Test your knowledge on Keynesian models, nominal rigidities, and the Phillips curve.
1. True or False: In the expectations-augmented Phillips curve, if the coefficient on expected inflation is less than 1, a long-run trade-off between inflation and unemployment exists.
Correct Answer: True.
The expectations-augmented Phillips curve is given by $$\Delta w_t = f(UN_{t-1}) + \alpha \Delta p_t^e$$. A long-run steady state requires that wage inflation equals price inflation ($$\Delta w_t = \Delta p_t$$) and expected inflation equals actual inflation ($$\Delta p_t^e = \Delta p_t$$). If $$0 \le \alpha < 1$$, the equation becomes $$\Delta p_t (1-\alpha) = f(UN)$$. This implies a stable, downward-sloping relationship between the steady-state inflation rate ($$\Delta p_t$$) and the unemployment rate (UN). Only when $$\alpha = 1$$, as the natural rate hypothesis posits, does this trade-off disappear, making the long-run Phillips curve vertical.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, pp. 182-183.
2. According to the Friedman-Phelps "natural rate" hypothesis, the long-run Phillips curve is:
Correct Answer: c) Vertical.
The Friedman-Phelps argument is that workers and firms are concerned with real wages, not nominal wages. Therefore, the Phillips curve should be augmented with expected inflation, with a coefficient of one ($$\alpha=1$$). In a steady state where expected inflation equals actual inflation, the inflation terms cancel out, leaving an equation that determines a unique "natural" rate of unemployment (UN) where $$f(UN) = 0$$. This unemployment rate is independent of the steady-state inflation rate, meaning the long-run Phillips curve is vertical at this natural rate.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, p. 183; Phelps, E. S. (1967). Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time.
3. What is a key difference between the sticky-price models of Fischer and Taylor?
Correct Answer: c) In Taylor's model, monetary policy has more persistent effects on output than in Fischer's model.
Both models use rational expectations and multi-period staggered contracts. However, in Fischer's model, wages are *predetermined* but not fixed, set at the expected market-clearing level for each period of the contract. In Taylor's model, wages are *fixed* at the same nominal level for the entire contract duration. This feature in Taylor's model, where current wage-setting decisions depend on wages set in the past, creates a significant propagation mechanism. As a result, the effects of a monetary shock can persist for much longer than the contract length itself, a feature less pronounced in the Fischer model.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. pp. 7, 35-37; McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, pp. 188-191.
4. True or False: In a model with staggered two-period wage contracts like Fischer's, an activist monetary policy can reduce output fluctuations even if the central bank has no informational advantage over private agents.
Correct Answer: True.
The ability of policy to be effective stems from the timing of actions. In a staggered contract model, some wages are set based on old information. For example, at the start of period 't', half the wages are newly set, but the other half were set at the start of period 't-1'. If a shock occurs in period 't-1' after that period's wages were set, the monetary authority can, in period 't', adjust the money supply to counteract the shock's effect on the price level that the workers of period 't-1' will face. The policy is effective because it can react to new information more quickly than the locked-in wage contracts can.
Source: Fischer, S. (1977). Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule; Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 35.
5. "Menu costs" can explain why nominal prices are sticky because:
Correct Answer: a) In an imperfectly competitive economy, the private benefit to a firm of changing its price is smaller than the social benefit.
This is the "pecuniary externality" argument. When a firm cuts its price, it privately bears the full cost of being at a non-optimal price relative to other firms, but it doesn't capture the full social benefit. The social benefit includes the fact that a lower price increases real money balances, which boosts aggregate demand for all firms. Because the private gain from adjusting is a second-order loss, while the social gain is a first-order gain, even small physical costs of changing prices ("menu costs") can be enough to deter a firm from adjusting its price in response to a nominal shock, leading to price stickiness and real output effects.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. pp. 46-48.
6. True or False: Multi-period price setting, as in Taylor's model, leads to real and persistent effects of monetary policy primarily because current wage/price decisions are influenced by past wage/price decisions.
Correct Answer: True.
