Exam True/False Answers

May 2012

This response provides a detailed assessment of each statement (True, False, or Uncertain) supported exclusively by the provided source material.

1. When looking at business cycles, the component of real GDP we are most interested in is the trend.

Statement Assessment: False

Detailed Explanation:

When analyzing business cycles, the primary focus is on the short-term fluctuations of real GDP around its long-term trend, known as the cyclical component or the output gap.

  1. Definition of Business Cycles: Business cycles are literally defined as the fluctuations of real GDP around its trend component. Economists attempt to decompose the data into its trend and business cycle component in order to analyze the latter’s volatility, persistence, and cyclicality.
  2. Policy Relevance: The distinction between the short-term and long-term components is crucial for policy analysis because there is a consensus among economists that monetary policy makers can only influence short-term fluctuations in output and its constituent parts (like consumption and investment).
  3. Nature of the Trend: Conversely, the long-term (trend) component is generally believed to be driven by factors that are not easily controllable by monetary or fiscal authorities, such as demographic changes and long-term technological progress. While understanding the reasons for persistent changes in growth rates (the trend) is one of the key problems in macroeconomics, the investigation of the specific features of the cycle (duration, amplitude, slope, and cumulative movements) relies on detecting turning points in the level of output.

Therefore, while the trend is relevant for long-run growth analysis, the specific purpose of studying "business cycles" is to analyze the cyclical component.

2. The Lucas critique implies that it is difficult to exploit the empirically observed Phillips curve.

Statement Assessment: True

Detailed Explanation:

The Lucas critique, formulated by Robert Lucas in 1976, directly undermines the stability and usefulness of empirically observed macroeconomic relationships, such as the Phillips curve, for policy exploitation.

  1. Definition of the Critique: The Lucas critique asserts that the structure of an econometric model consists of the optimal decision rules of economic agents, and since optimal decision rules vary systematically with changes in the policy rule, any change in policy will systematically alter the structure of those econometric models.
  2. Application to the Phillips Curve: The Phillips curve, which historically suggested a trade-off between inflation and unemployment, is the classic example of a reduced-form expression whose parameters are non-structural and likely to change when the policy regime changes. The critique implies that "If policy makers attempt to take advantage of statistical relationships, effects operating through expectations may cause the relationships to break down".
  3. Exploitation Difficulty: If policymakers attempt to "exploit" the short-run Phillips curve trade-off—for example, by using surprise monetary expansion to reduce unemployment—private agents who form rational expectations will anticipate the policy and adjust their expectations. This action immediately shifts the short-run Phillips curve, causing the systematic component of monetary policy to lose its real effect. Since the reduced-form coefficient on the output gap (the slope of the Phillips curve) is a complicated function of underlying parameters and the policy rule itself, policies based on exploiting that observed slope will be invalid once the policy changes.

Thus, the core implication of the Lucas critique is that attempts to systematically exploit historical relationships, like the Phillips curve, will lead to the collapse of that relationship, making exploitation "difficult" or impossible.

3. The Baumol-Tobin inventory model can explain the precautionary demand for money.

Statement Assessment: False

Detailed Explanation:

The original and primary function of the Baumol-Tobin inventory model is to explain the transactions demand for money, and it does so by explicitly excluding the uncertainty required for the precautionary motive.

  1. Transactions Focus: The Baumol (1952) and Tobin (1956) models use an inventory theoretic approach to explain how a "cash manager" minimizes the costs of holding cash (foregone interest) versus the costs of converting assets to cash (brokerage fees). The models explain why the transactions demand for money is sensitive to interest rates.
  2. Exclusion of Uncertainty: A central criticism of this inventory theoretic model is that it assumes the pattern of expenditure and receipts is known perfectly. This assumption of certainty means the model cannot capture the motive that defines precautionary demand.
  3. Precautionary Demand vs. Inventory Model: The precautionary motive arises from uncertainty about future payments or receipts. The sources note that by allowing "more flexible assumptions on the expected pattern of expenditures and receipts," analysis "can incorporate a precautionary motive for money holdings". This modification leads to models like those developed by Miller and Orr (1966), which incorporate a known probability distribution of receipts and payments. In conditions where payments flows are not known for sure, it is difficult to make a clear distinction between the two motives.

Since the Baumol-Tobin model in its original, specific formulation is based on certainty and explicitly excludes the risk inherent in the precautionary motive, the statement is technically false, although the inventory-theoretic approach serves as the foundation for models that do incorporate precaution.

4. Patinkin argued that the classical theory omitted real balance effects.

Statement Assessment: True

Detailed Explanation:

Patinkin’s major contribution to monetary theory was his critique of the classical dichotomy, arguing that the system was mathematically and logically inconsistent because it omitted the necessary mechanism linking the real and monetary sectors: the real balance effect.

