Week 3 Flashcards
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
which is strictly interpreted in our model through agents’ expectations
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
says that agents update their understanding of the economy with new policy when it is credibly proposed
Expectations that are unbiased are called:
Answers:
1. adaptive
2. rational
3. surely do not exist
4. none of the above
rational
Claim: Expectations are not formally included in our model
FALSE
Claim: Unbiased expectations are always right
FALSE
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
the PC curve
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
yesterday’s bank panic
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
a CB pursues a higher than equilibrium output
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.
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.
True/False: Rational expectations means that agents do not make systematic errors. Justify your answer.
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)
True/ False: Rational, forward-looking central banks’ forecasts are often wrong. Justify your answer.
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.
Claim: Under adaptive expectations agents expect inflation to be what it was in the previous period (backward-looking).
True
Claim: Under rational expectations agents use the model and all available information to form forecasts (forward-looking)
True
What is Stagflation?
Stagflation is a combination of high unemployment and high inflation. Hence, the long-run relationship between output and inflation breaks down.
Claim: under rational expectations the disinflation is costless as it did not involve a rise in unemployment.
True
Claim: Better communication by central banks can influence the path the economy takes after an economic shock.
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.
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).
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.
How does the economy react to an inflation shock if the CB is fully credible?
If the CB is fully credible (𝜒 = 1), the economy reacts in the same way as under rational expectations
How does the economy react to an inflation shock if the CB is not fully credible?
If the CB is not credible at all (𝜒 = 0), the economy reacts in the same way as under adaptive expectations
Expect inflation be to what it is in the previous period: … Expectations
Adaptive (Backward - Looking)
Agents use the model and all available information to form
forecasts: …Expectations
Rational (Forward-looking)
Claim: Under rational expectations, there is always upward pressure on inflation if
output is above its equilibrium level.
False,
Under adaptive expectations, there is always upward pressure on inflation if
output is above its equilibrium level.