In Taylor's staggered contract model, workers and firms setting a new multi-period contract care about their wage/price relative to those who are not currently re-contracting. This means the new contract price ($$x_t$$) is a function of contracts set in the past ($$x_{t-1}$$) and contracts expected to be set in the future. This dependence on past contracts provides a powerful propagation mechanism. A monetary shock that affects output today will influence the contracts set today, which in turn will influence the contracts set tomorrow, and so on, causing the real effects of the shock to persist over time, often for much longer than the length of the individual contracts.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, pp. 188-189; Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 37.
7. According to Poole's (1970) analysis, if an economy is primarily subject to shocks in the money market (LM shocks), which policy instrument is superior for stabilizing output?
Correct Answer: b) Interest rate targeting.
Shocks to the money market (LM shocks), such as instability in money demand, cause the LM curve to shift. If the central bank targets the money supply, these shocks are fully transmitted to output. However, if the central bank targets the interest rate, it will automatically adjust the money supply to counteract the LM shock and keep the interest rate at its target. This action completely insulates output from money market disturbances. Therefore, interest rate targeting is the superior strategy when LM shocks are dominant.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part II, Slides 11-14.
8. True or False: The widespread shift by central banks from money supply targeting to interest rate targeting in the 1980s can be largely attributed to increased instability in the goods market (IS shocks) due to globalization.
Correct Answer: False.
The shift was primarily due to a wave of financial innovation during the 1980s, which led to significant instability in money demand. These are considered shocks to the LM curve, not the IS curve. As Poole's (1970) analysis shows, interest rate targeting is more effective at stabilizing output when LM shocks are the dominant source of economic disturbance. Faced with an unstable relationship between money, income, and interest rates, central banks found it more practical and effective to target interest rates directly.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part II, Slide 15.
9. In the context of modern Keynesian models, "real rigidity" refers to:
Correct Answer: c) A weak response of a firm's desired relative price (or a worker's desired real wage) to changes in aggregate demand.
Real rigidity is a necessary condition for nominal rigidities (like menu costs) to generate large and persistent real effects from nominal shocks. If firms desire to change their relative prices significantly in response to a demand shift (i.e., if real rigidity is low), they will have a strong incentive to overcome any small nominal rigidities. However, if their desired relative price is largely insensitive to demand (i.e., real rigidity is high), then their incentive to change price is weak, and a small menu cost can be sufficient to cause nominal stickiness.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 38.
10. True or False: According to Brainard's (1967) analysis, uncertainty about the effects of monetary policy (parameter uncertainty) should lead a central bank to adopt a more aggressive policy stance to ensure it meets its targets.
Correct Answer: False.
Brainard's analysis shows that parameter uncertainty induces caution. When a central bank is unsure about the magnitude of the multiplier effect of its policy instrument (e.g., how much a 1% interest rate cut will boost output), it will act less aggressively than it would under certainty. The reason is risk aversion: a very aggressive policy action could lead to a massive overshoot if the true parameter is larger than expected, causing high output volatility. Therefore, the central bank trades off fully closing the output gap in exchange for reducing the variance of output.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part III.
11. The "Lucas Critique" argues that:
Correct Answer: D) The parameters of traditional econometric models may change if the policy regime changes.
The Lucas Critique is a fundamental argument in modern macroeconomics. It posits that the behavioral relationships (represented by coefficients in econometric models) are not structural, but instead depend on the prevailing policy regime. For example, the observed relationship between inflation and unemployment might hold under one monetary policy rule, but it would change if the central bank adopted a new rule, because agents' expectations and behaviors would adapt. Therefore, using a model estimated under an old regime to predict the effects of a new policy is unreliable.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 11, p. 228; Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 11.
12. True or False: According to Lucas's monetary misperceptions model, the real effects of money on output occur because individual producers mistake unexpected changes in the aggregate price level for changes in their own relative prices.
Correct Answer: True.
In the Lucas (1972, 1973) model, producers operate in separate markets and have incomplete information about the aggregate price level. When they observe an increase in the price of their own product, they cannot be sure if it is due to a real increase in demand for their specific good (a relative price change) or an increase in the overall price level (a nominal shock). They rationally respond by attributing part of the price change to each possibility. By reacting in part to the perceived relative price change, they increase their output. When the price change was actually due to a nominal shock (e.g., an increase in the money supply), all producers react this way, leading to a temporary increase in aggregate output.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, pp. 185-187.
