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    Monetary Economics: Problem Set #3 Due Thursday September 11th in Class

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    youzy rk
    This problem set introduces students to key concepts in monetary economics through a series of questions related to new Keynesian models. Students are asked to: 1) Solve for equilibrium inflation and output gap terms based on policy shocks and exogenous shocks. 2) Explain how shocks impact inflation, interest rates, and output, and determine the optimal feedback coefficient to minimize variability. 3) Compare interest rate versus money supply rules, showing how optimal policy can be achieved through interest rates but not constant money supply, then deriving the optimal money supply rule.

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    Monetary Economics: Problem Set #3 Due Thursday September 11th in Class

    Uploaded by

    youzy rk
    17 views2 pages
    This problem set introduces students to key concepts in monetary economics through a series of questions related to new Keynesian models. Students are asked to: 1) Solve for equilibrium inflation and output gap terms based on policy shocks and exogenous shocks. 2) Explain how shocks impact inflation, interest rates, and output, and determine the optimal feedback coefficient to minimize variability. 3) Compare interest rate versus money supply rules, showing how optimal policy can be achieved through interest rates but not constant money supply, then deriving the optimal money supply rule.

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    This problem set introduces students to key concepts in monetary economics through a series of questions related to new Keynesian models. Students are asked to: 1) Solve for equilibrium inflation and output gap terms based on policy shocks and exogenous shocks. 2) Explain how shocks impact inflation, interest rates, and output, and determine the optimal feedback coefficient to minimize variability. 3) Compare interest rate versus money supply rules, showing how optimal policy can be achieved through interest rates but not constant money supply, then deriving the optimal money supply rule.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    17 views2 pages

    Monetary Economics: Problem Set #3 Due Thursday September 11th in Class

    Uploaded by

    youzy rk
    This problem set introduces students to key concepts in monetary economics through a series of questions related to new Keynesian models. Students are asked to: 1) Solve for equilibrium inflation and output gap terms based on policy shocks and exogenous shocks. 2) Explain how shocks impact inflation, interest rates, and output, and determine the optimal feedback coefficient to minimize variability. 3) Compare interest rate versus money supply rules, showing how optimal policy can be achieved through interest rates but not constant money supply, then deriving the optimal money supply rule.

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    © All Rights Reserved
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    of 2

    Monetary Economics

    Problem Set #3

    Monetary Economics: Problem Set #3


    Due Thursday September 11th in class

    This problem set is marked out of 100 points. The weight given to each part is indicated below.
    Please contact me asap if you have any questions.

    1. Policy tradeoffs in the new Keynesian model. Consider a new Keynesian model with
    output gap and inflation given by
    1
    ỹt = − (it − Et [πt+1 ] − ρ) + Et [ỹt+1 ] (1)
    σ
    and
    πt = βEt [πt+1 ] + κỹt + xt (2)
    where {xt } is an exogenous shock. Monetary policy is given by the interest rate rule

    it = ρ + φπ πt + vt

    where {vt } is an exogenous monetary policy shock and is independent of {xt }.

    (a) Explain in words the economic interpretation of equations (1) and (2). How could you
    interpret the xt shock? (10 points)

    To simplify the algebra, assume for the rest of this question that σ = 1 and that {xt } and {vt }
    are both IID white noise.

    (b) Solve for equilibrium inflation πt and the output gap ỹt in terms of the shocks vt and xt .
    (20 points)
    (c) Explain how inflation, interest rates and the output gap respond to the vt and xt shocks.
    Give economic intuition for all your answers. (10 points)
    (d) Suppose the central bank chooses the feedback coefficient φπ to minimise the loss function

    L = Var[πt ] + Var[ỹt ] (3)

    Solve for the value of φπ that minimises this loss function. Is there a policy “trade-off”
    here? Explain how your answer depends on the parameter κ and on the variances of the
    shocks, Var[vt ] and Var[xt ]. Give economic intuition for your answers. (15 points)
    (e) Does the value of φπ that minimises the loss function (3) satisfy the Taylor principle? Why
    or why not? (5 points)
    Monetary Economics: Problem Set #3 2

    2. Interest rate versus money supply rules. Consider an economy again described by the
    equilibrium conditions
    1
    ỹt = − (it − Et [πt+1 ] − rtn ) + Et [ỹt+1 ]
    σ
    πt = βEt [πt+1 ] + κỹ

    and now also a money demand equation of the form

    mt − pt = yt − ηit , η>0

    where all variables are defined as usual. Both ytn and rtn evolve exogenously, independent of
    monetary policy. The central bank seeks to minimize a loss function of the form

    L = Var[πt ] + Var[ỹt ]

    (a) Explain how the optimal monetary policy outcomes can be implemented by an interest
    rate feedback rule. (10 points)
    (b) Show that a constant money supply will generally not be optimal. (15 points)
    (c) Derive a money supply rule that would implement the optimal monetary policy. (15 points)

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