Week 3

Question 1

Credibility of the central bank is an abstract concept:

Answers:
1. therefore it makes no objective difference in our models
2. which is strictly interpreted in our model through agents’ expectations
3. which is modelled but makes no difference
4. it considerably lenghtens the agents’ reaction time when a CB is credible
5. none of the above

Answer 1

which is strictly interpreted in our model through agents’ expectations

Question 2

The Lucas critique:

Answers:
1. is not relevant to us
2. says that agents update their understanding of the economy with new policy when it is credibly proposed
3. is impossible to include in our models
4. makes all our predictions invalid
5. all of the above

Answer 2

says that agents update their understanding of the economy with new policy when it is credibly proposed

Question 3

Expectations that are unbiased are called:

Answers:
1. adaptive
2. rational
3. surely do not exist
4. none of the above

Answer 3

rational

Question 4

Claim: Expectations are not formally included in our model

Answer 4

FALSE

Question 5

Claim: Unbiased expectations are always right

Answer 5

FALSE

Question 6

In the trade-off that the central bank faces, the binding constraint to achieve its goals is given by:

Answers:
1. the PC
2. the IS Curve
3. the MR rule
4. people’s behaviour not modelled 5. in our model
6. all of the above

Answer 6

the PC curve

Question 7

Adaptive expectations formed today will be changed by:

Answers:
1. today’s news of an attempted 2. assassination of a politician
3. tomorrow’s planned speech by Mario Draghi
4. yesterday’s bank panick
5. all of the above

Answer 7

yesterday’s bank panic

Question 8

Inflation bias arises when:

Answers:
1. a CB tries to pursue any raise in output
2. a CB pursues a very low inflation target
3. a CB pursues a higher than equilibrium output
4. none of the above
5. there is no such thing in real life as an inflation bias

Answer 8

a CB pursues a higher than equilibrium output

Question 9

If you work for the central bank and you observe that economic uncertainty has increased, would you advise to set looser monetary policy, to set tighter monetary policy or to leave monetary policy unchanged? Explain and defend your choice.

Answer 9

Faced with larger uncertainty, firms will be more cautious in investment and hiring decisions, and consumers will be less willing to buy durable goods (like cars). ( I and C will go down ). IS goes down.

The reason is that these decisions can relatively easily be postponed, but are (partly) irreversible. The agents prefer to wait for more information than to make a costly mistake.

This can lead to lower economic growth and higher unemployment. yt < ye

This means that output would fall below equilibrium, and we would advise to set looser monetary policy in order to keep the economy close to equilibrium.

Something can also be said for leaving policy unchanged, because of the mixed theoretical evidence. One might prefer to wait and see which policy is needed as empirical evidence does indicate that at least in the short-run, uncertainty shocks lead to a drop in output however.

Question 10

True/False: Rational expectations means that agents do not make systematic errors. Justify your answer.

Answer 10

Statement is true, by definition of REH. Under Rational expectations behaviour all available information is being used, agents do not make systematic errors, only unsystematic errors (unexpected shocks)

Question 11

True/ False: Rational, forward-looking central banks’ forecasts are often wrong. Justify your answer.

Answer 11

Statement is False.

CBs can be deemed to be rational, forward-looking agents as CBs build, test and refine their models of the economy under extensive external scrutiny and it is unlikely that the central bank would make systematic mistakes without being forced to reconsider its methods or deal with an unforeseen shock hitting the economy, pushing it in a different direction than the CB predicted.

Question 12

Claim: Under adaptive expectations agents expect inflation to be what it was in the previous period (backward-looking).

Answer 12

True

Question 13

Claim: Under rational expectations agents use the model and all available information to form forecasts (forward-looking)

Answer 13

True

Question 14

What is Stagflation?

Answer 14

Stagflation is a combination of high unemployment and high inflation. Hence, the long-run relationship between output and inflation breaks down.

Question 15

Claim: under rational expectations the disinflation is costless as it did not involve a rise in unemployment.

Answer 15

True

Question 16

Claim: Better communication by central banks can influence the path the economy takes after an economic shock.

Answer 16

True?

Communication affects the extent to which inflation expectations are anchored to target, which affects the Phillips curve.

While affecting the supply side of the economy, it has no impact on the demand side, leaving the IS unchanged.

Therefore, the reaction of agents to a given change in interest rates will be unaffected by communication.

Question 17

Claim: Better communication by central banks does not affect how agents react to interest rate changes (which is the main tool used by monetary policy makers to achieve their inflation target).

Answer 17

True:
While affecting the supply side (PC) of the economy, it has no impact on the demand side, leaving the IS unchanged.

Therefore, the reaction of agents (Households, Firms, Govs) to a given change in interest rates will be unaffected by the quality of communication.

Question 18

How does the economy react to an inflation shock if the CB is fully credible?

Answer 18

If the CB is fully credible (𝜒 = 1), the economy reacts in the same way as under rational expectations

Question 19

How does the economy react to an inflation shock if the CB is not fully credible?

Answer 19

If the CB is not credible at all (𝜒 = 0), the economy reacts in the same way as under adaptive expectations

Question 20

Expect inflation be to what it is in the previous period: … Expectations

Answer 20

Adaptive (Backward - Looking)

Question 21

Agents use the model and all available information to form
forecasts: …Expectations

Answer 21

Rational (Forward-looking)

Question 22

Claim: Under rational expectations, there is always upward pressure on inflation if
output is above its equilibrium level.

Answer 22

False,

Under adaptive expectations, there is always upward pressure on inflation if
output is above its equilibrium level.