13. The "policy ineffectiveness proposition," as developed by Sargent and Wallace, suggests that systematic, feedback-based monetary policy is ineffective at stabilizing output because:
Correct Answer: B) Rational agents anticipate the policy response, so it has no effect on the surprise component of money growth.
The proposition holds in models where only the *unanticipated* part of monetary policy affects real variables. A systematic policy rule (e.g., increase money supply when unemployment rises) is known to rational agents. They will build this rule into their expectations. Consequently, the systematic actions of the central bank become fully anticipated ($$E_{t-1}m_t$$ includes the policy rule) and only the random, unsystematic part of policy ($$e_t$$) can cause a monetary surprise and affect output. Therefore, any predictable attempt to stabilize the economy is neutralized by agents' expectations.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 11, pp. 223-224.
14. Okun's Law describes a tight empirical relationship between:
Correct Answer: C) The unemployment rate and the percentage deviation of real GNP from its potential level.
Okun's Law is an empirical observation, noted by Arthur Okun, that shows a strong negative correlation between the unemployment rate and the "output gap" (the deviation of actual output from its normal or potential level). High unemployment rates are associated with low levels of output relative to trend, and vice versa. This relationship is often used in macro models to translate the effects of shocks on output into effects on unemployment.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, p. 184.
15. True or False: In his analysis of the history of wage and price adjustment, Robert Gordon (1982) finds that the responsiveness of wages and prices to aggregate demand has remained remarkably constant in the U.S. over the last century.
Correct Answer: False.
Gordon's major finding is the opposite: the degree of wage and price stickiness has varied enormously over time and across countries. For example, he shows that prices and wages in the U.S. were significantly more flexible during and after World War I than in the post-World War II era. He argues that the high degree of inertia in the postwar U.S. is a distinct phenomenon, partly attributable to the unique institution of three-year staggered wage contracts, and not a universal feature of the economy.
Source: Gordon, R. J. (1982). Wages and Prices Are Not Always Sticky: A Century of Evidence for the U.S., U.K., and Japan. pp. 2, 14.
16. In Phelps's (1967) model of optimal employment over time, a society with a higher rate of time preference (a higher utility discount rate, $$\delta$$) will choose a path that results in:
Correct Answer: A) A higher long-run rate of inflation.
In this dynamic model, the policy choice is a trade-off between present gains and future costs. A more inflationary policy today allows for a temporary increase in employment, but at the cost of a permanently higher expected (and actual) inflation rate in the future steady state. A society that discounts the future more heavily (a higher $$\delta$$) places less weight on this future cost. It will therefore be more willing to pursue higher employment in the present, which means it will choose a path that converges to a long-run equilibrium with a higher rate of inflation.
Source: Phelps, E. S. (1967). Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time. pp. 257, 279.
17. Which of the following is NOT a barrier to the widespread adoption of wage contracts fully indexed to nominal GNP, according to Gordon (1982)?
Correct Answer: D) Such indexation is technically impossible to write into a contract.
Gordon argues that while nominal GNP indexation is superficially attractive for insulating the real wage from productivity shocks, it has never been observed due to several practical barriers. These include: 1) Pre-set prices and gradual adjustment mean nominal GNP shocks cause real fluctuations, creating real wage risk for workers. 2) In open economies, costs of imported goods don't move with domestic GNP. 3) Information lags make timely adjustment impossible. 4) Velocity shocks mean that even if indexed to a monetary aggregate, real demand can still fluctuate. The issue is not technical impossibility but the risks and imperfections that make such a contract undesirable for both firms and workers.
Source: Gordon, R. J. (1982). Wages and Prices Are Not Always Sticky. pp. 35-37.
18. True or False: The key insight of the Fischer (1977) and Taylor (1980) models is that introducing rational expectations into a model with sticky wages or prices eliminates the effectiveness of systematic monetary policy.
Correct Answer: False.
The key insight is precisely the opposite. These models were developed to show that even with rational expectations, the presence of nominal rigidities (specifically multi-period staggered contracts) is sufficient to restore a significant role for activist, systematic monetary policy in stabilizing output. Because some contracts are fixed based on past information, the central bank can use its ability to react to more current information to offset shocks and reduce economic fluctuations, a conclusion that stands in sharp contrast to the policy ineffectiveness proposition derived from flexible-price rational expectations models.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 7; McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, p. 191.