  1. Classical Inconsistency: The classical dichotomy stated that real variables determined real outcomes, while the quantity of money determined the absolute price level. Patinkin argued this was inconsistent because the demand for money, derived from Walras’s Law, should depend on relative prices (the real side), yet the quantity theory stipulated it depended on the absolute price level (the monetary side).
  2. The Omission: Patinkin showed that in a Walrasian general equilibrium system, money-holding decisions and real decisions cannot be kept apart, but the classical formulation attempted to partition them. Patinkin claimed that the classical model required a correction.
  3. Patinkin’s Solution: Patinkin resolved the inconsistency by introducing the concept of the real balance effect. He did this by including the value of real money balances (\(S_n/P_n\)) as a determinant in the excess demand function for goods. The existence of this effect ensures that the demand for goods is affected by changes in nominal variables, providing a "bridge between the real and monetary sectors of the classical system and dispose[ing] of the classical dichotomy". Patinkin claimed that the assumption that a real-balance effect exists in the commodity markets is the "sine qua non of monetary theory".

Therefore, Patinkin argued that the omission of the real balance effect was the fundamental flaw causing the logical inconsistency and invalidity of the classical dichotomy.

5. Governments are inherently inflation averse.

Statement Assessment: False

Detailed Explanation:

While governments may dislike the political fallout of high inflation, economic theory focusing on monetary policy and political incentives suggests that governments often have an inherent bias towards inflationary policies or a positive inflation rate, especially in a discretionary regime.

  1. Incentive to Exploit: Governments are often tempted to exploit the short-run positive relationship between inflation and real output (or employment) in order to achieve temporary high real output or reduce unemployment. The democratically elected government always seeks to expand the economy, making the position of zero inflation time inconsistent.
  2. Inflation Bias: In models of time inconsistency, if the monetary authorities pursue discretionary policy aimed at minimizing a social loss function (which gives positive weight to output being above the natural rate, \(k>1\) in the loss function \(L\), they will have an incentive to choose a positive rate of inflation when optimizing. This systematic deviation from the optimal zero inflation rate is termed the inflation bias.
  3. Inflation as Revenue/Tax: Governments can also benefit from surprise inflation because it generates revenue via seigniorage (the inflation tax) or reduces the real value of public debt (a capital levy on nominal liabilities). These factors provide inherent benefits to inflating, counteracting any theoretical aversion to it.

The existence of the inflation bias, which occurs because the policymaker values short-term gains, suggests that governments are not sufficiently inflation-averse to pursue the long-run social optimum of low inflation unless institutional constraints are imposed, such as adopting fixed rules or delegating authority to an independent, conservative central bank.

6. If the business cycle component of consumption is found to be countercyclical, this implies higher volatility of consumption relative to investment.

Statement Assessment: False

Detailed Explanation:

This statement confuses two distinct business cycle stylized facts: cyclicality (direction of movement relative to output) and volatility (amplitude of movement). The implication regarding volatility is contradicted by established macroeconomic facts found in the sources.

  1. Volatility Fact: Consumption is consistently found to be less volatile than output, while investment is consistently found to be more volatile than output. This stylized fact is often explained theoretically by the idea that agents, being risk-averse, prefer to smooth consumption streams over time, absorbing income fluctuations into saving/investment decisions.
  2. Investment vs. Consumption Volatility: Real business cycle (RBC) models specifically predict and explain why investment is more volatile than consumption. The source notes that consumption goods display "much smaller fluctuations" than producer goods (investment goods).
  3. Cyclicality: Cyclicality describes the direction of movement (pro-cyclical: moves with output; countercyclical: moves against output). Even if consumption were countercyclical (a premise the sources do not empirically support, as output and consumption growth move somewhat together around peaks), this fact has no direct, necessary implication for consumption having higher volatility than investment.

Since consumption is universally described in the context of business cycles as being smoother and less volatile than both output and investment, the statement is false.

7. The terms of money neutrality and superneutrality can be used interchangeably.

Statement Assessment: False

Detailed Explanation:

Money neutrality and superneutrality are distinct concepts in monetary theory that describe the non-effect of monetary variables on real variables under different assumptions regarding the change in the money stock.

  1. Money Neutrality: Neutrality is the condition that changes in the level of the money supply have no effect on real variables. This property is central to the classical dichotomy.
  2. Money Superneutrality: Superneutrality is a stronger condition, defined as the property that variations in the long-run, and hence fully anticipated, inflation rate (or the rate of money growth) have no effect on the equilibrium values of other economic variables.
  3. Distinction: The key difference is that neutrality deals with a one-time change in the money stock (level), whereas superneutrality deals with a permanent change in the money growth rate. Money is only superneutral if all money balances, including high-powered money, bear a competitive rate of return. Because this condition is usually not met, the sources imply that money is generally not superneutral.

Because superneutrality is a stricter condition that is often violated even when neutrality holds, and the two terms refer to different types of monetary changes (level vs. growth rate), they cannot be used interchangeably.

8. Parameter uncertainty refers to the uncertainty about policymakers’ preferences.

Statement Assessment: False

Detailed Explanation:

Parameter uncertainty and policymaker preferences are distinct concepts addressed in monetary policy design, though they both introduce uncertainty into the outcome of policy decisions.

