Keynesian Models with Money Supply as a Policy Instrument
EC3115 Monetary Economics Exam Preparation
1. The primary feature that distinguishes the basic Keynesian model from the classical model is the assumption that nominal wages are rigid and do not adjust promptly to clear the labor market.
Correct Answer: True
Explanation: The classical model assumes that all prices, including wages, are fully flexible and adjust to equate supply and demand in all markets. The Keynesian model, developed to explain persistent unemployment, departs from this by assuming that nominal wages are "sticky" or do not adjust in the relevant period, allowing for an excess supply of labor (unemployment) to persist.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 174-175.
2. Nominal rigidities are unimportant for monetary policy to have real effects; even with fully flexible prices, changes in the money supply will always have significant, short-run effects on output.
Correct Answer: False
Explanation: Economic theory suggests that with fully flexible prices, money should be approximately neutral. Changes in nominal money would be reflected in proportional changes in nominal prices, with little to no effect on real variables like output. The entire premise of Keynesian and New Keynesian models is that nominal rigidities (sticky prices or wages) are necessary to explain the significant real effects of monetary policy observed in the real world.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 5.
3. The original Phillips curve, as proposed by A. W. Phillips, described an empirical relationship between the rate of change of money wage rates and the unemployment rate.
Correct Answer: True
Explanation: Phillips's 1958 paper posited that the rate of change of money wage rates is a function of the excess demand for labor, for which the unemployment rate serves as a proxy. He found a stable negative relationship for the U.K. over the period 1861-1957, suggesting a policy trade-off between wage inflation and unemployment.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 177.
4. The expectations-augmented Phillips curve is identical to the original Phillips curve; it just uses a different measure of unemployment.
Correct Answer: False
Explanation: The key difference is the inclusion of expected inflation. Friedman and Phelps argued that workers and firms care about real wages, not nominal wages. Therefore, nominal wage changes should depend not only on unemployment but also on the expected rate of price inflation. The equation is typically written as \(\Delta w_t = f(UN_t) + \alpha \Delta p_t^e\). This augmentation implies that the trade-off between inflation and unemployment exists only in the short run, when expectations are incorrect.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time", p. 255; McCallum, B. T. (1989), p. 181-182.
5. According to the Friedman-Phelps "natural rate" hypothesis, there is no permanent, long-run trade-off between inflation and unemployment.
Correct Answer: True
Explanation: The natural rate hypothesis posits that in the long run, when inflationary expectations have fully adjusted to actual inflation (\(\Delta p = \Delta p^e\)), the Phillips curve becomes vertical at the "natural rate of unemployment" (\(u^*\)). This means that any attempt to hold unemployment below the natural rate will lead to accelerating inflation, but will not succeed in permanently lowering unemployment.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 182.
6. In Stanley Fischer's sticky-wage model, nominal wages are set for multiple periods and are fixed at the same level for the duration of the contract.
Correct Answer: False
Explanation: This describes John Taylor's model. In Fischer's model, while wages are set in multi-period contracts, the wage levels for future periods within the contract are not necessarily the same. Instead, the wage for each period is set to the level that is *expected* to clear the market in that future period, based on information available at the time the contract is signed. This is a key distinction from Taylor's model, where the nominal wage is fixed for the entire contract length.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 190.
7. In John Taylor's model of staggered contracts, the persistence of monetary policy's effects on output can last longer than the length of the wage contracts themselves.
Correct Answer: True
Explanation: A key feature of the Taylor model is that because contracts are staggered (i.e., not all set at the same time) and workers care about their wage relative to others, wage adjustments are slow and gradual. A monetary shock will cause a slow adjustment of the average wage level, and therefore the price level, leading to real effects on output that persist exponentially and last much longer than the two-period duration of any individual contract.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 188, 193.
8. "Menu costs" refer to the idea that even small costs to changing prices can lead to large nominal rigidities and significant real effects from demand shocks, especially in an environment of imperfect competition.
Correct Answer: True
Explanation: The menu cost argument, prominent in New Keynesian economics, states that because of a pecuniary externality under monopolistic competition, the private incentive for a firm to cut its price in response to a fall in aggregate demand is very small (a second-order loss). Therefore, even a small physical cost of changing prices (a "menu cost") can be enough to prevent price adjustment, leading to nominal rigidity. This rigidity, in turn, causes the demand shock to have a large (first-order) effect on output.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 46-48.