19. The time-inconsistency problem in monetary policy, as described by Barro and Gordon, arises because:
Correct Answer: D) The central bank has a discretionary incentive to create surprise inflation to boost output, even if its announced goal is zero inflation.
The problem arises from a conflict between ex-ante (before the fact) and ex-post (after the fact) optimality. Ex-ante, the best policy is to announce zero inflation, which leads the public to expect zero inflation. However, ex-post, once expectations are set, the central bank sees that it can achieve a temporary output gain by creating a small amount of surprise inflation. Rational agents understand this incentive, so they never believe the zero-inflation announcement in the first place. The only credible equilibrium is one with a positive inflation bias, where actual inflation is high enough that the central bank is no longer tempted to create more surprise inflation.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part IV.
20. True or False: In a "near-rational" model (Akerlof and Yellen), small menu costs can lead to large output effects from nominal shocks because the private loss to a firm from not changing its price is only a second-order cost, while the social welfare gain from price adjustment is a first-order benefit.
Correct Answer: True.
This is the core of the near-rationality/menu-cost argument. When a firm is at its profit-maximizing price, the profit function is flat at the top. Therefore, a small deviation from this optimal price (i.e., not adjusting to a shock) results in a very small (second-order) loss of profit for the firm itself. However, the failure to adjust has a larger (first-order) negative effect on the economy as a whole (a pecuniary externality) by contributing to a lower aggregate price level and thus lower real money balances and aggregate demand. Because the private cost of not adjusting is so small, even a tiny physical menu cost can be enough to prevent the firm from changing its price, leading to nominal rigidity.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. pp. 46-48.
21. According to Gordon's (1982) comparative analysis, which feature was most characteristic of the U.S. wage-setting process in the post-WWII era compared to the U.K. and Japan?
Correct Answer: D) Long-term, three-year staggered (unsynchronized) contracts.
Gordon identifies the prevalence of long, staggered contracts as a unique feature of the postwar U.S. economy. In contrast, Japan was characterized by an annual, highly synchronized "Shunto" (Spring Labor Offensive), and the U.K. had a mix of contract lengths but with more indexation than the U.S. This institutional difference in the U.S. is a key reason Gordon gives for the high degree of wage and price inertia observed during that period, as it creates the overlapping structure formalized in the Taylor model.
Source: Gordon, R. J. (1982). Wages and Prices Are Not Always Sticky. pp. 2, 23-24.
22. True or False: In the baseline New Keynesian model, the "flexible-price equilibrium" level of output (or "natural output") is the level that would prevail if all nominal rigidities were absent, and it is determined solely by real factors like technology shocks and household preferences.
Correct Answer: True.
This is the definition of the flexible-price equilibrium, often denoted as $$Y_t^n$$. It serves as the benchmark level of output in New Keynesian models. The central goal of policy in these models is often framed as closing the "output gap," which is the difference between actual output ($$Y_t$$) and this flexible-price equilibrium level. Because $$Y_t^n$$ is determined by real shocks, it can fluctuate over time, meaning that stabilization policy is not about keeping output constant, but about keeping it close to this moving, theoretically optimal target.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 10, p. 201.
23. In the context of the expectations-augmented Phillips curve, the "accelerationist" hypothesis refers to the idea that:
Correct Answer: C) Maintaining unemployment below the natural rate requires not just a high but an ever-accelerating rate of inflation.
This follows from the natural rate hypothesis ($$\alpha=1$$) combined with adaptive expectations. If policymakers try to hold unemployment at $$UN < UN^n$$, they must generate surprise inflation. But under adaptive expectations, people will revise their inflation expectations upwards. To create a new surprise in the next period, policymakers must generate an even higher rate of inflation. This process continues, requiring an ever-increasing rate of inflation to keep unemployment below the natural rate.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, p. 184.
24. True or False: A key assumption in the baseline menu-cost models of price stickiness is that the economy is characterized by imperfect competition (e.g., monopolistic competition).
Correct Answer: True.
In a perfectly competitive economy, firms are price takers. If a firm did not raise its price when all other prices and costs went up, it would face infinite demand and incur massive losses. It therefore has a very strong (first-order) incentive to adjust its price. In an imperfectly competitive economy, firms are price setters and face downward-sloping demand curves. This structure is what creates the possibility that the private loss from not adjusting is small, allowing small menu costs to have a large macroeconomic effect.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 46.