  1. Parameter Uncertainty (Model Uncertainty): This concept refers to uncertainty regarding the true values of the coefficients (parameters) in the structural economic model. For instance, the Lucas critique fundamentally concerns the instability of reduced-form parameters if the policy rule changes. Parameter uncertainty is often grouped with issues like imperfect information and lags under the general heading of problems that complicate policy-making, often referred to as model uncertainty.
  2. Policymaker Preferences: Policymaker preferences are represented by the weights given to various objectives in the central bank's loss function. For example, the loss function \(L = \rac{1}{2}(x^2_t + \eta \rac{ au^2_t}{2})\) reflects the central bank's relative preference (\(eta\)) for stabilizing output deviation (\(x_t\)) versus inflation (\( au_t\)). Uncertainty about preferences relates to the potential divergence between the policymakers' objectives and society's objectives or uncertainty about the "type" of government ("wet" vs. "hard-nosed").

Therefore, parameter uncertainty relates to the objective scientific understanding of the economy's structure, while uncertainty about preferences relates to the subjective objectives (loss function weights) of the authority.

May 2023

1. Without asymmetric information, there would be no need for financial intermediaries.

False

Detailed Explanation:

The existence of financial intermediaries (such as banks) is explained by several key factors, not solely by the presence of asymmetric information. While informational asymmetries are a crucial element—often hindering the development of public markets in primary securities and being suggested as a primary reason for intermediaries to exist—other imperfections provide justification for intermediaries even in their absence:

  1. Economies of Scale in Transactions and Information: Financial intermediaries address the need for economies of scale in transactions and information gathering. For an agent to hold a sufficiently diversified portfolio, they would need to hold a large number of different assets, which is costly unless funds are pooled together (as provided by unit trusts and pension funds). Likewise, if a large sum is required for a loan (e.g., to buy a factory), it is unlikely a single agent could provide it, making aggregation via a bank necessary.
  2. Reconciliation of Preferred Habitats/Insurance: Intermediaries reconcile the differing preferences of savers and borrowers. Savers often prefer liquid assets for transaction and precautionary purposes, but productive borrowers often need long-term funding. This difference can be analyzed in terms of lenders seeking insurance against uncertain future cash flows. The archetypal financial intermediary makes profits by issuing liabilities preferred by lenders (often short-term, low-yield, liquid deposits) and investing in assets preferred by borrowers (often longer-term, higher-yielding loans).
  3. Risk Aversion and Insurance Services: Intermediaries provide insurance services. For instance, banks help agents consume when they need to most by offering liquidity insurance.

If markets were perfect, financial intermediation would be irrelevant to economic activity (as in the Miller-Modigliani analysis). However, market imperfections like transaction costs and the need to overcome economies of scale provide a need for intermediaries even if information were symmetric.

2. The optimal inflation rate is equal to zero.

Uncertain

Detailed Explanation:

The statement is subject to debate depending on the specific theoretical framework and practical considerations:

  1. Theoretical Ideal (Zero Inflation): In many economic models, particularly those examining time inconsistency and inflation bias, the socially optimal inflation rate is often assumed or calculated to be zero (\( au_T = 0\)). For instance, in the Barro-Gordon model, if policy rules were feasible, the optimal inflation rate would be zero. If the central bank minimizes a loss function centered on zero inflation deviations, achieving zero inflation is the theoretical goal. A system based on a rule (rather than discretion) would guarantee low and relatively stable rates of inflation, with zero inflation being the rule-type policy superior to the positive inflation resulting from discretion.
  2. Equilibrium Outcome vs. Optimal Target: When policy is conducted under discretion, even if the optimal inflation rate is zero, the resulting equilibrium inflation rate will be positive (the inflation bias) because policymakers exploit the short-run trade-off when expectations are low. This positive outcome reflects the "best enforceable rule" or "pure discretion" outcome, which is excessive relative to the efficiency criterion (zero).
  3. Practical Targets (Positive Inflation): Central banks often adopt inflation targets slightly above zero for practical reasons. For example, the Bundesbank has long had an official inflation target of two percent. A target above zero is justifiable because:

Therefore, while zero inflation represents the theoretical ideal in foundational models, practical criteria (such as accommodating measurement bias in indices and allowing for price adjustment friction) lead policy makers to aim for a slightly positive target.

3. Data revisions provided by the US Federal Reserve Bank tend to not be well-behaved.

True

Detailed Explanation:

The sources contain specific analysis documenting that revisions to major macroeconomic variables in the United States are generally "not well behaved".

"Well-behaved" Revisions Defined: Revisions are considered "well behaved" if they satisfy three properties, meaning they are rational forecast errors:

  1. Zero Mean (P1): The initial announcement is an unbiased estimate of the final value.
  2. Small Variance (P2): The variance of the final revision is small compared to the variance of the final value.
  3. Unpredictability (P3): The final revision is unpredictable given the information set at the time of the initial announcement (initial announcements are optimal forecasts).

Findings for US Data: The empirical properties of revisions to major macroeconomic variables in the United States suggest they do not satisfy these desirable statistical properties. These findings are robust across subsamples.

