EE432 2010: Revision

Here are some Q&As, from my mailbox.

Topic 4

1. What is the intuition of the positive relationship between income and demand for loan?

If you read the paper, Bernanke and Blinder, they say "The dependence on GNP ( y ) captures the trans- actions demand for credit, whch might arise, for example, from working capital or liquid- ity considerations." This means the higher income the economy has, the bigger are the firms, and the greater need for loans to finance working capital or the need for more cash to run the business.

2. Is the condition "R greater than 1 and diminishing marginal utility" enough for C1* greater than 1 and C2* less than R? How risk aversion involves in this?

"R>1 and diminishing marginal utility" are enough to infer that C2* is greater than C1* (see equation 3). But to ensure that C1* is greater than 1 and C2* is less than R, we showed in the lecture that we need gamma*u''/u' being less than 1 for all gamma. This is exactly the definition of relative risk aversion. So we do need risk aversion.


3. Is there a typo on Diamond&Dybvig p.408? And are you gonna include the stochastic t in the exam? Or we should focus on the model studied in class?

The mathematical question will only be based on what we covered in lectures. For essays or discussion, I set no ceiling, you're free to discuss whatever you learn from the readings. (which line do u see the typo?)


Topic 5

I get the concept that time inconsistency arises when preference before and after are different, but Im confused about the graph and relationship among pies.
1. For time inconsistency problem, can you elaborate more about the implication when L = 1/2(pie-pie star)2 , so it is the same as commitment case?
And after we arrive at pie = pie star, which leaves total loss fn to be only 1/2 (y-y*)2, what is the implication? Do you expect further explanation or just how to get there?
Im also confused about the relationship btw pies, expected pie and pie star, can you explain more on it. is it correct that the optimal solution is
for both society and cb to set pie and expected pie equal to pie star? is this the essence of it already? Also, can you elaborate more about how to interprete the graph?

Let me lay out the basics.

pi is the actual inflation. The solution for pi will have to be determined by an equilibrium condition. In this case, it is a Nash equilibrium, or in other words when we have both the central bank minimizing its loss function and the public holding rational expectations.

pi-star is a parameter, a number, that tells us what the ideal level of inflation is for the central bank. pi-star is in other words the targeted inflation. Now, in the lecture, I say pi-star happens to be what the society thinks of as ideal inflation as well, but this needs not be the case. If the society prefers some other inflation, then what this means is that the social loss function will be different from the central bank's loss function.

Expected pi, that's the expectation of inflation. Under rational expectations, it will have to be the same as actual inflation. This is the same definition of rational expectations that we work with since the first semester.

Your last statement, that the optimal solution entails that both the society and central bank should set pi and expected pi to pi-star is generally wrong. What do u mean by optimal? If optimal means that everyone is optimizing, then the time-inconsistency result precisely tells us that the optimal outcome could be a higher inflation than pi-star. That's our standard result (unless we consider some limiting case). But if you mean what is the outcome that yields the highest welfare, then yes, if the central bank can somehow make sure that pi=pi-star will be delivered in equilibrium, we have maximum welfare possible (assuming the society also thinks of pi-star as ideal). This will be 1/2(ybar-y*)2 by the way, in our original model.

Topic 6

(1) why the science of monetary paper really makes clear about cost-push and demand-pull? why the shock,u, can only can only cost push?

In the model we consider, 'u' is the shock applied directly to the Phillips curve, i.e. it's an inflation shock. That's why we call it the cost-push shock, or equivalently, it is a supply-side shock because it shifts the aggregate supply curve. The demand shock in this model is very easy to deal with, we just operate monetary policy to offset it. Remember I skip the details about the aggregate demand side because we assume the LM curve can be chosen to be anything we like….so even if IS shifts up or down, the LM can be chosen to move to offset it.

Intuitively, with demand shock, there is no interesting tradeoff. Negative shock hits, inflation and growth will be lower, so u want to expand monetary policy to boost demand. When there's a supply shock, that's interesting. Do you want a higher inflation, or a lower growth? Or a combination of both? How much?"

(2) in the case of commitment rule, is it always that k must equals to zero?

It doesn't have to be. 'k' is a preference parameter, so it depends on the central bank's preference. I let it equal zero for simplicity, and to highlight the key point here that even if k is zero, there is a gain to commitment (check that you understand why). In the standard simple time-inconsistency problem, if k=0 we don't have any time-inconsistency, and commitment or not it doesn't matter.

EE432 2010: Extra problems for topics 6 and 7

Download them here. There is no need to submit them, as these are just for practice.

For those of you resubmitting problem set 4, I left them at the BE office some time last week so you can pick them up.

As for extra tutorial class, we may not be able to use a room at Thammasat, as the exams already started. I will try to look for an alternative location. In the mean time, if you have questions, you can send them in right away, there's no need to wait.