25. In the Barro-Gordon model of time inconsistency, the equilibrium inflation rate will be higher if:
Correct Answer: A) The central bank places a greater weight on reducing unemployment relative to inflation (a higher 'b' parameter).
The equilibrium inflation bias in the Barro-Gordon model is given by $$\pi = (a/c)b(k-1)y^n$$, where 'b' is the weight the policymaker puts on the unemployment gap in their loss function. A higher 'b' means the central bank is more "dovish" and cares more about output gains. This gives it a stronger incentive to create surprise inflation, which rational agents foresee. The result is a higher equilibrium inflation rate to offset this stronger temptation.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part IV, Slide 10.
26. True or False: In Brainard's (1967) model of policymaking under uncertainty, if a central bank is uncertain about the magnitude of the money multiplier (parameter uncertainty), it should always use a smaller policy instrument setting than it would under certainty.
Correct Answer: False.
This is only true if the expected value of the parameter is the only thing that matters. Brainard's key insight is about the variance. The principle of "attenuation" or caution holds: the central bank should be less aggressive. However, if the *target* for the policy is non-zero, the optimal policy setting might be larger or smaller. The principle is that the *change* in the instrument in response to a shock should be smaller. For example, if the goal is to move output from 100 to 105, and the multiplier is uncertain, the bank might choose a policy setting that, on average, only gets it to 104 to avoid the risk of overshooting. But the absolute size of the instrument setting itself isn't always smaller.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part III, Slide 10.
27. "Efficiency wage" theories provide a rationale for real wage rigidity because they argue that:
Correct Answer: D) A firm's productivity or effort from its workers depends positively on the real wage it pays, making it reluctant to cut wages even with high unemployment.
Efficiency wage models (e.g., the Shapiro-Stiglitz shirking model) posit that by paying a wage above the market-clearing level, firms can increase productivity by improving worker nutrition, reducing turnover, attracting a higher quality applicant pool, or, most famously, inducing effort by increasing the cost of being fired for shirking. This makes firms unwilling to lower the real wage even when there is an excess supply of labor, thus creating real wage rigidity and involuntary unemployment.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. pp. 39-40.
28. True or False: The McCallum (1989, Ch. 10) model demonstrates that if prices are sticky, the aggregate supply curve is upward sloping, but the aggregate demand curve is vertical.
Correct Answer: False.
In the model, sticky prices lead to an upward-sloping aggregate supply (AS) curve, as firms are willing to produce more at a higher aggregate price level. However, the aggregate demand (AD) curve is downward sloping. The AD curve is derived from the IS-LM model. A higher price level reduces real money balances ($$M/P$$), which shifts the LM curve to the left, leading to a higher interest rate and lower output (demand). Thus, the model features an upward-sloping AS curve and a downward-sloping AD curve.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 10, pp. 202-205.
29. In an "insider-outsider" model of unemployment, real wages may be rigid because:
Correct Answer: B) Employed workers ("insiders") have bargaining power and set wages to their own benefit, largely ignoring the interests of unemployed workers ("outsiders").
This model explains rigidity by focusing on the power of the incumbent workforce (insiders). Insiders may have this power due to turnover costs (hiring/firing/training costs) that make it expensive for the firm to replace them with outsiders. Insiders use this power to bargain for a wage higher than the market-clearing rate, and since the outsiders are not part of the bargain, their presence does not drive the wage down.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 41.
30. True or False: A key difference between the Fischer and Taylor staggered contract models is that in Taylor's model, the wage for the entire duration of a contract is fixed at the time of signing, whereas in Fischer's model, the wage for each future period of the contract is set based on expectations at the time of signing.
Correct Answer: True.
This is a subtle but crucial distinction. In Taylor's model, a two-period contract signed at time 't' specifies the *same* nominal wage for both period 't' and 't+1'. In Fischer's model, the contract specifies a wage for period 't' and a *different* wage for period 't+1', with the wage for 't+1' being set based on the information and expectations available at time 't'. This makes wages in Fischer's model predetermined but not fixed, while in Taylor's they are fixed, leading to the stronger persistence mechanism in the Taylor model.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 36.