Although the analysis covers macroeconomic variables generally, many of the monitored variables—such as monetary measures, banking system data, and NIPA variables like real output, consumption, and investment—are collected and processed by agencies including the Federal Reserve Board of Governors and the Federal Reserve Bank of St. Louis.

4. In most countries Fiat money has replaced Credit money.

False

Detailed Explanation:

The statement is false based on the quantitative relationship between these two forms of money in modern economies:

In modern financial systems, Credit money is quantitatively dominant. In the UK today, inside money (Credit money) is quantitatively much larger than outside money (Fiat money). The nominal value of inside money is approximately 30 times the value of outside money (notes and coins).

While the world has moved onto a fiat money standard since 1971, meaning currencies are no longer backed by commodities, the physical currency component (fiat money) makes up only a small fraction of the total money stock (which is dominated by credit money/bank deposits) in highly developed financial systems.

5. An unemployment-averse central bank will always try to exploit short-term Phillips curves to increase output, at the cost of higher inflation.

False

Detailed Explanation:

While an unemployment-averse central bank (one that is "wet" or assigns a higher weight to output deviations in its loss function, such as \(λ > 1\) or low \(β\)) has the fundamental incentive to exploit the short-term Phillips curve trade-off, the word "always" makes the statement false for several reasons established by dynamic models of monetary policy:

  1. Equilibrium under Discretion: In a rational expectations equilibrium under discretion (like the Barro-Gordon model), policymakers cannot systematically achieve an output gain. The equilibrium is reached at a point where the actual inflation rate (\(π_t\)) equals the expected inflation rate (\(π^e_t\)), and unemployment is at its natural rate (\(U^*\)). At this point, the policymakers are no longer motivated to select \(π_t > π^e_t\) because the marginal cost of inflation just balances the marginal gain from reducing unemployment. Thus, the exploitation ceases once the high-inflation equilibrium is reached.
  2. Reputation/Multi-period Game: If the central bank operates in a multi-period game and values its reputation, even a "wet" central bank will behave as if it is "hard nosed" (inflation-averse) in early periods to build credibility. By building a reputation of toughness on inflation, it avoids the inflation bias problem.
  3. Commitment to a Rule: If the central bank can credibly commit to a monetary rule, it avoids the time inconsistency problem, allowing it to achieve the optimal outcome (low/zero inflation and natural unemployment) without attempting to exploit the short-run curve.

Therefore, while the initial temptation to exploit the trade-off is present, the central bank will not always attempt this due to the consequences implied by rational expectations (ending in high inflation with no output gain) or the benefits of maintaining a reputation.

6. According to the Real Business Cycle model, investment is more volatile than consumption.

True

Detailed Explanation:

The Real Business Cycle (RBC) model explicitly predicts and explains why investment is significantly more volatile than consumption:

Oct 2023

1. Some people advocate the return of the Gold standard because it would remove the need for trust in the central bank when using money.

True

Detailed Explanation:

The argument for commodity standards, such as the Gold Standard, rests fundamentally on the idea that they provide an in-built restriction or nominal anchor, removing the need for reliance on the discretion or credibility of the monetary authorities.

  1. Constraint on Authority: The essence of commodity-based money is that the volume of money is limited by the supply of the commodity (e.g., gold). This system is fundamentally different from a fiat money standard, where the currency is inconvertible paper issued by the state.
  2. Trust vs. Rules: In fiat systems, the successful operation relies on the restraint by the issuing authority and/or budget agency. The world since 1971, when the Gold Standard ended, has been characterized by the search for mechanisms to anchor nominal values. The basis of trust in money under fiat systems must be established by the stability and credibility of the monetary system.
  3. Abuse of Monopoly: Critics of fiat money argue that the monopoly control of currency imposed temptations and pressures on governments to abuse that monopoly to gain command over resources, leading to inflation. The Gold Standard, by imposing the discipline of convertibility, protected central banks from political pressures.

Advocates of a return to a metallic standard look upon it as a way to achieve price stability by defining the currency base so that it is stable, thereby removing the discretion and associated need for trust or "restraint" inherent in managed fiat systems.

2. Maturity transformation is the reason for the existence of financial intermediaries.

False

Detailed Explanation:

While maturity transformation is consistently described as a key or most important function of financial intermediaries (FIs), it is not the sole reason for their existence.

The existence of FIs is attributed to a number of reasons, primarily stemming from market imperfections:

  1. Maturity Transformation: This is arguably the most important service provided by banks. It involves reconciling the differing preferences of savers (who generally desire highly liquid, short-term, capital-certain assets for transaction/precautionary purposes) and borrowers (who generally prefer longer-term funding for productive investments).
  2. Economies of Scale: FIs achieve economies of scale in transactions and information gathering and portfolio management. For instance, they aggregate small deposits to make large loans or allow small agents to hold diversified portfolios.
  3. Information Asymmetries and Insurance: FIs alleviate problems caused by informational asymmetries. They provide insurance services, such as liquidity insurance, against uncertain future cash flows. The specialized knowledge of borrowers' creditworthiness that intermediaries acquire makes this function profitable.

