EE432: Questions for Midterm Exams

Here are some questions I got from the mailbox. Check back for more.

In Fischer's staggered wage model, why do we set m = -v(-1)?

The objective here is to make output as stable as possible. With constant money supply, we found that output is given by 0.5(0.33(u-E(u|-1)) + 0.67(u-E(u|-2)). We know that the first part (u-E(u|-1))=v which the policy maker cannot do anything about. The current-period surprise v cannot be predicted by anyone. But the second part (u-E(u|-2))=v+v(-1) contains past shock v(-1) which has been observed by everyone. Therefore v(-1) is adding to the fluctuations of output unnecessarily.

How should we set m to eliminate this extra shock v(-1)? Because m and u enter the output in exactly the same way and we know (u-E(u|-2))=v+v(-1), it makes sense to set m such that (m-E(m|-2))=-v(-1) so that to cancel out v(-1). Setting m=-v(-1) accomplishes this goal precisely

Could you briefly summarize (in words) why money works in Staggered wage setting introduced by Fischer, Taylor and Calvo and why it does not work in Lucas'?

In Lucas (as well as Friedman), the starting point is the natural rate hypothesis which is the idea is that any change in monetary policy will translate into higher inflation, simply because nothing real or fundamental has changed in the economy. Any change in the quantity of money is a change in nominal quantity, that should not affect real quantities like employment or output. The exception is when people confuse these nominal changes with real changes, as in Lucas where agents sometimes interpret aggregate demand shock (which is nominal shock) wrongly as a relative price shock (which is real shock). When they make this kind of mistake, they may respond by producing more or less, which is why monetary policy is effective. But people only make mistakes when the change in monetary policy manages to surprise them (i.e. there is unanticipated demand change). Money does not work in this setting, in the sense that monetary policy cannot always surprise people, unless it is implemented randomly (and even so, we show in Lucas model that this will soon become ineffective too).

In (new) Keynesian models, we don't have an immediate pass-through from nominal changes to price adjustments, because these models assume price (or nominal) rigidity. Because prices do not fully adjust, real quantities such as output or employment must adjust instead to any aggregate demand changes. For example, after a negative demand shock (e.g. a monetary contraction), if the prices do not fall, lower demand will necessarily lead to lower equilibrium output. This holds true even with rational expectations (as we see in Fischer's model). Since a change in monetary policy is a demand or nominal change, this means that monetary policy is effective.

Questions from readings:
Lucas' Nobel Lecture, p.675, how does it follow from U'(n)=x that the equilibrium level of employment n will be a decreasing function of the rate of money growth.

The rate of money growth in this model is x. That n is decreasing in x follows from the fact that the marginal utility function U'(n) is decreasing in n (because of diminishing marginal utility assumption).

EE432: Key to problem sets 1 and 2

• Key to problem set 1.
• Key to problem set 2.

Happy revising for exams!

EE432: Reading pack for topic 3

The lecture note and the reading pack for topic 3 is now available for download.

Let me know if you have problems unzipping the file.

By the way, we will have to reschedule the class for February 25th to some other date. More update coming up.

EE432: Q&As for topic 1 and reading pack for topic 2

This is the first post for this semester, welcome to EE432!

Here are some questions I get for topic 1, which are based on Blanchard and Fischer textbook.

In the text book on page 161, What is the rate of return on money? Is it n or ((the money demand @t+1) - (the money demand @t))/(the money demand@t)?

The rate of return on money is simply the change in the 'value' of money over time. In this model, money is valued relative to only one good available in the economy. The price level P_t tells us how much that good is worth relative to money, or equivalently how much money is valued relative to good. Rate of return on money is then simply P_t/P_t+1, the deflation rate! If you hold money, and it buys more goods over time, money is effectively paying a rate of return.

Also, there is a statement "we can rule out non-steady-state paths in which the price level is falling at a rate greater than n".

Does this mean that if g is greater than n, the non-steady-state is impossible?

If this is the case, why the non-steady-state is impossible.