31. According to Poole's (1970) analysis, if an economy is primarily subject to shocks in the goods market (IS shocks), which policy instrument is superior for stabilizing output?
Correct Answer: A) Money supply targeting.
When the IS curve shifts due to real shocks (e.g., changes in investment or government spending), a fixed money supply acts as an automatic stabilizer. For example, if the IS curve shifts right, pushing up output and interest rates, the rising interest rate crowds out some investment, partially dampening the initial shock. If the central bank were targeting the interest rate, it would have to increase the money supply to prevent the interest rate from rising, thereby accommodating the shock and leading to a larger fluctuation in output. Therefore, money supply targeting is superior when IS shocks dominate.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part II, Slides 11-14.
32. True or False: The main reason Robert Gordon (1982) found that prices were more flexible in the U.S. around WWI than after WWII is that the government imposed price controls during WWII.
Correct Answer: False.
While price controls were a factor, Gordon's primary argument is about a structural change in the nature of labor contracts. He argues that the post-WWII era was dominated by the institution of long-term, staggered, and largely un-indexed wage contracts, which was not the case in the earlier period. This institutional change is what he credits with creating the high degree of price and wage inertia seen in the later period, making the economy behave more in line with Keynesian sticky-price models.
Source: Gordon, R. J. (1982). Wages and Prices Are Not Always Sticky. pp. 14, 23.
33. In the Phelps (1967) model of optimal inflation, the "golden rule" level of employment is the level that:
Correct Answer: D) Maximizes the sustainable (steady-state) level of social utility, which occurs when the marginal utility of employment equals the marginal disutility of inflation.
The golden-rule path is the steady-state path that provides the highest possible level of utility forever. In the Phelps model, this involves a trade-off. Higher employment gives utility, but maintaining it requires higher inflation, which gives disutility. The golden-rule point is where the marginal gain from more employment is exactly offset by the marginal pain of the inflation required to sustain it. The optimal path for the economy will converge to this golden-rule steady state.
Source: Phelps, E. S. (1967). Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time. p. 261.
34. True or False: One of the proposed solutions to the time-inconsistency problem is to appoint a conservative, inflation-averse central banker (a "Rogoff hawk").
Correct Answer: True.
This is the principle of delegation. By appointing a central banker who is known to care much more about inflation than unemployment (i.e., has a very low 'b' parameter in the Barro-Gordon model), the public will believe that this banker will not be tempted to create surprise inflation. This credibility leads to lower inflation expectations and a lower equilibrium inflation rate, closer to the socially optimal outcome, even though the banker's preferences don't perfectly match society's.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part IV, Slide 13.
35. The concept of "staggering" or "asynchronization" in wage and price setting is crucial for generating monetary policy persistence because:
Correct Answer: B) It makes the aggregate price level adjust slowly to shocks, as only a fraction of firms change their price at any given time.
If all firms changed prices on January 1st for the whole year, a monetary shock on January 2nd would have real effects for the rest of the year, but there would be no persistence beyond the contract length. With staggering, some firms set prices in January, some in February, etc. A firm setting its price in February will look at the prices set in January. This creates a dependency on past prices, which acts as a propagation mechanism. The aggregate price level becomes a slow-moving average of past and expected future desired prices, causing the effects of a monetary shock to persist over a long period.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 37.
36. True or False: In the Lucas misperceptions model, a fully anticipated increase in the money supply will lead to a temporary increase in real output.
Correct Answer: False.
The entire mechanism for real effects in the Lucas model relies on monetary *surprises*. If an increase in the money supply is fully anticipated, rational agents will expect the aggregate price level to rise accordingly. When they see their own local price rise, they will correctly attribute the entire change to the aggregate nominal shock and will not mistake it for a relative price increase. Therefore, they will not increase their output. Only the unanticipated component of money growth can affect real output.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, p. 187.
37. "Implicit contract" theory explains wage rigidity as a form of:
Correct Answer: C) An informal risk-sharing arrangement between risk-neutral firms and risk-averse workers.