9. In the long run, monetary policy is a powerful tool for permanently increasing an economy's output level.
Correct Answer: False
Explanation: Most modern macroeconomic models, including those with sticky prices, adhere to the principle of long-run neutrality of money. While monetary policy can affect output in the short run by exploiting nominal rigidities, in the long run, prices and wages are expected to fully adjust. Consequently, changes in the money supply will only affect nominal variables like the price level, not real variables like output or employment. The long-run level of output is determined by real factors like technology, capital, and labor supply.
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 216.
10. A key weakness of Fischer's sticky-wage model is that it implies a strong inverse relationship between real wages and employment, which is not consistently observed in the data (real wages appear to be weakly procyclical).
Correct Answer: True
Explanation: In Fischer's model, firms are on their labor demand curves. An unexpected increase in the price level lowers the real wage, inducing firms to hire more labor and increase output. This creates a countercyclical real wage. However, empirical evidence for the U.S. economy suggests that real wages do not have a strong cyclical pattern and may even be slightly procyclical (rising in booms). This discrepancy is a significant criticism of the model.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 191.
11. The Lucas misperceptions model explains the Phillips-curve correlation as a result of firms' inability to distinguish between changes in the aggregate price level and changes in relative prices, even when they have full and immediate information about the money supply.
Correct Answer: False
Explanation: The Lucas model is based on incomplete information. Specifically, it assumes that individual producers observe the price of their own good but do not know the current aggregate price level or money stock. If they had full information about the money stock, they could infer the aggregate price level and would not misperceive a general price increase as a relative price increase. Therefore, they would not change their output, and money would be neutral. The model's relevance is questioned in modern economies where money supply data is published frequently.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 187-188.
12. Multi-period pricing, as seen in the Taylor model, can lead to real and persistent effects of monetary policy because wage-setting decisions are staggered over time.
Correct Answer: True
Explanation: The staggering of contracts is crucial. When one group of workers sets its wage, it must consider the wages that will be in place for other groups during the life of its own contract. Since other contracts are already in place and will not change immediately, the new wage will adjust only partially to a shock. This slow, overlapping adjustment process imparts inertia to the aggregate wage and price level, allowing monetary policy to have effects that are both real and persistent over time.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 37.
13. In a model with sticky prices, an expansionary monetary policy (e.g., an increase in the money supply) leads to a decrease in output in the short run.
Correct Answer: False
Explanation: An expansionary monetary policy increases aggregate demand. With prices being "sticky" or slow to adjust, this increased demand cannot be immediately choked off by higher prices. Instead, firms respond by increasing production to meet the demand. Therefore, in the short run, expansionary monetary policy leads to an *increase* in output.
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 206.
14. Okun's Law describes the tight negative relationship observed between the unemployment rate and the deviation of aggregate output from its trend or "potential" level.
Correct Answer: True
Explanation: Okun's Law is an empirical regularity that shows a strong negative correlation between unemployment and output. When output is high relative to its normal trend, unemployment is low, and vice versa. This relationship is often used to translate the effects of policies on output into effects on unemployment.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 184.
15. The "policy ineffectiveness proposition", associated with Sargent and Wallace, states that monetary policy is ineffective at influencing output, even if the policy is unanticipated.
Correct Answer: False
Explanation: The policy ineffectiveness proposition argues that *systematic, anticipated* monetary policy is ineffective. In models with rational expectations and flexible prices (like the Lucas model), agents will anticipate the effects of any systematic policy rule and adjust prices accordingly, neutralizing any real effects. However, *unanticipated* monetary policy (random shocks) can still affect real output by causing price misperceptions. The proposition is about the ineffectiveness of predictable policy rules, not all policy actions.
Source: McCallum, B. T. (1989). Chapter 11, "Analysis of Alternative Policy Rules", p. 224.
16. One reason nominal prices may be sticky is that firms have an informal relationship with their repeat-purchase customers and wish to avoid the appearance of unfairness that frequent price changes might create.
Correct Answer: True
Explanation: This is a central argument in Arthur Okun's theory of "customer markets." He argues that firms avoid frequent price changes to maintain good relationships with their regular customers, who value price stability. Upsetting these informal "contracts" by raising prices at every opportunity could drive customers to search for other suppliers, leading to a loss of business that outweighs the short-term gain from the price hike.