With g greater than n, the real balance @t+1 divided by the real balance @t is greater than 1. Since this is possible, that g is greater than n should be possible, isn't it?

The last sentence of your argument is wrong. Suppose that there is a non-steady-state equilibrium where g>n. You're right that the real balance per person will keep growing over time, because money pays a higher return than population growth. As real balance per person keeps growing, it will eventually exceeds 1. That implies that each young person will have to save more than 1 unit of good. That is impossible since he is only endowed with 1 unit of good. So our assumption that there is a non-steady-state equilibrium must be false. (This is called proof by contradiction)

On the same page, does the word " a monetary equilibrium" mean the equilibrium in the money market?

Not quite. In Blanchard and Fischer, a monetary equilibrium is an equilibrium in which money is used. This is in contrast to a barter equilibrium, in which everyone ignores money and use storage technology if available. (In this model, since trade cannot take place anyway, a barter equilibrium is really the same as an autarky equilibrium, that is you are on your own and never trade with anybody)

Thanks for the questions and keep them coming.

*********************

Here's the reading pack for topic 2.

Happy reading!

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.

EE432 2010: Topic 7 Materials

Presentation file and reading pack for our final topic is now available for download

• Topic 7 materials

Key readings are articles in the JEP symposium, contained in a separate 'JEP articles' folder.

EE432 2010: Topic 6 Materials

Lecture note and the reading pack for topic 6 is now available for download at:

• Reading pack for topic 6

As I mentioned, the key reading is the paper by Clarida et al, up until the part covered by the lecture note. Among other highly recommended readings (though not required) are

• Blinder's "What can central bankers learn from academics and vice versa", from the perspective of someone who's been on both sides of the fence.
• Bernanke's "Inflation targeting: a new framework?" published 3 years before Thailand imported the idea, which we still use to this day.
• Woodford's survey article on the optimal monetary policy for the Handbook for Monetary Economics, which is the most up-to-date account of what the current research frontier is. This is quite advanced, so perhaps just skim through to get some general ideas.

Modern Bank Failures

Diamond-Dybvig tells us that deposit insurance should have prevented bank runs and bank failures. The US has been having the insurance system for decades, so what was new in 2007-2008?

Krugman's recent post

Other commenters say that lessons from the 1930s are no longer relevant, because now we have deposit insurance. Um, shadow banking? That’s the point I keep trying to make: what happened to us in 2007-8 was that a large banking system had grown up, relying on repo and other forms of short-term borrowing rather than deposits, that wasn’t covered by New Deal-era protections and regulation. So what we had was the 21st-century version of a bank run; not crowds of people lining up at bank doors, but crowds of investors demanding haircuts on repo, which has the same effect.

EE432 2010: Topic 5 Materials and Problem sets

The lecture note and reference materials for topic 5 is here:

• Reading pack

These attached articles are for reference only, but these are original papers that introduce this concept to monetary policy issues. The key reading is, as I mentioned in class, the relevant sections from Romer's book.

Copies of the problem sets are available here:

• Problem set 3
• Problem set 4

Both of these are due in the evening of April 21st (We have a makeup class in the evening).

EE432 2010: Revision for Mid-term

Q1: What do we mean by the following statement, " the key source of uncertainty is the fact that workers cannot always discern whether they are experiencing a relative price change or a general price change"?

Both Friedman and Lucas agree that, in the world of completely flexible prices, the only reason that any individual firm will produce more or less than the 'normal' or 'natural' level is if it thinks there is really a greater or lesser demand for its goods, relative to other goods in the economy. As the analogy I used in the lecture went, the firm's entrepreneur may expand output if he believes he has become the new Steve Job, whose product is relatively more popular than others. In terms of prices, this means there is a relative price change: the price of my product may now increase, while prices of other goods are unchanged, because there's more demand for my good only.