The theory suggests that since workers are more risk-averse than firms, they prefer a stable wage over a fluctuating one, even if it means a slightly lower average wage. Firms provide this insurance by paying a relatively stable wage across good and bad times, absorbing the income fluctuations themselves. This results in a real wage that is less volatile than the marginal product of labor, which is a form of real rigidity.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 42.
38. True or False: A major empirical failure of the original, simple Phillips curve in the 1970s was its inability to explain the simultaneous occurrence of high inflation and high unemployment (stagflation).
Correct Answer: True.
The simple Phillips curve posited a stable, negative relationship between inflation and unemployment. The 1970s saw "stagflation," where many countries experienced rising inflation and rising unemployment at the same time. This was inconsistent with the simple curve but could be explained by the expectations-augmented Phillips curve. Adverse supply shocks (like the oil price shocks) and rising inflation expectations shifted the short-run Phillips curve outwards, leading to a worse trade-off and generating stagflation.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, p. 182.
39. In the sticky-price model presented in McCallum (Ch. 10), a positive, unanticipated shock to aggregate demand (e.g., an unexpected increase in the money supply) will lead to:
Correct Answer: B) A rise in both output and the price level.
The shock shifts the aggregate demand (AD) curve to the right. Since the aggregate supply (AS) curve is upward sloping due to sticky prices, the new equilibrium occurs at the intersection of the new AD curve and the existing AS curve. This new intersection point will be at a higher level of output (Y) and a higher price level (P) than the initial equilibrium.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 10, p. 206.
40. True or False: According to the logic of the Lucas critique, econometric models built in the 1960s would have been perfectly reliable for predicting the effects of the Volcker disinflation of the early 1980s.
Correct Answer: False.
This is a classic example of the Lucas critique in action. Models from the 1960s were estimated during a regime of accommodative monetary policy and showed a very flat Phillips curve, implying that reducing inflation would require a massive and prolonged recession. However, the Volcker disinflation represented a fundamental change in the policy regime. This credible shift in regime likely changed expectations and the underlying economic structure. In the event, the disinflation was costly, but perhaps less so than the old models would have predicted, because the credible policy shift helped lower inflation expectations more quickly.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 11, p. 228.
41. A primary criticism of the original implicit contract theory as an explanation for wage rigidity is that:
Correct Answer: A) It explains wage stability but does not directly explain why firms lay off workers instead of reducing wages to maintain full employment.
The simple risk-sharing model implies that firms should keep all workers employed and simply vary their hours or pay, with the wage bill being smoothed by the firm. It does not, in its basic form, predict the large quantity adjustments (layoffs) that are a key feature of business cycles. More complex versions with asymmetric information are needed to explain layoffs, but the basic model is more about wage smoothing than employment fluctuations.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 42.
42. True or False: In Japan's annual "Shunto" or Spring Labor Offensive, wage bargaining is highly synchronized, which, according to Gordon (1982), should lead to less price inertia compared to the staggered system in the U.S.
Correct Answer: True.
Synchronization means that most wage contracts are negotiated at the same time. This allows the economy to react more quickly and cohesively to aggregate shocks that have occurred in the preceding year. In a staggered system, today's wage settlement is heavily influenced by contracts signed months ago under different economic conditions. This backward-looking element is much weaker in a synchronized system, leading to less inertia in the aggregate wage and price level.
Source: Gordon, R. J. (1982). Wages and Prices Are Not Always Sticky. p. 24.
43. The parameter $$\theta$$ in the New Keynesian Phillips Curve (NKPC), $$p_t = \theta E_t p_{t+1} + (1-\theta) p_{t-1} + ...$$, represents:
Correct Answer: C) The weight that price-setting firms place on expected future prices versus past prices.
This is the "hybrid" NKPC, which includes both forward-looking (rational expectations) and backward-looking (adaptive expectations or rule-of-thumb) components. The parameter $$\theta$$ captures the degree of forward-looking behavior. A higher $$\theta$$ means firms are more forward-looking, while a lower $$\theta$$ implies more inertia or dependence on past inflation. The pure Calvo/Taylor model would have $$\theta=1$$.
Source: Based on the sticky-price models in McCallum (1989), Ch. 10, which form the basis for the NKPC.
44. True or False: The policy ineffectiveness proposition implies that monetary policy can have no effect on real output under any circumstances.
Correct Answer: False.