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 214.
17. In the long run, the expectations-augmented Phillips curve is horizontal.
Correct Answer: False
Explanation: In the long run, the expectations-augmented Phillips curve is *vertical* at the natural rate of unemployment (\(u^*\)). This verticality represents the absence of a long-run trade-off between inflation and unemployment. Any rate of inflation is consistent with the natural rate of unemployment once expectations have fully adjusted.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 183 (Figure 9-5).
18. A model with staggered, multi-period nominal wage contracts (like Taylor's or Fischer's) can explain why activist monetary policy might be effective in stabilizing output, even with rational expectations.
Correct Answer: True
Explanation: Because some wage contracts are already in place and cannot be changed, the price level cannot respond immediately and fully to a monetary policy action. A central bank that can react to shocks more quickly than wages can be renegotiated can use monetary policy to offset the effects of demand shocks on the price level, thereby stabilizing the real wage and employment. This invalidates the policy ineffectiveness proposition in a world with nominal rigidities.
Source: Fischer, S. (1977) as discussed in Blanchard, O. J. (1987), p. 34.
19. All sticky price models agree that in the short run, an expansionary monetary shock causes the real wage to fall.
Correct Answer: False
Explanation: The models have different implications for the real wage. In Fischer's model, where nominal wages are preset but prices are flexible, an unexpected price increase lowers the real wage (a countercyclical real wage). In Taylor's model, where prices are a markup over the average of staggered wages, the real wage tends to be constant or acyclical. The actual behavior of the real wage is a key point of debate and a criterion for judging these models.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 41 (footnote 18).
20. The "Lucas critique" suggests that the observed statistical relationships in macroeconometric models (like an empirical Phillips curve) may change if the government changes its policy-making rule.
Correct Answer: True
Explanation: Lucas argued that the parameters of many macro models are not "structural" but are instead reduced-form coefficients that depend on agents' expectations, which in turn depend on the policy regime. If the government changes its policy rule (e.g., starts aggressively fighting unemployment), rational agents will change their expectations, causing the parameters of the model (like the slope of the Phillips curve) to shift. This makes the model unreliable for policy evaluation.
Source: McCallum, B. T. (1989). Chapter 11, "Analysis of Alternative Policy Rules", p. 228-229.
21. Real rigidities, such as a low elasticity of the desired real wage with respect to employment, are a necessary condition for monetary policy to have persistent effects in a Taylor-style staggered contract model.
Correct Answer: True
Explanation: In Taylor's model, the persistence of monetary effects is governed by a parameter \(k\) which is closer to 1 (implying more persistence) when the parameter \(a\) is small. The parameter \(a\) measures the elasticity of the target real wage with respect to employment. A small \(a\) means that the desired real wage is not very responsive to labor market conditions, which is a form of "real rigidity." This real rigidity, combined with the nominal rigidity of staggered contracts, generates slow adjustment and high persistence.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 38.
22. If an economy is dominated by shocks to the money market (LM shocks), then a policy of targeting the money supply is superior to targeting the interest rate for stabilizing output.
Correct Answer: False
Explanation: The opposite is true. If LM shocks (e.g., from unstable money demand) are dominant, targeting the interest rate is superior. An interest rate target forces the central bank to adjust the money supply to keep the interest rate fixed. This automatically accommodates the money demand shocks, insulating the IS curve and output from the shock. In contrast, a money supply target would allow the LM shock to shift the LM curve, causing both interest rates and output to fluctuate.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part II, p. 13-15.
23. If an economy is dominated by shocks to the goods market (IS shocks), then a policy of targeting the money supply is superior to targeting the interest rate for stabilizing output.
Correct Answer: True
Explanation: With a money supply target, a positive IS shock (shifting IS to the right) increases the demand for money, which raises the interest rate. This "crowding out" effect partially dampens the initial expansionary impact on output. Under an interest rate target, the central bank would have to *increase* the money supply to prevent the interest rate from rising, thus fully accommodating the IS shock and leading to a larger fluctuation in output. Therefore, money supply targeting is a better automatic stabilizer against IS shocks.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part I, p. 5-7.
24. The shift by many central banks from money supply targets to interest rate targets in the 1980s can be explained by a wave of financial innovation that made money demand (the LM curve) more unstable.
