UNIVERSITY OF OSLO DEPARTMENT OF ECONOMICS

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1 UNIVERSITY OF OSLO DEPARTMENT OF ECONOMICS Exam: ECON4325 Moneary Policy Dae of exam: Tuesday, May 24, 206 Grades are given: June 4, 206 Time for exam: 2.30 p.m p.m. The problem se covers 5 pages Resources allowed: No wrien or prined resources or calculaor - is allowed (excep if you have been graned use of a dicionary from he Faculy of Social Sciences) The grades given: A-F, wih A as he bes and E as he weakes passing grade. F is fail. The exam consiss of hree pars,, 2 and 3. In he grading, problem is given 30 per cen weigh, problem 2 is given 20 per cen weigh, and problem 3 is given 50 per cen weigh. The max page limi should be respeced, bu is no required (i.e. a shorer answer may be jus as good). Problem a Imagine ha you are working as a senior advisor in Norges Bank in May 206, and he nex moneary policy meeing is one week away. The ineres rae is now 0,75 per cen afer a 25 basis poins ineres rae cu a he las meeing. The economic developmen since he las meeing can be described as follows: The oil price has increased from very low levels, however, he negaive impulses o he real economy from he recen oil price fall has been much sronger han expeced. No improvemen is expeced any ime soon. The oil price is expeced o say a approximaely his level for he nex hree years. The unemploymen rae is now 4,2 per cen and higher han he «naural» level of unemploymen. Norges Bank does no expec he unemploymen rae o increase furher. Inflaion, measured by 2-monh growh in CPI-ATE, is 3,3 per cen and is kep up by srong growh in impored inflaion (which has a /3 weigh in CPI-ATE). Expeced yearly growh for 206 is 3 per cen. Nominal wage growh is expeced o be approximaely 2,5 per cen in 206. House price growh is increasing and has developed as expeced. I is expeced ha i will be somewha higher in he nex monhs, hen sabilize.

2 Foreign ineres raes and ineres rae expecaions have dropped more han expeced. The expeced rise in foreign raes has been posponed o lae 208, a he earlies. In he following, i is aken for graned ha you are familiar wih Norges Bank s forward guidance sraegy and he hree crieria for an appropriae ineres rae pah, o he exen ha we have covered i in his course. Based on he informaion given above, you are asked o wrie a recommendaion on wha o do wih he ineres rae a he nex meeing. Your draf should make use of wha you have learned in his course in general and he informaion given above, in paricular. The Governor asks for your personal opinion and your draf should herefore give an independen and inuiive explanaion for your choice of ineres rae decision. Your wrien answer should exceed one page, bu be no more han hree pages long. Problem b The Norges Bank Wach 206 repor recommends ha Norges Bank opens up for a discussion of wheher he cenral bank mandae should be changed. Give wo examples of how he mandae could be changed and provide argumens boh in favor of and agains boh examples. Nex, provide a recommendaion and explain your choice. Your answer should be no more han wo pages long. Problem c A lecure 8, and in Clarida, Gali and Gerler (2000), his able is presened: The able describes moneary policy in he US in wo differen periods. β is he ineres rae reacion o a percen increase in expeced inflaion. γ is he ineres rae reacion o a percen increase in he expeced oupu gap. From he able i can be argued ha he moneary policy conduced in he period was successful in bringing down and sabilizing inflaion. Briefly explain why. Furhermore, briefly explain (in words) why he parameers are posiive, and give an economic inerpreaion for why he γ esimae no longer is significan in he laer period. Your answer should be no more han wo pages long. 2

