Structured essay plans of past exam Monetary policy essay questions. Prepared and used by a first class E&M student to revise for Section B of the Macroeconomics FHS paper.
[2019] Suppose that a new technology delivers an immediate and permanent improvement in
productivity that is observed by both the central bank and private sector agents. Discuss how an
inflation-targeting central bank should adjust monetary policy in response to the productivity change.
What factors determine the magnitude of the monetary policy response?
Introduction:
o Permanent productivity improvements: MPL shifts up, so PS shifts up since PS is a
markup over ED = MPL due to imperfect competition in labour demand allowing lower
real wages
Setup and initial shock t=0:
Assume one-period interest rate to output
transmission lag in IS curve (
)
Assume AEPC ( )
T
Economy starts at A (π= π , y=ye)
MPL shifts up to MPL', so PS shifts up to PS'
VPC shift right to VPC' with new y e'.
PC and MR immediately shift right to intersect VPC
at new equilibrium Z
At t = 0, economy still at old ye since CB cannot
influence output today. Inflation below target (π 0)
at new PC.
T=1 onwards
In t=0, CB anticipates PC to shift down due to AE (π e
= π0), so targets C and cuts rates below new lower r s
to hit MR line, creating positive output gap.
At t=1, economy at C (positive output gap, higher
inflation π1 > π0 but still below πT)
Rise in inflation since WS>PS and price setters have
last mover advantage. Wage setters ask for high
nominal wages, firms agree, but set prices even
higher to move economy to PS curve
Future periods, PC slowly shifts up due to AE and
CB slowly raises rates to new rs' (lower than initial
rs) to hit new ye'. C >> Z along MR line.
Flatter slope of IS curve (-1/a), higher a, less change in r needed to shift y. Smaller monetary
response needed.
o IS curve:
o higher a: more loans/ mortgages in economy on variable rather than fixed rates, rates
affect real economy more easily
Gentler MR curve, higher β (more inflation aversion in CB loss function, so allow more y volatility
to reduce π volatility), greater y1 at point C, larger monetary response needed.
o MR solves:
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