Correct Answer: True
Explanation: The 1980s saw significant financial innovation (e.g., new types of bank accounts, electronic payments) which made the relationship between money, income, and interest rates unstable. This meant that the economy was subject to more frequent and larger LM shocks. According to Poole's analysis, in an environment dominated by LM shocks, interest rate targeting is the superior strategy for stabilizing output. This provides a strong rationale for the observed shift in central bank policy.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part II, p. 15.
25. In a model with preset prices, unanticipated monetary policy shocks have no effect on real output.
Correct Answer: False
Explanation: The entire point of models with preset prices (a form of nominal rigidity) is to show how monetary shocks *can* have real effects. An unanticipated increase in the money supply boosts aggregate demand. Because prices are fixed in the short term, firms must meet this demand by increasing production. The output solution in such a model is typically of the form \(y_t = \bar{y}_t + \beta_1(m_t - E_{t-1}m_t) + v_t\), where the term \((m_t - E_{t-1}m_t)\) is the unanticipated money shock, which clearly affects output \(y_t\).
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 206.
26. The "time inconsistency" problem in monetary policy suggests that discretionary, period-by-period policymaking can lead to a suboptimal outcome with an inflationary bias, even when the central bank dislikes inflation.
Correct Answer: True
Explanation: The time inconsistency problem (developed by Kydland, Prescott, Barro, and Gordon) arises because at any given moment, a discretionary policymaker has an incentive to create surprise inflation to temporarily boost output. Rational agents understand this incentive and expect higher inflation. In equilibrium, the policymaker creates inflation, but because it is anticipated, there is no output gain. The economy ends up with an inflationary bias but no reduction in unemployment, an outcome worse than what could be achieved by credibly committing to a zero-inflation rule.
Source: McCallum, B. T. (1989). Chapter 12, "Rules Versus Discretion in Monetary Policy", p. 241-242.
27. In the basic Keynesian framework, an increase in the money supply causes real output to rise by increasing the real wage, which encourages more people to work.
Correct Answer: False
Explanation: The mechanism is the opposite. In the original Keynesian model, an increase in money leads to higher prices. With nominal wages assumed to be sticky, the rise in the price level *lowers* the real wage (w/P). This makes it cheaper for firms to hire labor, so they increase employment and production. The increase in output is driven by a fall in the real wage from the perspective of the firm.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 9.
28. A key assumption in Taylor's staggered contract model is that when workers set their nominal wage, they care about the wage they will receive relative to other workers.
Correct Answer: True
Explanation: Taylor's model can be interpreted as one where workers care about their wage relative to the wages of other workers who are setting contracts at different times. This concern for relative wages is what creates the "staggering" dynamic. A group setting its wage today will look at the wages set by other groups in the previous period and the expected wages of other groups in the next period. This leads to the slow, incremental adjustment of the aggregate wage level that generates persistence.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 192.
29. In the long run, a higher rate of money growth leads to a permanently lower rate of unemployment.
Correct Answer: False
Explanation: This would imply a permanent trade-off between inflation and unemployment. The modern consensus, based on the natural rate hypothesis, is that there is no such long-run trade-off. In the long run, the unemployment rate returns to its natural rate, regardless of the steady rate of inflation (which is determined by the rate of money growth).
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 182.
30. In the long run, the effects of monetary policy are primarily on nominal variables, such as the price level and inflation rate, rather than on real variables like output.
Correct Answer: True
Explanation: This is the principle of long-run monetary neutrality. While short-run non-neutralities are the focus of Keynesian models, it is a widely accepted principle that over a long enough horizon for all prices, wages, and expectations to adjust, changes in the quantity of money will be reflected proportionally in the aggregate price level, leaving real quantities (output, employment, real interest rates) unaffected.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 174.
31. The persistence of monetary policy effects in the Fischer model is limited to the length of the longest-running nominal contract.
Correct Answer: True
Explanation: In Fischer's model, the effect of an unanticipated shock lasts only as long as it takes for all contracts to be renegotiated with knowledge of the shock. In his two-period model, a shock in period \(t\) affects output in period \(t\) and \(t+1\), but by period \(t+2\), all contracts will have been reset, incorporating the new information, and the effect of the shock vanishes. The persistence is not "inherited" from one contract to the next as in the Taylor model.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 34.