3 Problem d Describe he hree key vulnerabiliies for financial sabiliy emphasized by he Financial Sabiliy Repor 205 (and lecure 2). Briefly explain why i is imporan o pay aenion o heir developmen. Your answer should be no more han wo pages long. Problem 2 In he New Keynesian Model used in his course, inflaion is a resul of aggregae consequences of carefully reasoned price-seing decisions made by firms based on heir curren and fuure cos condiions. The non-policy block of equilibrium behavior in he model can be explained by he following wo equaions: ~ y e y 0, 0 () E E ~ ~ y i E e, e eˆ, 0 naural Where π is inflaion, y y y rae, 0 < σ < (2) ~ is he oupu gap in period, i is he nominal ineres e is he demand shock and e is whie noise. e is known when moneary policy is deermined and is he only shock in his economy. Inroducing moneary policy, he cenral bank is commied o he following Taylor rule: i = ρ + φ π π + φ y y, (3) where φ π, φ y are non-negaive parameers, se by he cenral bank. ρ equals he naural ineres rae (in he absence of echnology shocks) and is, ogeher wih all oher parameers (κ, σ, μ, β) given by naure. Problem 2a As a cenral banker, you wish o se he parameer values of φ π, φ y so ha he model has a unique soluion. Show ha he necessary condiion for such uniqueness is ha he following holds: κ(φ π ) + ( β)φ y > 0 (4) In your answer, which should be based on wha you have learned in his course, you should briefly explain wha you do as you go along. Hin : Sar by combining equaions ()-(3) ino an equaion sysem. Hin 2: In your calculaion, you may a some poin end up wih a second order equaion of he form aλ 2 + bλ + c = 0. Then noe ha he necessary and sufficien condiions for wha you are afer are ha he absolue value of c is smaller han and he absolue value of b is smaller han + c.). 3

4 Problem 2b Given ha equaion (4) holds: As a cenral banker, wha would be your chosen values for φ π and φ y? Briefly explain your choice (which should be your own opinion). Your answer should be no more han one page long. Problem 3 In he following, you may assume ha equaion (4) holds. Problem 3a The parameer in equaion () is defined as: κ = ( θ)( βθ) θ ( α) α+αε (σ + φ+α α ) where (-θ) measures he fracion of firms ha can rese heir prices in any given period, while a fracion θ keep heir prices unchanged. 0 < β < is he discoun facor, 0 < α < is a measure of decreasing reurn o scale (hin: α affecs price seing behavior in wo differen ways). ε is he demand elasiciy, and 0 < σ < and φ > are he inverses of he elasiciy of subsiuion and he Frisch elasiciy of labor supply, respecively. Describe he evoluion of aggregae inflaion in period in he presence of a posiive demand shock, knowing ha here are an infinie number of periods. Explain how he oucome depends on he size of (he more parameers inerpreed, he higher is he score). In your answer, i migh also be beneficial o remember ha marginal cos deviaion from seady sae is given by: mc = (σ + φ+α ) α y~ Problem 3b Use he mehod of undeermined coefficiens (wih he following guess parameers: α and ψ for he effec on he oupu gap and inflaion in period, respecively) o find he equilibrium soluions for inflaion and he oupu gap in his economy in he presence of a posiive demand shock. Your answer should include i) Your calculaion of he equilibrium soluions for inflaion and oupu gap in he presence of he shock. ii) An inerpreaion of he economic mechanisms (he more effecs inerpreed, he higher is he score). In your calculaion, you do no have o inser for κ, bu may consider κ a measure of price sickiness only. Also, you do no have o simplify he soluions. For insance, he soluion for he full effec of a demand shock on he oupu gap can look like his: αe = μ + κφ π σ( βμ) + φ y σ e κμ σ( βμ) 4

5 Problem 3c Briefly explain (in words only) why he equilibrium soluions for inflaion and he oupu gap found in 3b are no a resul of opimal moneary policy. Your answer should be no more han ½ page long. Problem 3d Use wha you have learned in he course and derive he equilibrium soluions for inflaion and he oupu gap under opimal moneary policy wihou commimen when he economy is explained by equaions () and (2), agens have raional expecaions and he cenral bank wans o sabilize boh inflaion and he oupu gap, bu does no ry o boos oupu above is naural level. Your answer should include a mahemaical soluion and an inerpreaion of your soluions. Your answer should be no more han hree pages long. Hin: Under opimal moneary policy wihou commimen, he cenral bank may re-opimize in every period and herefore has o ake expecaions as given in is opimizaion problem. Problem 3e Show ha he opimal response wih he ineres rae is: i = ρ + σe Inerpre he soluion and briefly explain (in words only) why i differs from he soluion found in 3b. 5