The proposition is more nuanced. It states that *systematic, anticipated* monetary policy is ineffective. However, *unanticipated* or surprise monetary policy can still have real effects, even in these models. The proposition's bite is that policymakers cannot exploit this by creating surprises in a predictable way, as rational agents would see it coming.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 11, p. 224.
45. One reason that "real rigidity" is important for menu-cost models is that if real rigidity is high:
Correct Answer: B) A firm's desired relative price changes very little in response to a demand shock, weakening its incentive to pay the menu cost to adjust.
Real rigidity means that the firm's optimal price relative to other firms is not very sensitive to aggregate conditions. If a nominal shock occurs (e.g., money supply falls), and other firms don't change their price, a firm with high real rigidity feels little need to change its own price. Its private loss from inaction is small. This amplifies the power of a small nominal rigidity (the menu cost), allowing it to be a sufficient deterrent to price adjustment, thus causing the nominal shock to have large real effects.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 38.
46. True or False: In Poole's (1970) framework, if an economy experiences both significant IS shocks and significant LM shocks, a policy of targeting the interest rate or the money supply may be inferior to a combination policy.
Correct Answer: True.
Poole's analysis showed that the choice of instrument depends on the source of shocks. If one type of shock dominates, a pure targeting strategy is best. However, if both are present and significant, neither pure strategy is optimal. A pure interest rate target perfectly offsets LM shocks but exacerbates IS shocks. A pure money supply target partially offsets IS shocks but fully transmits LM shocks. Therefore, a policy that is a weighted combination of the two is likely to be superior in minimizing output variance.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part II, Slide 14.
47. Which of the following is NOT a potential solution to the time-inconsistency problem in the Barro-Gordon model?
Correct Answer: D) Announcing a zero-inflation target and then using discretionary policy to fine-tune the economy.
This is the very setup that *causes* the time-inconsistency problem. The ability to use discretion to "fine-tune" after expectations are set is what creates the incentive to cheat on the announcement. The solutions all involve some way of removing or constraining this discretion, either through a binding rule, building a reputation that makes cheating too costly, or delegating to an agent who is not tempted to cheat.
Source: EC3115 - Monetary Economics, Unit L Lectures.pdf, Part IV, Slides 12-13.
48. True or False: The evidence presented by Gordon (1982) strongly supports the view that the degree of wage and price stickiness is a structural, unchanging feature of the U.S. economy.
Correct Answer: False.
Gordon's central thesis is the exact opposite. By examining a century of data, he argues that the degree of stickiness has changed dramatically over time, particularly becoming much higher after World War II. This suggests that stickiness is not a deep structural parameter but rather a result of prevailing institutions, norms, and policy regimes, which is an idea that resonates with the Lucas critique.
Source: Gordon, R. J. (1982). Wages and Prices Are Not Always Sticky. p. 2.
49. In the Shapiro-Stiglitz efficiency wage model, involuntary unemployment exists in equilibrium because:
Correct Answer: A) If there were no unemployment, the threat of being fired for shirking would be meaningless, and all workers would shirk.
The model's logic is that to induce effort, firms must pay a wage higher than what workers can get elsewhere, and there must be a penalty for being fired. The penalty is the spell of unemployment that a fired worker must endure. If the labor market always cleared (no unemployment), a fired worker could instantly get a new job at the same wage. There would be no cost to being fired, so the incentive to work hard would disappear. Therefore, unemployment is a necessary equilibrium outcome to maintain discipline.
Source: Blanchard, O. J. (1987). Why Does Money Affect Output? A Survey. p. 40.
50. True or False: The introduction of staggered, multi-period contracts (as in Taylor, 1980) into a rational expectations model provides a powerful propagation mechanism, allowing the real effects of a monetary shock to persist for longer than the length of any single contract.
Correct Answer: True.
This is the key insight of the Taylor model. Because wage-setters care about their wage relative to others, a contract signed today depends on wages set in contracts signed in the past. This backward-looking element means that a shock today influences today's contracts, which in turn influence tomorrow's contracts, and so on. This chain reaction, or propagation mechanism, causes the aggregate price level to adjust very slowly and allows the real effects of a shock on output to be highly persistent.
Source: McCallum, B. T. (1989). Monetary Theory and Policy. Chapter 9, pp. 188-189.