Because FIs solve problems related to economies of scale, information costs, and risk aversion in addition to reconciling preferred habitats through maturity transformation, maturity transformation alone is not the exclusive reason for their existence.

3. Variations in monetary aggregates are closely associated with variations in inflation.

True

Detailed Explanation:

Monetary theory and empirical evidence support a close association between money supply growth and inflation, particularly over long time periods:

  1. Monetarist Consensus: There is a strong consensus among economists that variations in monetary aggregates are closely associated with variations in inflation over a reasonably long time period. The Quantity Theory of Money (QTM) is the theoretical support for this, arguing that money supply variations lead to proportional inflation changes, assuming long-run neutrality of money.
  2. Empirical Findings (Long Run/High Inflation): Empirical analysis across a large sample of countries confirms a strong positive relation between long-run inflation and the money growth rate. This strong link, however, is almost wholly due to the presence of high- (or hyper-) inflation countries in the sample.
  3. Low Inflation Exception: The relationship is weak for countries experiencing low rates of inflation (e.g., averaging less than 100% per annum over 30 years). In low-inflation countries, variations in money growth often reflect "noise" coming from velocity differences rather than systematic differences in monetary policies.

Despite the weakening of this link in low-inflation environments and the fact that the relationship is often non-proportional, the general proposition that money variations are closely associated with inflation holds as a major stylized fact in macro-monetary economics.

4. The Real Business Cycle model captures the stylized facts of the business cycle.

True

Detailed Explanation:

The Real Business Cycle (RBC) model is credited with successfully explaining many core cyclical regularities, although it has shortcomings with others:

  1. Successful Captures: RBC theory explicitly does a good job at explaining a number of the stylized facts of the macroeconomy. These successful explanations include the procyclical nature of employment, labour productivity, and the real wage, and the explanation for why investment is more volatile than consumption. Furthermore, a quantitative version of the RBC model generates cyclical fluctuations that are surprisingly similar to the actual cyclical properties of the U.S. economy for key real variables.
  2. Shortcomings: The model faces difficulties in other areas: it is hard to identify the underlying productivity shocks, it requires a flatter aggregate labor supply curve than typically observed, and it incorrectly predicts that the price level will be countercyclical, whereas the empirical evidence is inconclusive or suggests otherwise.

Since the model successfully accounts for a number of major and important stylized facts, the statement that it captures them is accurate, even if its success is incomplete.

5. Brainard conservatism implies that central banks should limit their use of monetary policy as it has long and variable lags.

True

Detailed Explanation:

Brainard's conservatism principle, stemming from his work on parameter uncertainty, dictates cautious policy adjustments, and this approach is explicitly connected in the sources to the rationale provided by long and variable lags:

  1. Brainard's Principle: Brainard's (1967) analysis focuses on monetary policy formulation under parameter uncertainty, particularly dealing with multiplicative errors where the effect of the policy instrument is uncertain. The resulting Brainard's conservatism principle suggests that policymakers should be more cautious and adopt "small steps" rather than large ones, as big steps cause too much variance per unit of return.
  2. Link to Lags (Friedman's Concern): The source explicitly links this caution to the classical monetarist critique of activism: This conservatism principle is supportive of Friedman's concern that central banks should adopt a predictable and simple rule for policy given the long and variable lags in the transmission mechanism.

Therefore, although the formal theoretical justification for Brainard conservatism is uncertainty (risk minimization), the policy implication of "limiting use" or taking "small steps" is supported by, and often cited in conjunction with, the practical problem of long and variable lags in policy transmission.

6. Setting base money alone is not enough to control the supply of money.

True

Detailed Explanation:

While the theoretical base-multiplier (B-M) model suggests that controlling base money (\(H\)) should control the total money supply (\(M\)), in practice, central bankers find that controlling \(H\) alone is insufficient due to volatility in the multiplier components:

  1. Theoretical Conditionality: The money stock (\(M\)) is related to high-powered money (Base Money, \(H\)) by a multiplier that depends on the public's currency-deposit ratio (\(α\)) and the bank's reserve-deposit ratio (\(β\)). Control of \(M\) is possible if \(H\) is controllable and if the ratios (\(α\) and \(β\)) are stable through time.
  2. Practical Instability: Central banks find that monetary base control is highly problematic, often referring to it as a "non-starter". The ability of the central bank to control the total money supply is complicated because the component ratios, particularly the reserve/deposit ratio, are often volatile, especially if interest rates are paid on reserves.
  3. Decoupling Control: If the reserve/deposit ratio becomes much more volatile, then greater control over the monetary base would not translate to a similarly improved control over the broader monetary aggregates. Furthermore, fluctuations in the public's demand for cash (part of base money), which are unpredictable, must often be accommodated by the central bank.

Since the total money supply depends on the monetary base multiplied by a factor that is often unstable and unpredictable, manipulating the base alone is insufficient to guarantee control over the broader money supply in a complex financial system.

