degree of inflation aversion of the CB.

The Phillips curve is a constraint for the central bank, because it shows all the output and
inflation combinations from which the CB can choose for a given level of expected inflation.
 E
π t =π t + α ( y t − y e )

Deriving the MR curve:

2 E T 2
L=( y t − y e ) + β (π t + α ( y t− y e )−π ) =0

2 ( y t − y e )+ 2 αβ ( π Et + α ( y t − y e )−π T )=0

2 ( y t − y e )+ 2 αβ ( π t−π T )=0

2 ( y t − y e )=−2 αβ ( π t −π T )
T 2
( y ¿ ¿ t− y e )=−αβ (π t −π ) ¿

(b) Draw the central bank loss circle the Phillips curve and the MR curve for the case
where the central bank adopts a balanced approach.
(10 marks)

(c) Graphically and in words explain the difference in the central bank loss function in the
case where the central bank is more unemployment averse.
(10 marks)
In this case central bank attaches more importance to being away from equilibrium output
than from the inflation target. This results in a more egg-shaped loss circle and as a result in
a steeper monetary rule. Given these preferences, any inflation shock that shifts the Phillips
curve upward implies that the optimal position for the central bank will involve a smaller
output reduction than in the balanced case.

Question 3
a) Use the 3-equation model to show the impact of an increase in consumer confidence
on the economy. Make sure you show the period 1 mark-up on your diagram and
discuss what happens to both the policy rate and the lending rate.
(10 marks)
The increase in consumer confidence shifts the IS curve to the right. The CB responds using
'
the MR curve to determine its desired output gap by raising the policy rate to r p to achieve a
lending rate of r 0 . The increase in lending rate dampens AD and pushes down inflation. The
'
policy rate is then lowered over following periods until the lending rate reaches r S , hence,
T
economy gradually returns to π ∧ y e .

b) Use the 3-equation model to discuss whether contractionary fiscal policy should be
used in the case of increased consumer confidence.
(10 marks)
 If contractionary fiscal policy is used the IS curve shifts to the left. Depending on the
size of the policy, this might cancel out the initial rise in consumer confidence. If so,
the central bank might not need to intervene through interest rate changes.

c) The UK government introduced lending targets for the five major UK banks after the
global financial crisis. Use the simple model of the macroeconomy and the financial
system to discuss this policy. Make sure you refer to:
i. Whether you think the policy makes economic sense.
ii. Are there any potential pitfalls with the policy?
iii. How could it affect stabilization policy?
(10 marks)

A policy aimed at introducing lending targets for the major banks seeks to bring them back
towards what is generally deemed as the core activity for a banking system: providing loans
to households and to small and medium sized firms. The financial crisis worsened bank
balance sheets and saw a reduction of lending, perceived by banks as too risky. In principle,
therefore, a policy of lending targets could be effective. Being obliged to increase the share
played by loans in their balance sheets, banks would regain the role of stabilising the
economy that is typical of the model considered here.

There are two factors that limit the effectiveness of a policy of lending targets.
 - the first relates to the incentives of the banks and
- the second to the demand for loans by firms.

When the regulatory authorities are trying to improve the safety of the banking system by
requiring banks to have larger equity cushions, there will be a tendency for banks to reduce
their lending. Setting higher lending targets is an attempt to prevent this reaction by banks.
This highlights the difficulties for the government in inducing the banks to contribute to
stabilization in a recession by raising their lending at a time when the authorities are also
attempting to ensure a safer financial system by requiring banks to reduce leverage.
Reducing their lending is a direct way of reducing leverage. The second factor that may limit
the effectiveness of policy relates to the demand for credit. In particular, firms may reduce
their demand for loans because they have low confidence in the future profitability of their
own business. If it is credit constrained firms that represent the main driver of the slowdown
in investment during a recession, increasing bank lending may improve their external
financing position and help the economy to recover, inducing a virtuous cycle. If, on the other
hand, credit is depressed mainly because of weak demand for loans due to the lack of
confidence of firms in the future of their business, a policy of setting lending targets may be
ineffective.

Question 4

An economy experiences an inflationary shock.

(a) Draw the PC-MR, the IS-RX and the AD-ERU diagrams to help you explain the path
back to medium-run equilibrium.

(15 marks)
 ¿
After an inflationary shock, the Forex market foresees that r >r for some periods. Via
the UIP condition the real exchange rate appreciates immediately. To get the
economy on the MR curve, the CB sets r 0 on RX at ‘C’, which factors in the new
IS (q 0). The higher r 0 and appreciated q reduces output y next period due to a lag in
transmission. Both output and inflation fall and the PC shifts down. The CB desires
point ‘D’ now, but the CB knows that a lower r means that the real exchange rate will
depreciate. Therefore, the IS predicted to shift right. As before, the CB sets r 1 on RX.
The process repeats until MRE ‘Z’ is reached.

(b) Draw the 3-equation model to help you explain the path back to medium-run
equilibrium in the closed economy.

(10 marks)
 Period 0:
• The economy is initially at point ‘A’ (the Bliss point)
• The PC Curve shifts upwards due to the inflation [Link] economy moves from A
to B.
• The CB wants to move to point C by raising the interest rate to r 0 .

Period 1:
• The economy is now at point C.
E
• The CB forecasts PC for the next period, which is PC ( π 1 =π 1) to locate at point D.
• The CB lowers the interest rate and repeats this process until the new equilibrium Z
is reached which is equal to the initial equilibrium.

(c) Comment in detail on the differences between the closed and open economy
adjustment paths in your diagrams.
(5 marks)

Differences: Closed vs Open Economy:

1. Initial rate hike after π shock (to r 0 ) is greater in closed economy because q
appreciation shoulders the burden of adjustment in the open economy.
2. IS shifts each period in the open economy as the change in q also changes y due to
net exports.
3. The closed economy moves along IS to equilibrium; the open economy moves along
the flatter RX back to equilibrium.