32. The "Real Business Cycle" (RBC) approach explains output fluctuations as the efficient response of the economy to nominal shocks, assuming sticky prices.
Correct Answer: False
Explanation: The RBC approach turns the traditional causality around. It posits that business cycles are driven by real shocks, primarily to technology (productivity). The observed correlation between money and output is explained as a reverse-causal relationship: the monetary authority endogenously responds to the state of the economy (e.g., by accommodating real shocks), so money growth is correlated with output, but it does not cause the fluctuations.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 192-193.
33. The existence of "real rigidities" is sufficient to ensure that monetary policy has real effects.
Correct Answer: False
Explanation: Real rigidities (e.g., flat marginal cost curves or insensitive labor supply) are a necessary but not sufficient condition for monetary non-neutrality. They explain why the price level might not respond much to output changes, but they do not, by themselves, explain why nominal prices fail to adjust to changes in nominal aggregate demand. To get monetary non-neutrality, one also needs *nominal rigidity* (e.g., menu costs, staggered contracts).
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 38.
34. In the context of the Phillips curve, if the coefficient on expected inflation (\(\alpha\)) is less than 1, it implies a long-run trade-off between inflation and unemployment.
Correct Answer: True
Explanation: If \(\alpha < 1\) in the equation \(\Delta p_t = f(UN_t) + \alpha \Delta p_t^e\), then in the long-run steady state where \(\Delta p = \Delta p_t^e\), the equation becomes \(\Delta p(1-\alpha) = f(UN)\). This shows a stable, downward-sloping relationship between the steady-state inflation rate \(\Delta p\) and the unemployment rate \(UN\). A lower unemployment rate can be "bought" at the cost of a permanently higher, but stable, inflation rate. The Friedman-Phelps natural rate hypothesis argues that theory requires \(\alpha = 1\), eliminating this long-run trade-off.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 182-183.
35. The main reason Keynes proposed his model of a sticky nominal wage was strong empirical evidence showing that real wages were highly countercyclical.
Correct Answer: False
Explanation: Keynes's model *implied* a countercyclical real wage, but it was not based on strong evidence for it. In fact, subsequent empirical work by Dunlop and Tarshis shortly after the General Theory was published showed that the real wage was, if anything, procyclical. This contradiction with the facts was a major reason the simple sticky-wage model was quickly questioned by macroeconomists, including Keynes himself.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 10.
36. In a model with staggered two-period contracts, a monetary policy action taken today can affect the price level in the next period.
Correct Answer: True
Explanation: Yes. An unexpected monetary action today will affect today's price level and output. The group of workers setting their wages for the next two periods (today and tomorrow) will observe this shock and incorporate it into their expectations for tomorrow's price level. This will influence the wage they set, which will in turn be a component of the actual price level tomorrow. Thus, today's policy action has a transmitted effect on future prices.
Source: Fischer, S. (1977) as discussed in Blanchard, O. J. (1987), p. 34.
37. The "pecuniary externality" in menu-cost models refers to the fact that changing prices on a menu is physically costly.
Correct Answer: False
Explanation: The physical cost of changing prices is the "menu cost" itself. The pecuniary externality is a separate concept. It refers to the fact that when one firm lowers its price, it lowers the aggregate price index slightly, which increases real money balances and thus aggregate demand. This benefits *all* other firms. However, the individual firm does not take this external benefit to others into account when making its own pricing decision. This externality is why the social gain from price adjustment can be large even when the private gain is small.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 47.
38. In a basic sticky-price model, the short-run effect of a contractionary monetary policy is a decrease in both output and the price level, relative to their initial paths.
Correct Answer: True
Explanation: A contractionary monetary policy reduces aggregate demand. With prices being sticky downwards, they do not fall immediately to the new long-run equilibrium level. The fall in aggregate demand, when met with sticky prices, leads to a reduction in the quantity of goods and services firms are able to sell. Consequently, firms reduce output and employment. The price level will also begin to fall, but more slowly than output.
Source: General principles of sticky-price models, e.g., McCallum (1989), Chapter 10.
39. The theory of staggered contracts predicts that a fully credible, announced disinflation can be achieved with no loss of output.