Oct 2024

1. Inventory theoretic model can adequately explain the transaction demand for money.

Statement Assessment: False (or Uncertain, leaning heavily toward False based on empirical adequacy).

Detailed Explanation:

The inventory theoretic approach, popularized by Baumol (1952) and Tobin (1956), explicitly models the transactions demand for money. The basic idea involves a "cash manager" (individual or firm) balancing the costs of holding cash (foregone interest) against the costs of converting assets to cash (brokerage fees). By making fewer, larger transfers from bonds to cash, the agent avoids frequent brokerage fees but misses out on potential interest earnings.

However, the sources present significant criticisms regarding the model's empirical adequacy, leading to the assessment of "False":

  1. Unrealistic Assumptions: A primary criticism is that these models assume the pattern of expenditure and receipts is known perfectly. This assumption is "clearly not true in reality".
  2. Empirical Failure (Micro Level): Even when modifications are made to incorporate uncertainty (such as the Miller and Orr model), these inventory theoretic models "face a huge uphill struggle when faced with empirical evidence". Specifically, at the micro level, the percentage of actual cash balances held by firms that is explained by the Baumol model is tiny. One estimate suggests that the simple Baumol model explains only around 2-3% of the actual cash balances held by large firms.
  3. Aggregation Concerns: Although the Baumol–Tobin analysis deals with money holding as an inventory at the individual agent level, it is not found to be very helpful at an aggregate level.

While the model provides an "intellectual appeal and simplicity" and establishes that transaction demand is sensitive to the level of interest rates, its inability to explain observed real-world money holdings, particularly at the micro level, suggests it cannot adequately explain the transaction demand for money.

2. A Central Bank can never control the monetary base directly.

Statement Assessment: False.

Detailed Explanation:

The statement claims that a Central Bank (CB) can never control the monetary base directly, which contradicts the theoretical capabilities and operational procedures described in the sources, even though practical complications often lead central banks to prioritize controlling interest rates instead.

  1. Theoretical Control: The monetary base, also known as high-powered money, consists of the CB's monetary liabilities, specifically currency in circulation and bank reserves. The government (via the CB) directly controls the amount of cash in the economy because it is the monopoly supplier. Therefore, the CB should be able to directly control the stock of high-powered money, H.
  2. Mechanism of Control: Central banks create money and can change the monetary base by adjusting their balance sheets, typically by conducting open market operations (purchasing and selling government bonds from the banking system) to inject or withdraw reserves. By forcing banks to hold a certain level of reserves, the government can directly control the monetary base.
  3. Practice vs. Capability: While control is possible, central banks often choose not to exercise strict monetary base control due to practical and operational constraints. The CB's primary instrument is typically the short-term money market rate. If the CB were to try to run a monetary base control system, it would face problems because the demand for bank reserves is highly inelastic in the short run, leading to severe interest rate volatility. Central banks generally accommodate the day-to-day demand of the banking system for reserves. Consequently, many central bankers regard monetary base control as a "non-starter".

Since the CB has the monopoly power to issue high-powered money and can manipulate bank reserves through open market operations, and is theoretically capable of controlling its own liabilities, the claim that it can never control the monetary base directly is refuted by the theoretical analysis in the sources.

3. The Fisher equation defines the relationship between nominal interest rates, inflation and the output gap.

Statement Assessment: False.

Detailed Explanation:

The Fisher equation defines the relationship between interest rates and inflation, but it does not include the output gap as a definitional component:

  1. Definition of the Fisher Equation: The Fisher equation relates the nominal interest rate (\(R_t\)) to the real rate of interest (\(r_t\)) and the expected inflation rate (\(π^e_{t+1}\)). By definition, the relationship is: \(r_t ≈ R_t - π^e_{t+1}\). The equation distinguishes between the quoted (nominal) rate and the rate reflecting the actual purchasing power change (real rate).
  2. Role of the Output Gap: The output gap (\(y - y^*\)) is a measure of the deviation of real output from its potential or equilibrium level. This variable is central to Taylor rules (or monetary policy reaction functions), which describe how the nominal interest rate (\(i\) or \(R\)) is set by the central bank in response to economic conditions. A typical Taylor rule relates the nominal interest rate (\(i\)) to the equilibrium real rate (\(r^*\)), inflation (\(π\)), and the output gap (\(y - y^*\)).
  3. Distinction: The output gap is an input into the monetary policy decision (like the Taylor rule) that determines the nominal rate, which is then related to inflation via the Fisher equation. The Taylor rule reduces to the Fisher equation only when inflation and the output gap are both at their target or zero deviation levels (i.e., \(R = r^* + π\)).

Since the Fisher equation itself is fundamentally defined by the identity linking nominal rates, real rates, and inflation/inflation expectations, and the output gap is included only in policy reaction functions (Taylor Rules), the statement is False.

4. The classical dichotomy refers to the separation of real output fluctuations from those of employment.

Statement Assessment: False.

