AKh3m-F2001 - Mario Catalan Macroeconomic Theory SAIS Johns...

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Mario Catalan SAIS Macroeconomic Theory Johns Hopkins University Part 1-Due November 14 th , 2001. Part 2-Due November 29 th , 2001. Answer Key - Homework #3 - Fall 2001 This homework consists of two parts. The first part includes Questions 1-4 and the second part consists of Questions 5-6. Question 1-A Permanent Reduction in the Rate of Growth of the Money Supply-Flexible Prices (20 Points) Motivation: In many historical episodes, governments implemented anti-inflationary policies aimed at reducing the long-run inflation rates of their economies. In the stylized and so-called money-based stabilization plans, governments promise to reduce the rate of money growth. We analyze the effects of this policy in an economy characterized by flexible prices (as an approximate description of economies characterized by high inflation). Throughout the analysis, we will be (explicitly) assuming that the change in monetary policy is fully credible. In reality, the “credibility problem” can severely jeopardize the success of the stabilization plan. When credibility is an important issue, the money-based stabilization plans are usually launched in conjunction with additional measures to enhance credibility, for instance, the announcement of more autonomy of central bank authorities (independence). Analyze the effects of a permanent reduction in the rate of growth of the (nominal) money supply. The government (central bank) announces at t=0 that the money supply will grow at a lower rate each period, starting at t=0. Observe that there is a permanent change in the “rate of growth” of the money supply. This policy exercise differs from the case in which there is a permanent change in the “level” of the money supply. A) Assume that the real output level of the economy is constant and show the effects of the new monetary policy on variables related to the money market. Use graphs to trace the time path of the following variables: nominal money supply, real money supply, price level, inflation rate and the nominal interest rate. (15 Points) B) Explain (in detail) the long-run equilibrium of the money market. Specifically, justify the long-run level of the inflation rate, nominal interest rate, output and the price level. (5 Points) Answer A and B: The following equalities and facts characterize the equilibrium of the money market in the long run (the economy is in the “long-run” at t=0, immediately after the policy shock, because prices are fully flexible). 1) The rate of money growth is equal to the inflation rate (long-run money neutrality), 2) The Fisher equation holds, i.e. the actual rate of inflation plus the real rate of interest equal the nominal interest rate, 3) The real rate of interest is equal to the marginal productivity of physical capital (see chapter 3-Mankiw) 4) The real output level is the full employment output level,
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Mario Catalan SAIS Macroeconomic Theory Johns Hopkins University 5) The money market must be in equilibrium, i.e. the real money supply must be
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This note was uploaded on 02/03/2012 for the course ECON 302 taught by Professor Quan during the Spring '11 term at Canadian University College.

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AKh3m-F2001 - Mario Catalan Macroeconomic Theory SAIS Johns...

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