However the price of my good can rise for 2 reasons. (1) There can be a relative price change, in the sense that my good really becomes more popular and there's more demand for it. If I knew that was really the case, I would quite rightly expand my output (the same way Steve Job expands his company in response to greater demand). Or (2), there's simply an increase in aggregate demand stemming from expansionary monetary policy for example. Here, everyone's prices will tend to increase, and there's a change in general prices rather than relative prices. If I knew that this was the case, my reaction would be to produce the same amount I did before, but simply readjust my price in line with the new general price level.

In practice, firms cannot always differentiate between the two. So even if there is purely an aggregate demand shock, which affects general prices only, some firms may mistakenly (given their imperfect information about both the relative price and general price shocks) think that there have been some relative price changes and hence they will respond by changing the output produced. When all firms respond to aggregate demand in the same way, the result is a huge macro level change in output, GDP if you like. This is the mechanism, according to Friedman and Lucas, how changes in aggregate demand can bring about changes in total output, i.e. 'money matters'.

EE432 2010: Topic 4 Materials and Solution to Problem Set 2

• Reading pack for topic 4: Credit and Banking
  
• Solution to problem set 2
  

EE432 2010: Topic 3 Materials and Problem set 2

The reading pack for topic 3 is now available for download

• Topic 3 materials
  

The following problem set is due on Friday 19th next week.

• Problem set 2

Friedman's Interviews

To follow up on our discussion of the natural rate hypothesis, here are some Milton Friedman's thoughts on more general topics. Admire the brilliance but keep an open mind and retain your critical thinking!

On greed...

Where does a pencil come from?

The Great Depression and monetary policy

What about market failures?

Policies must be judged by their results, not their intentions (reposted; this is a 30-min full interview)

Discrimination? Market solution vs affirmative actions.

Why drugs should be legalized

EE432 2010: Topic 2 Materials and Problem Set 1

Here are the materials for topic 2, New Classical Macroeconomics, including the lecture notes.

• Topic 2 reading pack

And here is problem set 1, to be handed in on Wednesday 10th February, i.e. next week.

• Problem set 1

As you know, we are some way behind our schedule, and there are a lot to catch up. It's important to concentrate in the weeks ahead, as the mid-term is coming up in a month time. Make-up classes are being arranged, and I'll let you know once that's confirmed.

EE432 2010: Course Description and Topic 1 Materials

Welcome to EE432 2010! I hope you all will have a good and enjoyable semester.

I have uploaded the following for your downloading pleasure.

• Course description
• Topic 1: Lecture note and the reading pack

The key reading for topic 1 will be Blanchard and Fischer's chapter on money (find precise pages in the course description). All readings included in the pack are optional.

In terms of the lecture note, we will only cover materials up to the toy version of Kiyotaki-Wright model (i.e. up to page 6). The latter part will not be covered and will not be assessed in exams, but I include them in case you wish to see the formal model in full.

Don't forget the Wednesday class is cancelled. A makeup class will take place as early as possible once the registration for the course is finalized.

EE432 2009: Revision series - Misc

Here are some questions from some of you.

1) Can u explain more in details on " Impulse responses in the Inflation-Unemployment-Interest rate Recursive VAR"(details on each graph) ie. Inflation shock to unemployment- how inflation causes higher unemployment, Unemployment shock to unemployment- why it go up and down(below 0) then up again ?

Remember that VAR gives you a statistical fact...so it doesn't have to agree with any theory necessarily (in the case of disagreement, you could either blame the theory, or VAR itself). The job of interpreting the result and checking if it makes sense lies with us, the economists. I encourage you to try and interpret these, using what you know from the course and elsewhere. In this example, why should inflation raise unemployment? We learn from various topics that inflation shock is an AS (or Phillips curve shock). What happens when there is a positive inflation shock? The equilibrium output will be reduced! (Revise topic 5 again if you don't follow this step.) So it's no surprise that unemployment rises. As for unemployment on itself, you may interpret it as a 'pendulum effect'...the economy is trying to settle to a new equilibrium after the shock, and the adjustment process involves overshooting in unemployment in the medium term.

2) For the supply of bank reserves (last lecture page10) I dont understand the graphes
and what is the shape for supply of bank reserves(horizontal,vertical or upward sloping?)