Detailed Explanation:

The classical dichotomy is a fundamental concept in classical monetary theory concerning the relationship between the real and monetary sectors of the economy, not the separation of two real variables (output and employment).

  1. Definition of Classical Dichotomy: The classical dichotomy refers to the separation of the real side of the economy from the monetary side.
  2. Real Sector Outcomes: According to this view, only real variables (such as preferences, technology, and endowments) determine real outcomes. Real outcomes include quantities, relative prices, investment decisions, and real output. Since employment and real output are both determined by these real factors, they belong together in the real sector.
  3. Monetary Sector Outcomes: The monetary side, governed by the quantity of money, determines only the absolute price level (or the value of goods in monetary units). Money is considered "neutral" in that the quantity of it has no effect on any real variable.

The statement attempts to separate two variables (real output and employment) that are explicitly grouped together under the "real outcomes" side of the classical dichotomy. Patinkin criticized the dichotomy precisely because the real and monetary decisions cannot be kept apart in a general equilibrium system.

5. New Keynesian models cannot explain the inflationary impact of aggregate demand shocks.

Statement Assessment: False.

Detailed Explanation:

New Keynesian models, particularly the three-equation IS-PC-MR framework, are designed to analyze and explain the inflationary impact of aggregate demand shocks.

  1. Mechanism of Demand Shock: A positive aggregate demand shock (IS shock) leads to output rising above the equilibrium or trend output level (\(y > y^e\)).
  2. Inflationary Outcome: Due to the Phillips curve relationship within the model (which links the output gap to inflation), this positive output gap causes inflation to rise above the target level (\(π_0 > π_T\)).
  3. Observed Correlation: Consequently, an aggregate demand shock is associated initially with a rise in both output and inflation. The model explicitly predicts that an aggregate demand shock leads to procyclical inflation. The central bank must raise the interest rate in response to the aggregate demand shock because it can forecast the resulting consequences for inflation.

Since the framework clearly shows that an aggregate demand shock results in an immediate increase in inflation above target, the statement that New Keynesian models cannot explain this impact is False.

6. Credit-market conditions may themselves be the facilitating factor depressing economic activity.

Statement Assessment: True.

Detailed Explanation:

This statement is directly supported by the literature discussing financial frictions and accelerators within macroeconomic models:

  1. Recognition of Credit Markets as a Source of Depression: It has been "long recognised that credit-market conditions may themselves be the source factor depressing economic activity".
  2. Link between Financial and Real Cycles: There is a "tight association between financial cycles and real output cycles". Financial factors, including credit, play a role in explaining the duration and amplitude of economic cycles.
  3. Mechanism (Financial Frictions): In models incorporating credit market imperfections, problems arise due to asymmetries of information in borrower-lender relationships. A worsening of informational asymmetries leads to increased agency costs. These elevated costs can result in fewer projects receiving external financing, which then has "widespread real effects".
  4. Financial Accelerator Models: Financial accelerator models, such as those studied by Bernanke et al. (1999) in a New Keynesian context, incorporate this idea, demonstrating how factors that affect the ability or cost of the banking system to provide intermediation impact real allocation and are useful for understanding the macroeconomic effects of phenomena such as financial crises. The inability of banks to grant credit, rather than just the contraction of the money stock, has been suggested as a primary cause for the depth of historical depressions.

Therefore, the sources confirm that credit-market conditions can facilitate and worsen economic downturns by impairing the financial intermediation process.

May 2024

1. Direct barter typically fails due to a lack of double coincidence of wants.

Assessment: True

Detailed Explanation:

The core impediment to trade in a direct barter system is the necessity of a 'double coincidence of wants'. For a transaction to be mutually beneficial, it is required that trader A not only has what trader B wants, but also that trader B has something to offer that trader A wants in exchange.

The search costs involved in finding a partner who simultaneously wants what you have and has what you want are substantial, making the occurrence of a successful trade unlikely, especially when goods are specialized. The sources describe this necessity as imposing "restrictions imposed on the feasible set of transactions" and resulting in "very large search and information costs". This constraint forces people to spend a large fraction of their time and energy shopping for exchange partners.

The failure of direct barter due to this constraint is the fundamental reason societies developed money or indirect barter (where a good is accepted not for consumption but for future trade).

2. Aggregate money demand functions have not proven to be very stable over time.

Assessment: True

Detailed Explanation:

Historically, there was a period when simple functional forms of money demand appeared "reasonably well at explaining the demand for money". For instance, Goldfeld (1973) suggested that the conventional demand function exhibited "no marked instabilities", and early studies found a stable and predictable long-run relationship.

However, the sources stress that the stability of the money demand function is a crucial empirical question, and evidence from the mid-1970s onward demonstrated significant instability:

  1. Breakdown of Stability: The later sections of the sources extensively discuss the "breakdown of the macroeconomic demand for money function" and note that previously stable empirical demand-for-money functions in many countries "have been shifting around".
  2. Policy Implications: This widespread instability caused concern among economists and policy-makers. The failure of the function meant that the assumption of stability, necessary for monetary authorities to target the money supply successfully, was undermined. The instability has been severe enough that the use of a single money supply target has been abandoned in countries like the UK.
  3. Causes of Instability: The breakdown was attributed to factors like financial innovation and temporary supply shocks, which led to the "erosion" of the previous stability.

