EC422 Advanced Macroeconomics Tutorial 2

Please attempt all questions in advance of your scheduled tutorial in week 5, either on
your own, or with others. Take your answers with you to the tutorial.
Refer to lectures 2 to 4 and to C&S Chapters 2, 3, and 4 as appropriate.

Question 1:
a) Changes in the actual (observed) unemployment rate can be decomposed into a cyclical
component and a structural or equilibrium component. Provide a concise definition of
each.

b) Suggest one factor that increase i) cyclical unemployment and another that can increase
ii) structural unemployment.

c) Think about the IS and WS-PS models developed in Lectures 1 and 2. Which model (and
curves) do we use to explain changes in b)i) and which ones do we use to explain
changes in b)ii)?

Question 2:

Consider the IS-PC-MR model with adaptive expectations, such that πe = π-1.
a) What does the MR curve represent? Using a suitable diagram, explain how the MR curve
is derived.

b) The figure below illustrates equilibrium in the IS-PC-MR model. Set out the conditions
that hold in this state.
c) If the equilibrium is disturbed by any ‘shock’ the lag structure of the model means that
the Central Bank is unable to affect the initial impact of the shock, but it will work through
clear steps to determine its appropriate policy response in subsequent periods.
Set out each of these steps in order.

Question 3
Use the IS-PC-MR model to contrast the response of an inflation-targeting Central Bank to:
a) an increase in cyclical unemployment due to a negative aggregate demand shock.
b) a similar sized increase in the unemployment rate, but one that is entirely structural, i.e. a
rise in the NAIRU.
c) How does optimal monetary policy change in b) if wage and price setters keep their
inflation expectations anchored to 2% target rate in the belief that the central bank will do all
it can to control inflation. Use the IS-PC-MR model to support your reasoning.
Hint: For part c) focus on the differences between the policy rate the Central Bank choses at
the end of period zero (as the impact of the shock becomes clear), and on the subsequent
paths of inflation and output in the period after the shock (period 1).

Question 4
A year ago the credibility of the Bank of England seemed to be poor (see Public confidence
in Bank of England’s inflation strategy hits record low, Valentina Romei, FT September 15,
2023).
What do you consider to be the main reasons for this? What could be done about it?
Hint: perhaps take some inspiration from the Financial Times, for example:
• A bumpy ride: the Bank of England governor’s first three years, Chris Giles, FT March
16 2023
• The Bank of England needs to improve its communication on inflation, Opinion, Jagdit
Chadha May 24 2023.
• Ben Bernanke to lead Bank of England review into forecasting FT July 28 2023
• The Bank of England Walks a Tightrope, FT Editorial Board, August 3 2023.
• ECB must accept forecasting limitations to restore trust, says Christine Lagarde FT
September 4 2023,

Julia Darby, October 2024

 EC422 Advanced Macroeconomics
Tutorial 2 Answer Guide
Question 1:
Key elements of answer:
This diagram shows the emergence of cyclical unemployment. Students should note that the
cyclical component here is that in excess of the equilibrium unemployment, and equilibrium
unemployment = structural unemployment.

The diagrams below show increases in structural (=equilibrium) unemployment. Another

possibility (not illustrated here, would involve shifts in both LF and WS – e.g. a change in
immigration policy).
Figure 2.5: The impact on equilibrium unemployment of shifts in WS and PS curves
i) Higher unemployment benefits → ii) Higher mark-up (less competition)
WS shifts up → higher equilibrium U, shifts PS down → higher equilibrium U
but real wage fixed by PS. and lower equilibrium real wage.

Question 2:

a) The MR curve represents the best response monetary rule in the context of an inflation
targeting central bank. More specifically, on any Phillips curve the central bank faces, the
MR curve provides the optimal output-inflation pair that will minimise the loss incurred
from being away from the inflation target and equilibrium output. The slope of the MR
 curve is affected by the central bank’s degree of inflation aversion and by the slope of the
Phillips curves i.e. the sensitivity of output (and unemployment) to changes in inflation.

