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ECN324 Monetary Economics

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Question number Mark (first marker) Adjusted mark
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Q2
Q3
Q4
Q5
Q6
Q7
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First marker’s initials Second marker’s initials”

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2. [a]

In general, the equations imply a Neoclassical model with time inconsistency. The

expectation Et −1 π t indicates that agents during the period t-1 are trying to predict the

inflation in the next period, which is period t. In other words, it is the expected inflation at t,

using the information up to t-1.

For the first equation, this is a welfare function used by the central banker to maximize the

gains to society. The coefficient of y t − y n (how much output at time t deviates from its

natural rate of output) is ø, and this indicates the weight that the central banker attaches to

the output gap relative to inflation. The larger the ø, the more important is the stabilization
¿
of output to her, but this of course, depends on the assumption of different models. π is

also assumed to be 0 in this model due to the set-up of the welfare function, which implies

that the central banker has set a targeted inflation of 0. Overall, this welfare function

reflects the gains from how the central banker weighs the losses from the trade-off that

she faces in stabilizing the output gap (depending on the weight of importance she

attaches) and inflation.

The trade-off is further implied by the second equation, which is also a Lucas-type supply

function with shock e t . Because coefficient α is positive, this means when the inflation

exceeds the expected inflation ( π t −Et −1 π t ) > 0, the output y t will increase. This means the

central banker must bear a higher inflation when increasing output. The coefficient α

indicates the slope of the PC, something that the central banker cannot make changes. In

this model, because y t is on the left-hand side of the equation, the slope indicates the

sensitivity of output in response to ( π t −Et −1 π t ), the difference between actual inflation and

expected inflation made in time t-1. Lastly, the PC also links the output y t to exogeneous

shock e t . The latter impacts output independently of inflation since changes in variances

affect the volatility of the shocks, hence further adding complexity to the trade-off.
1
2. [b]

Firstly, discretion implies that the central banker will optimize with regards to the current

period, but regardless of what was promised in the past. Thence, Et −1 π t can be ignored.

The answers to this question were solved with my iPad and attached below.

The Optimal Targeting Rule (OTR) is π t =ϕα , this means that it is a horizontal line when

plotted on the plane with π on the y-axis and y on the x-axis. This is because due to the

nature of the loss function, y t does not appear on the OTR. Therefore, there is no trade-off

between inflation and the output gap as implied by the OTR.

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Inflation is equal to the expected inflation at time t made in the period t-1. This shows that

agents can accurately predict the inflation, implying that agents have rational expectations.

As for the output, if there are no shocks, the output at time t will be same as the natural

rate of output, which is optimal. Substituting the above values into the welfare function and

then taking variances give the following:

The larger the variance of the shock, the greater will be the volatility. This further results in

a greater variance and thus a greater volatility in the welfare function V, making the gains

more uncertain and unpredictable to the central banker. Overall, it become more

challenging for the central banker to maximize the welfare.

2.[c]

ϕ = 0 means that the weight that the central banker places on stabilizing the output gap is

0. In other words, she does not care about what happens to the output gap nor the

stabilization of output relative to inflation, which can be inferred that she only cares about

the stabilizing inflation. This is explained by the OTR above, where π t =ϕα now becomes

π t =0. This makes sense as the central banker would only fully focuses on stabilizing

inflation. Assuming that there are no shocks (e t =0), then according to the solution obtained
n n
earlier where y t = y + e t , this implies y t = y . Because output is equal to natural rate, and

3
that inflation is fully stabilised, then this justifies why V=0. In other words, there are no

further welfare gains from stabilizing output as welfare is already maximized by fully

stabilizing inflation and ignoring the output gap. This may seem like a stylised, but an ideal

condition for the central banker with output at its natural rate, no deviations in prices while

having to pay no heed to the social welfare.

n
Even when there are shocks, then y t ≠ y , but the central banker will not bother about

stabilizing the output since ϕ is not included in y t = y n + e t . Therefore, the welfare is still

maximized where V=0 because there is still no trade-off as output will not be stabilised and

inflation remains fully stabilised at π t =0 and is also not impacted by shocks (because e t is

not included in π t =ϕα )

2[d].

As per the next page (page.5), it is found that t 1=∅ α−π t maximizes social welfare. Using

this, the contract t ( π t ) is expressed in terms of π t , further finding the values of t 1 and π t

that optimizes the contract t ( π t ). Finally, the optimal contract is found as shown in the

steps in the next page.

As shown in page 6, the values found mathematically implied that t 1=π t and they

maximize the contract t ( π t ). In other words, it is optimal to impose a penalty that is the

same rate as inflation in period t, for the contract to be optimal (a maximum). To add

further comments, the equilibrium level of inflation π t is now reduced from π t =¿ ϕα without

ϕα
the penalty as in question (a), now to π t = with the contract that includes a penalty. As
2

a result, this improves the social welfare as mathematically described on page 6.

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1. [a]

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Monetary equilibrium exists when agents (when young in time t and when old in time t+1)

in the OLG model optimize their utility subject to the budget constraint. The existence of

the monetary equilibrium is dependent on the values of r and n.

The above results showed that in the storage only economy, if the goods are fully

perishable (r =−1¿ , then c 2 ,t +1 will be 0. If the young in the period t saved up their goods in

this economy, all their goods will perish, and they will not be able to consume them when

they are old in the period t+1. Hence, utility becomes mathematically unidentified.

To analyse further, the budget constraint is then found as shown in the steps below.