Thus, despite initial findings of stability, subsequent empirical experience has shown that these functions are highly unstable, leading to a loss of confidence in their use for short-run policy management.

3. An important rationale for the existence of banks is that they only need to hold fractional reserves.

Assessment: False

Detailed Explanation:

The necessity of holding fractional reserves is a characteristic or consequence of the commercial banking system that allows the money supply to be larger than the monetary base and provides benefits to society, but it is not presented as the primary rationale for the existence of financial intermediaries or banks themselves.

The core reasons explaining why banks exist as intermediaries, rather than borrowers and lenders dealing directly, are rooted in addressing market imperfections:

  1. Economies of Scale and Information: Banks achieve economies of scale in gathering information and managing transactions. They pool limited funds to make large loans and are better able to assess the creditworthiness of borrowers.
  2. Risk Management/Liquidity: Banks provide insurance services against the risk of needing funds early (liquidity risk). They hold reserves to honor the promise of convertibility between deposits and cash.
  3. Specialization: Banks specialize in providing credit for projects that are costly to evaluate and monitor (information intensity of bank investments).

The fractional reserve system (\(r < 1\)) is a design feature derived from the fact that not all depositors will withdraw funds simultaneously. While this system allows for the creation of money at a lower social cost, the fundamental justification for the intermediary role lies in overcoming information costs and scale barriers.

4. The baseline Real Business Cycle model predicts a negative association between prices and real output in the case of technology shocks.

Assessment: True

Detailed Explanation:

Real Business Cycle (RBC) theory posits that business cycles are driven primarily by real shocks, such as positive or adverse productivity (technology) shocks.

The model's predictions regarding the correlation between output and prices are explicit:

  1. RBC Prediction: RBC theory explicitly "predicts that the price level will be countercyclical".
  2. Definition of Countercyclical: A variable is defined as countercyclical if it moves negatively with output.
  3. Mechanism: Consider a beneficial technology shock: this shock raises the marginal product of labor, increasing the demand for labor, employment, and real output (a boom). Because the shock increases the overall supply capacity of the economy, prices tend to fall, resulting in a negative correlation or association between prices and output.

Therefore, the baseline RBC model predicts a countercyclical price level, confirming a negative association between prices and real output following a technology shock.

5. When a government finances its structural deficit through money creation, there is a risk of hyperinflation.

Assessment: True

Detailed Explanation:

The sources establish a clear and strong causal link between fiscal deficits financed by money creation and extreme inflation, including hyperinflation:

  1. Deficit Finance and Inflation: High inflation is considered a fiscal phenomenon, often arising when the government finances budget deficits by creating money. Printing currency or creating bank deposits to finance government spending is described as inflationary.
  2. Inflation Tax (Seigniorage): Financing the deficit through money creation means the government extracts resources via seigniorage, which is effectively an "inflation tax" levied on money holders.
  3. Risk of Hyperinflation: The relationship between money-financed deficits and inflation is non-linear. As the government tries to finance a larger deficit (\(gY\)), the required rate of inflation "increases steeply". Depending on money demand characteristics, there may be a maximum amount of resources the government can extract.
  4. Explosive Process: "Going beyond that range implies hyperinflation". Furthermore, financial adaptation, where institutions break down and people substitute away from domestic money (increasing velocity), intensifies the inflationary process. This ultimately causes the deficit to lead to hyperinflation because the inflation tax can be almost totally evaded. Historically, "Essentially all major inflations, especially hyperinflations, have resulted from resort by governments to the printing press to finance their expenditures".

6. The classical dichotomy predicts that money growth will not have an impact on nominal output.

Assessment: False

Detailed Explanation:

The classical dichotomy and the associated principle of money neutrality predict that money growth will affect nominal variables (like prices) but not real variables (like real output).

  1. Classical Dichotomy and Neutrality: The dichotomy separates the economy into a real side (determining real outcomes, like real output, \(y\)) and a monetary side (determining nominal outcomes, like the price level, \(P\)). Money is neutral, meaning changes in the quantity of money have no effect on any real variable.
  2. Impact on Real Output (\(y\)): Real output (\(y\)) is determined by real factors (technology, endowments) and remains fixed at the full employment level, \(y^*\), in the classical long run.
  3. Impact on Price Level (\(P\)): According to the Quantity Theory, an increase in the money supply leads to a proportional increase in the absolute price level, \(P\).
  4. Impact on Nominal Output (\(Y\)): Nominal output (\(Y\)) is defined as the product of the Price Level (\(P\)) and Real Output (\(y\)). Since the classical model predicts that \(y\) is constant, and money growth causes \(P\) to increase proportionally, Nominal Output (\(Y = P \times y)\) must increase proportionally as well.

Therefore, the classical dichotomy predicts that money growth has a direct and proportional impact on nominal output via the price level, making the statement False.