2019 EXAMINATIONS

MRes/MSc/Diploma in Money, Banking & Finance

ECON 400 – Macroeconomics for Money, Banking and Finance (Two Hours).
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Please answer THREE questions, with AT LEAST ONE question chosen from EACH of the TWO
sections below. All questions carry the same marks.

SECTION A
1. Explain the main building blocks of the IS-MP-PC model, and show how a credible central
bank, which is committed to a low and stable inflation target, can achieve macroeconomic
stability.
2. Use a simple New Keynesian model to explore the role of fiscal policy when interest rates
are at their lower bound. In particular, discuss the roles of government spending and changes
in labour taxation in this environment. You may use a standard AD-AS diagram to illustrate
3. Consider the following log-linear equations of the basic New-Keynesian model:
= +1 − ( − +1) (1)
= +1 + (2)
= + , > 1 (3)
Where is output deviations from steady state, is inflation deviations from steady state,
0 < < 1 is the discount factor, > 0 is a coefficient measuring the response of inflation to
output (a proxy for the marginal costs), and is the nominal policy rate. The term
represents a monetary policy shock, which is assumed to be a mean-zero, serially
uncorrelated shock. The term is the rational expectation operator conditional upon all
information up to and including period .
Note: all parts of this question carry equal weights.
a. Discuss equations (1) to (3) and where necessary comment on any assumptions and
microfoundations which determine them.

b. Suppose an shock hits the economy, and in the short-run remains away from its
long-run level with probability such that output and inflation persist in their values
away from steady state (, ≠ 0). Every period, with probability (1 − ), the
economy may return to its steady state level, resulting in output and inflation
returning also to their long-run levels (, = 0). Hence, for each endogenous
variable we have +1 = . Using this assumption about the nature of the shock,
show that both output and inflation are positively correlated with , and explain the
transmission channels of an exogenous rise in .
c. Explain why > 1 is crucial for stabilisation policy.