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The budget constraint contains both r and n, thus the existence of the monetary

equilibrium depends on these values. Diagrammatically, monetary equilibrium exists when

the budget constraint is tangent to the utility function. For instance, if n=−1 , then the

budget constraint is mathematically unidentified. Then, there will not be a budget

constraint for the utility curve to be tangential, so there will also be no monetary

equilibrium. Since n is the population rate, n=−1 implies that there will be no young

generation will be borned in future, meaning that the present young generation will not

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have anyone to trade their money for goods in the future. This is not efficient and thus is

not a monetary equilibrium.

Furthermore, r and n also affect the slope of the budget constraint. An increase in r will

make the budget constraint steeper. This is because there will be more yields in the next

period. Agents in period t will save more (reducing current c 1 ,t ) for the future so that they

could consume more by then (increase future c 2 ,t +1). In contrast, an increase in n leads to a

less steep budget constraint as c 2 ,t +1 decreases while c 1 ,t increases. Young agents in

period t knows that, when they become old agents in period t+1, there will be more young

people in the future to exchange their future money into goods by then. So, they will not

bother to save much in the period t and thus increases their c 1 ,t .

Hence, different slopes of the budget constraint will produce tangency points that are

different from one another. Since, monetary equilibrium exists when the budget constraint

is tangent to the utility function, then the existence of the monetary equilibrium will depend

on the slope of the budget constraint which further depends on the value of r and n.

The monetary equilibrium is a Pareto optimum because agents are maximizing their utility

subject to their budget constraint and their choices lie on that feasibility line. In other

words, resources could not be re-allocated to make the young better off without making

the old worse off and vice versa. For instance, imagine giving the young some money

together with their endowment of 1 in period t (when they are born). Since they now

possess money, they will not be trading their goods that much from the old to exchange for

money, compared to the situation with just endowment at time t. This makes the young

better off but worsens the old.

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[b]

9
[c]

As in (b), the inflation in steady state is determined inversely by the growth rate of

population. In other words, the higher the population, the lower the inflation. A higher

population growth increases the demand for money but reduces the good. This is because
10
young agents in period t will know that there will be more young people in period t+1 to

trade their money with (when the former becomes old in t+1). The young in period t will

then store more of their goods for future trade, so this means more exchange of goods for

money (demand for good decreases). Thus, the price of good fell. But since inflation in this

model is measured in prices of good in units of money, a fell in price of good will lead to a

fall in inflation.

Inflation in steady state is also determined positively by the growth rate of money supply.

The higher the growth of money supply, the higher is the inflation. This matches the

quantity theory of money that states this relationship as well (PV=MY).

To sum up, inflation in steady state is determined by the ratio of the growth rate of money

to the growth rate of population. In other words, due to the addition of the growth rate of

money stock, inflation is now the above growth rate times the inflation found in (b).

For the monetary equilibrium to exist, growth rate of money supply must be larger than -1,

σ >−1 . In other words, there must be a growth rate in the money supply. The budget

constraint in (a) can be written as shown below.

This means that the growth rate of money now enters the budget constraint.

Diagrammatically, monetary equilibrium exists when the budget constraint is tangent to the

utility function. Ifσ =−1 then the budget constraint is mathematically unidentified. Then,
11
there will not be a budget constraint for the utility curve to be tangential, so there will also

be no monetary equilibrium. Similarly, r >−1∧n>−1 for the same reasons mentioned in

question (a).

[d]

Inflation is same as in question [c] because the rate is still the same as in question [c]. This

is because new money that is introduced as nominal transfers equals the growth rate of

money supply as shown by the equation M t + ∆ M t =( 1+σ ) M t . Therefore, inflation will also

affect the allocation of the consumption by impacting c 2 ,t +1 and c 1 ,t choices. According to

the budget constraint obtained in question [c], increase in inflation will increase the slope

12
of the budget constraint. A steeper budget constraint means c 2 ,t +1 increases while c 1 ,t

decreases. This makes sense because the inflation was measured in the price of goods in

terms of money since increase in the price of good in period t will lead to a reduction in

consumption of c 1 ,t .

[e]

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Inflation effects the allocation of resources for the same reasons as in question (d), except

a slight difference in the budget constraint compared in question (d). An increase in

inflation will increase the slope of the budget constraint written above. To reiterate, a

steeper budget constraint means c 2 ,t +1 increases while c 1 ,t decreases. This makes sense

because the inflation was measured in the price of goods in terms of money since increase

in the price of good in period t will lead to a reduction in consumption of c 1 ,t .

For the value of inflation itself, it is the same as in question (b). Inflation is the inverse of

the population growth rate. This is because the assumptions were made like question (b),

where the money supply M is assumed to be constant. By keeping the money supply

constant, it the case that money introduced is being recycled and passed on from

generation to the next in this OLG model. In other words, the money introduced via the

interest payments are being neutralized by the population growth.

Therefore, the introduction of new money through interest payments will depend on the

assumptions made in the money supply (how the money supply grows).

Suppose the money supply grows as in ques [c], then inflation will be same as in ques [c].

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In other words, if the money supply grows according to the interest payments, then σ will

influence inflation.

If money supply growth is not equal to the rate of interest payments (unlike the

hypothetical example above), then interest payments will not affect inflation. This is

because they will be mathematically cancelled in the equations. In other words, interest

payments introduced new money but are offset by the population growth. As a result, per

capita money supply remains constant. Inflation will be only impacted by the inverse of the

population growth rate times whatever is the assumption/annotation made to the growth of

money supply.

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