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Exam December 2009

Monetary Economics (Erasmus Universiteit Rotterdam)

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FEB23010 Monetary Economics, 15 December 2009

Multiple choice: True / False / No opinion

The exam consists of 30 propositions. You must indicate whether the propositions are True or False, or
whether you do not know and prefer to give no opinion. Each correct answer scores 2 points, ‘no
opinion’ scores 1 point, and an incorrect answer scores 0 points. The first 30 points will not count
towards the calculation of your grade.

Start with giving True / False answers to the propositions of which you are absolutely certain. Incorrect
answers carry a penalty. If you are not certain, rather than guessing, it is better to use ‘no opinion’
because this option will score 1 point.

The italic texts provide the propositions that must be evaluated, sometimes with the help of the added
text. Propositions and the correct answers are based on the lecture materials of this course.

Unreadable or double answers will be treated as incorrect answers.

Propositions

1) The basic monetary relationship between nominal interest rate and inflation is called purchasing
power parity.

2) The stylized monetary fact for the (long run) relationship between real GDP growth and inflation is
that the estimated coefficient of the relationship equals 1.

3) The stylized monetary fact for the relationship between inflation and nominal interest rates is that
the estimated coefficient of the relationship equals 1.

4) Understanding empirical relationships requires an appropriate use of the macroeconomic AD-AS

model.
Because of the upward sloping SRAS, changes in aggregate demand always result in a positive
relationship between changes in output (relative to potential output y*) and prices (relative to expected
prices E(p)).

5) A short-run stylized monetary fact is that changes in money growth, if sufficiency sharp (i.e.
unexpected and dominating), produce changes in output.

6) The function of legal tender is an essential function of money.

7) The fact that money is important in various economic models proves the essential economic
function of money.

8) Among the various ways of organizing efficient economic trade in exchange economies,
government allocation is an important improvement over an economy using barter.

9) Bank reserves and monetary base are two measures of central bank money.

10) Standing facilities are made available to commercial banks by the central bank.
In the money market model the use of standing facilities is considered part of the demand for reserves
by commercial banks.

11) For a given level of the interest rates on its standing facilities, a (hypothetical) borrowed reserves
operating target of the ECB would effectively be the same as an interest rate operating target.

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12) The correct identification of monetary policy shocks is important because in case of incorrect
identification the presence of demand shocks is likely to create unexpected and puzzling relationships
between the perceived policy shock and other macroeconomic variables.

13) Historically, before 2003, the discount rate of the Federal Reserve functioned as a floor (minimum
level) for the federal funds rate.

14) One recurring question in monetary economics is whether central banks actually control the money
supply. The correct answer depends, and may be yes, or no.
In practice, in the short run, the answer is no: central banks prefer to stabilize their short-run interest
rate operating target. Thus, the central bank makes the money supply endogenous.

15) Alternative transmission channels of monetary policy are needed because basic empirical evidence
suggests that there is no real macroeconomic effect of monetary policy shocks.

16) Alternative transmission channels exist in addition to the traditional interest rate channel of
monetary policy used in textbook macroeconomic models such as the ISLM model.

17) The balance sheet channel relies on the idea that monetary policy actions affect the
creditworthiness of borrowers, for example by affecting the value of collateral

18) One test of the credit channel relies on the so-called financing mix: the proportion of financing
obtained by firms from bank loans relative to other sources such as commercial paper and bonds.
In the financing-mix test, the credit channel is assumed to be supported by the empirical evidence when
following a monetary policy tightening bank loans fall less than other sources of finance.

19) Consider the following model:

Economic structure: Yt = b Mt-1 + Zt + εt
Policy: Mt = c Yt where
Granger-causality test: Yt = a0 + a1(L) Yt-1 + a2(L) Mt-1 + a2(L) Zt + νt
We can expect that the Granger-causality test will correctly indicate that policy affects the economic
variable Y (i.e . a2(L)≠0).

20) Central bank reaction functions are one possible reason for incorrect conclusions drawn from
Granger causality tests on the effects of monetary policy shocks.

21) A policy rule describes how the (proxy) instrument of monetary policy reacts to the central bank’s
information about the economy (that is, revealed preference).

22) Empirical evidence suggests that in recent years the Taylor rule describes monetary policy in
various countries almost equally well.
This provides evidence that central banks in these countries have followed policies that are close to
optimal for their countries.

23) The Lucas critique, applied to the optimal control approach to monetary policy, argues that
determining optimal monetary policy in an estimated model will not work because of political business
cycles.

24) Consider the Taylor rule: rt = rr* + πt + α (πt – π*) + β (y-y*)t. Assume the basic Taylor coefficient
values for α, β. The equilibrium real interest rate is 2.5%, the inflation target is 2.0%, the inflation gap
is 0.5% and the output gap is -1%.
The Taylor rule interest rate equals 4.25%.

25) Empirical studies into central bank reaction functions have a tendency to show many different
results for the estimated reaction function.

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It has been shown that policy asymmetry is an important characteristic of policies that should be
examined in empirical studies on reaction functions.

26) The appropriate theoretical definition of inflation is: “a strong rise in at least some prices of goods
and services”.

27) The Phillips-curve model of inflation has been labeled a myth.

Output gaps result from various shocks and not all these shocks do always and necessarily lead to
changes in long-run inflation.

28) The demand for seigniorage in government fiscal policy can be one reason for high money growth
in a country, leading to inflation.

29) The time-inconsistency model concludes that discretionary monetary policy will result in higher
unemployment and no effect on inflation.

30) The central bank objective of price stability has been criticized on account of it leading to higher
output volatility.
The AD-AS model shows that this criticism is only valid if central banks are assumed to be able to
accurately identify permanent shocks to aggregate supply, to which they should not respond.

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