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Economics
ECON6002
Practice Final Exam - Solutions
1. Consider the role of nominal rigidities and market imperfections in explaining the e↵ects of
monetary policy shocks.
(a) Explain whether you agree or disagree with the following statement: “Nominal rigidity
can cause monetary policy shocks to have sizeable real e↵ects on output.” (3 points)
The statement is invalid. Given only a nominal rigidities, monopolistically competitive
firms will change their prices in response to changes in aggregate demand thus implying
that money is virtually neutral.
In the Lucas imperfect-information model the aggregate demand curve is: y = m p and the
aggregate supply curve is: y = 11
2z
2z+
2
m
(p E[p]) where 11 > 0 is the elasticity of labour
supply with respect to the real wage, 2z > 0 is the variance of the good-specific taste shock,
2m > 0 is the variance of the aggregate demand shock.
(b) Is there a distinction between the aggregate demand curve and the good-specific demand
curve? Explain how di↵erent factors influence the good-specific demand curve in the
Lucas imperfect-information model. (3 points)
In the Lucas imperfect-information model, the good-specific demand curve is yi = (m
p) ⌘(pi p) + zi. Three factors influence the good-specific demand curve. The first
factor is aggregate demand m p where higher aggregate demand results in higher good-
specific demand. The second factor is the relative price of the specific good, where a
higher relative price lowers demand and the relation is governed by the elasticity ⌘. The
third factor is a good-specific demand shock or a taste shock.
(c) Suppose that the volatility of aggregate demand shocks 2m increases relative to the
volatility of good-specific taste shocks 2z . How would the slope of the aggregate supply
curve change? Explain by providing an economic interpretation. (3 points)
An increase is 2m relative to
2
z would imply a decrease in the slop of the aggregate supply
curve. Intuitively, a higher aggregate demand volatility implies that when agents observe
a change in demand they would less likely attribute it to a change in the demand for their
own good and so would not adjust their production much, implying a lower response of
output to changes in prices and thus a smaller slope for the aggregate supply curve.
(d) Discuss the validity of the following statement within the context of the Lucas imperfect-
information model: “Money growth, whether observed by economic agents or not, raises
the price level which consequently translates into higher output.” (3 points)
The statement is invalid. If the change in money growth is expected by economic agents,
they will adjust their expectations implying that the change in money growth will only
have an e↵ect on the price level of the economy and not on the output level.
2. Consider the IS curve and New Keynesian Phillips curve:
y˜t = Et[y˜t+1] 1
✓
rt
⇡t = Et[⇡t+1] + y˜t + u
⇡
t
where u⇡t = ⇢⇡u
⇡
t1 + e⇡t is a cost-push shock. Assume that there is no serial correlation so
that ⇢⇡ = 0. The solution for the model takes the form y˜t = a⇡u⇡t , ⇡t = b⇡u
⇡
t and rt = c⇡u
⇡
t .
Suppose that monetary policy responds to expected inflation and and expected output gap
such that: rt = ⇡Et[⇡t+1] + yEt[y˜t+1].
(a) Use the method of undetermined coecients to solve for a⇡, b⇡ and c⇡ and explain how
a positive cost-push shock a↵ects the output gap, inflation, and the real interest rate.
(4 points)
With ⇢⇡ = 0, Et[y˜t+1] = Et[⇡t+1] = 0, so we get a⇡ = 0, b⇡ = 1 and c⇡ = 0. So
y˜t = 0, ⇡t = u⇡t and rt = 0. A positive cost-push shock would raise the current inflation
rate one-for-one and will have no impact on the output gap since the interest rate is
unchanged. The interest rate is una↵ected by positive cost-push shock in this case as the
shock has no e↵ect on expectations of future inflation or future output gap.
(b) How would an increase in ⇡ a↵ect the response of the real interest rate and inflation to
an unfavourable cost-push shock? (2 points)