The supplier of bank reserves in this case is not motivated by profit, so there's no reason for the supply curve to have any slope. The supply is motivated by the central bank's objective of meeting it's operating target - the overnight interest rate, as set by the monetary policy committee. In this case, you may think the idealised supply should be perfectly elastic at the targeted overnight rate...i.e. the central bank stands ready to supply whatever reserves to meet its target. This would in principle be correct. In practice, it is more complicated, because the central bank is only one among many participants in the market for reserves. The central bank in practice calculates how the supply of reserves is changing in quantity in the absence of its action (i.e. conduct liquidity forecasting), and then decides on the amount of open market operation needed to bring reserves supply in line with te reserves demand. In view of this practical implementation, it would be closer to the truth that the supply for reserves is vertical, i.e. just in line with the demand. But then the central bank quickly communicates to the market it's intention to meet the target interest rate. The vertical supply collapses to a point...on which the interest rate is as announced, and the quantity equals reserves demand.

3)In topic 5 what would be the optimal rule for commitment?
What whould be the level of pi that CB should commit to? Is it the same as problem set's answer: plug in y=y_star and pi=pi_star in AS function and find expected pi?
do we have to saperate into cheat case(y_star>y_bar) and no cheat case(y_star=y_bar)?

The upshot of this model is, if the public holds rational expectations, there is never any gain in terms of output that the central bank can enjoy. Output will always equal the natural rate in the rational expectations equilibrium (check the maths to see that you agree with me in this). So the best that the central bank can achieve is in meeting its inflation target. Committing to this particular inflation is the optimal strategy.

In topic 6, from the journal "The Science of Monetary Policy:..." by Richard Clarida, Gali, Gertler,
On Page 1680, on the right hand side paragraph
"... As the future comes to pass, the central bank has the incentive to renege on its planned toughness and, instead, promise again to undertake contractionary policy down the road. To see this, ......If the central bank is free to deviate from the rule, it will always choose the optimal policy under discretion,...."
So under this paragraph, does it mean that the central bank will choose to cheat from its commitment to fix the shock? which means it will fall into the case of time inconsistency? Would taking the limit to infinity into the model prove this statement?

At last, someone asks questions related to papers!
Yes, this is very similar to time inconsistency issue, as the problem arises because of the inability of the central bank to achieve an outcome that it deems optimal ex ante, but wishes to deviate ex post. Clarida et al mentions down the paragraph that they think this is different from the traditional time inconsistency however, because the incentive to cheat has nothing to do with the desire to push output beyond the natural rate (note that Clarida et al associates the concept of time inconsistency with k>0). Instead, the incentive to cheat here arises because the 'tough' act, which has a long-term benefit in taming inflation expectations but painful for output in the short-run, is not carried out under discretion. Hence the benefit in terms of low inflation expectations is never realised, because the people expect that the touch act is not optimal ex post. This leaves room for the commitment regime to add value.

EE432 2009: Solution to Problem Set 4

Solution guide for the last problem set.

Download here.

For people having questions during their revisions, I encourage you to post them using the chat, so that your friends may read them and interact etc. If the space limit gets on your nerve, let me know, and I'll open up a new post, and we can use the comment space there instead.

EE432 2009: Topic 7 Materials

Our final topic, on the 'Mechanics of Monetary Policy', will be split into 2 parts.

1. The transmission mechanism

The reading pack can be downloaded here.

2. The implementation

The reading pack as well as the final presentation file can be downloaded here.

The articles included are mainly on how the open market operation works. For the unconventional policy measures, the details can be found on the fed's website here. For a macro overview of crisis management and the general philosophy of unconventional monetary policy, consult two very good speeches by Bernanke [1.@LSE][2.@National Press]. Also don't forget the Brunnermeier's article included in topic 4's reading pack, which describes the unfolding of subprime crisis.

EE432 2009: Problem Set 4

Probably the final one now...download here. This is due on Wednesday 29th April.