UNIVERSITY OF PRETORIA
FACULTY OF ECONOMIC AND MANAGEMENT SCIENCES
DEPARTMENT OF ECONOMICS
ECONOMICS 234
Examiner:
SEMESTER TEST
Dr HR Bohlmann
SEPTEMBER 2019
Time: 90 Minutes
ANSWER ALL QUESTIONS CLEARLY AND CONCISELY
1.
2.
3.
The short-run model consists of the MP curve, IS curve, and the Phillips curve. Fill in the
missing words or phrases to complete the description of the short-run model:
From the MP curve, an increase in the nominal interest rate, will lead to a/an (1.1) in the real
interest rate. This is true in the very short run due to the assumption of (1.2). From here, the
IS curve shows that the change in the real interest rate will cause current output to (1.3)
relative to potential output, mainly due to the impact on (1.4) expenditure. Finally, the Phillips
curve shows that as current output (1.5) there will be a downward change in the rate of (1.6).
(10)
Using the various equations underpinning the short-run model, derive the equation for the AD
curve.
(10)
The aggregate demand (AD) curve slopes downward because of the link running from the
monetary policy rule to the IS curve.
3.1
3.2
4.
Write down the simple monetary policy or Taylor rule equation and define each of the
critical parameters in the equation.
(5)
Intuitively explain how this rule dictates the monetary policy response to higher than
target inflation.
(5)
Discuss i) moral hazard and ii) rules versus discretion as two potential dilemmas policymakers
face within the context of managing the business cycle. Use examples to support each of your
answers.
(20)
[50]
SUGGESTED ANSWER GUIDE
1.1
1.2
1.3
1.4
1.5
1.6
increase
sticky prices
fall
investment
falls
inflation
2.
Substitute the policy rule into the IS curve
Policy rule:
𝑅𝑡 − 𝑟̅ = 𝑚
̅ (𝜋𝑡 − 𝜋̅)
̅
̃
IS curve:
𝑌𝑡 = 𝑎̅ − 𝑏(𝑅𝑡 − 𝑟̅ )
To get the aggregate demand (AD) curve
AD curve:
𝑌̃𝑡 = 𝑎̅ − 𝑏̅𝑚
̅ (𝜋𝑡 − 𝜋̅)
Short-run output is a function of the inflation rate
3.1
Define each of the variables and parameters of the simple monetary policy rule
3.2
Taking into consideration the set of exogenous variables, the monetary policy rule suggests
by how much the central bank should change the nominal interest rate (which in turn affects
the real interest rate in the short run due to price stickiness) in response to a deviation in
inflation (or perhaps more accurately, expected inflation) from the target level of inflation.
The magnitude of the suggested change in the interest rate is determined by the size of the
inflation deviation and the size of the m parameter which governs how aggressively
monetary policy needs to respond to maintain price stability.
4.1
Moral hazard – too big to fail, bailouts, impact on incentives and good governance practices,
private gains when excessive risk pays off but public cost when failure occurs, balancing
regulation with cost and ease of doing business, etc.
4.2
Rules vs discretion – time consistency problem, understanding of short-run vs long-run
trade-offs and intergenerational burdens, impact on uncertainty, winners and losers of
discretionary policy use