The appropriate diagram was covered in lecture 3

Strong students should be able to discuss how either a change in inflation aversion of the
CB or a change in the responsiveness of inflation to output & unemployment, affecting
the slope of PC, will impact upon the slope of the MR curve.

b) Conditions that hold in equilibrium in the IS-PC-MR model…

• Output and unemployment at their equilibrium levels y = ye, U =Ue
• Constant inflation, at the target rate, with inflation expectations set to the inflation
target. 𝜋 = 𝜋T = 𝜋e
• The real interest rate at the stabilising rate r = rs
• CB losses = 0 (at bliss point).

c) Step 1) OBSERVE the shock, i.e. observe y0 and 𝜋0

Step 2) Use this information to FORECAST the PC curve and IS curve for the next
period;
Step 3) CALCULATE the best response, i.e. the combination of inflation and output y1
and 𝜋1 that minimise the loss function, given the forecasted PC curve --- > that is, find
the appropriate point on the MR curve;
Step 4) SET the real interest r0 using the forecast IS curve to deliver y1 and 𝜋1
Question 3
This answer guide goes through a) and c) for the demand shock, with adaptive expectations,
and only briefly covers what happens in this case if inflation expectations are anchored at
target, and leaves students to go through the analysis of the shock that increases in structural
unemployment. They can draw on lecture 4 to modify the analysis if expected inflation remains
anchored at the target, and section 3.3.4 in C&S (pages 107-109) to help them, but the book
covers a positive supply shock resulting in reduction in structural unemployment, while the
tutorial requires them to reverse this.

Key diagrams are as follows:

An appropriate explanation that clearly goes through the steps set out in Qu2 c) is expected.
Students should focus in detail on A → B → C, then briefly discuss ongoing adjustment to Z.
(If expectations remain anchored, the economy still moves from A→B but then directly to Z,
with the full reduction in the interest rate occurring as soon as the CB responds to the initial
shock. It’s necessary to make an assumption on whether the economy stays at IS’ at point C
or goes back to IS. If IS remains at IS’ point Z will be at ye with rz. Since the question doesn’t
specify, you could also choose to analyse a temporary demand shock.
If there is time, it might be a good idea to have a discussion about whether fiscal policy could
be used to shift IS’ back to IS, making the job of monetary policy easier. But the priority
should be 1) the correct diagrams and 2) the correct, and detailed, explanation of the
adjustment. Sketching out the impulse responses would also be helpful.
The example I have illustrated is the reverse of the permanent positive demand shock
discussed in C&S Ch3 in figure 3.4 and the surrounding text (pages 90-92). The detailed
explanation below draws on this text, but reverses the directions of the effects given that a
negative demand shock is specified here.
• The demand shock has its initial negative impact on output and employment shown by
the leftward shift in the IS curve and the movement from A to B in the IS diagram.
• In the labour market diagram, the impact of the fall in demand is reflected in a
disturbance in the initial constant-inflation equilibrium. At the first wage-setting round
following the rise in unemployment there is recognition that the shock has opened up a
gap between the prevailing real wage and a lower real wage consistent with the
reduction in labour market tightness will be agreed. Firms will then adjust prices, given
lower wage costs and their constant profit margin. As a result, wage and price inflation
will fall below 𝜋T.
• The reduction in inflation is shown by the movement along the Phillips curve (PC) from A
to B.
• We now need to take into account that lower inflation, at 𝜋0 will become embedded in the
expectations of wage setters for the next wage-setting round.
• The central bank must anticipate this change in inflation expectations when taking its
decision on the policy rate of interest. They forecast that PC will shift to PC1 on which
inflation is expected to remain at 𝜋0.
• Given this forecast of inflationary behaviour, the central bank chooses its best response
to the situation – the point on PC1 that reflects its preference for a balanced response –
making progress on returning inflation back to target but not generating an excessive
boost in demand – choosing point C on the MR line, which shows the central bank’s
optimal output-inflation pair (y1 and 𝜋1) for any Phillips curve it faces.
• In the IS curve diagram the central bank has to take a view on whether the reduction in
demand will persist or not. To deliver y1 they need to choose the policy rate consistent
with point C. The reduction in the interest rate should then feed through to higher
aggregate demand via the channels spelt out in the transmission mechanism of monetary
policy, moving the economy along IS’ to point C, and inflation should rise to 𝜋1 as
forecast.
• The adjustment process should continue. Inflation expectations should adjust to the new
higher rate, PC should shift up from P1 towards PC, and the policy decision of the central
bank should again be chosen as a point on MR between point C and point A…
adjustment should continue until the economy is back at equilibrium output and target
inflation (point Z). There will, however, be a lower interest rate at the new equilibrium, as
shown in the IS diagram.
Question 4
Open discussion based around the articles identified and any others found by the students.