Correct Answer: False
Explanation: While a credible disinflation is less costly than a non-credible one, the existence of staggered, multi-period contracts means that some wages have already been set based on previous, higher inflation expectations. These existing contracts impart inertia to the inflation process. To avoid a recession, the central bank must accommodate these pre-existing wage increases to some extent, meaning the disinflation must be gradual. A "cold turkey" disinflation would cause the real wages in existing contracts to be too high, leading to a fall in employment and output.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 53.
40. The "long and variable lags" of monetary policy, famously noted by Milton Friedman, are a key reason why activist, counter-cyclical policy can be destabilizing.
Correct Answer: True
Explanation: Friedman argued that because the effect of a monetary policy action on the economy occurs with a lag that is both long and variable, it is very difficult for policymakers to time their interventions correctly. An expansionary policy intended to fight a recession might only take effect when the economy is already recovering, thus adding to inflationary pressure. Conversely, a contractionary policy might hit just as the economy is entering a downturn, worsening the recession. This uncertainty is a core argument for preferring a simple, stable policy rule over discretionary activism.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part I, p. 2.
41. In the long run, under the natural rate hypothesis, the unemployment rate is determined by the central bank's inflation target.
Correct Answer: False
Explanation: The natural rate hypothesis states that in the long run, the unemployment rate is independent of monetary variables like the inflation rate. The long-run unemployment rate (the "natural rate") is determined by real, structural features of the economy, such as labor market frictions, technology, demographics, and regulations. The central bank's inflation target determines the long-run rate of inflation, but not the long-run rate of unemployment.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time".
42. A key difference between the models of Taylor and Fischer is that Taylor's model generates more intrinsic persistence in the effects of monetary shocks.
Correct Answer: True
Explanation: In Taylor's model, wages are fixed for the contract duration and workers care about relative wages. This means that a new wage settlement is heavily influenced by the other wages still in effect, leading to a slow, autoregressive adjustment of the average wage. This creates persistence that can last much longer than the contracts themselves. In Fischer's model, persistence only lasts as long as the longest contract, as there is no direct link between one contract negotiation and the next.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 37.
43. The "hysteresis" hypothesis of unemployment suggests that the natural rate of unemployment is a stable, unchanging constant over time.
Correct Answer: False
Explanation: Hysteresis is the idea that the natural rate of unemployment is not a fixed constant, but is itself affected by the past history of actual unemployment. For example, a long recession might cause some workers to lose skills or become detached from the labor force, raising the natural rate. In this view, a temporary monetary shock could have permanent effects on employment, because the equilibrium to which the economy returns has been altered by the shock.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 71.
44. In a model where prices are preset at their expected market-clearing levels, only the unexpected component of monetary policy can affect real output.
Correct Answer: True
Explanation: This is a core result of models that combine rational expectations with nominal rigidities. If prices \(p_t\) are set based on past information to equal the expected market-clearing price \(E_{t-1}\bar{p}_t\), then any anticipated part of monetary policy will be built into this expectation and thus into the price level. Output will only deviate from its natural rate \(\bar{y}_t\) if there is a surprise (an unanticipated shock to money or demand) that causes the actual market-clearing price to differ from the preset price.
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 206.
45. The original Phillips curve showed a positive relationship between inflation and unemployment.
Correct Answer: False
Explanation: The Phillips curve depicts a negative, or inverse, relationship. High unemployment is associated with low (or negative) wage inflation, and low unemployment is associated with high wage inflation. This suggested a trade-off for policymakers: they could choose lower unemployment at the cost of higher inflation, or vice versa.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 178 (Figure 9-1).
46. In the short run, when there are nominal rigidities, monetary policy can influence real variables like output and employment.
Correct Answer: True
Explanation: This is the central tenet of Keynesian and New Keynesian macroeconomics. Nominal rigidities (like sticky prices or wages) prevent the price level from adjusting instantaneously to changes in the money supply. As a result, a change in the nominal money supply causes a change in the real money supply (M/P), which affects aggregate demand and, consequently, real output and employment in the short run.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 6.
47. According to the Friedman-Phelps model, a government can achieve a permanently lower unemployment rate if it is willing to tolerate a permanently high, but stable, rate of inflation.
Correct Answer: False
Explanation: The Friedman-Phelps model, with its inclusion of inflation expectations, predicts that there is no long-run trade-off. To keep unemployment below the natural rate, the government must generate an actual inflation rate that is *continuously higher* than the expected rate. This would require not just a high and stable rate of inflation, but an *ever-accelerating* rate of inflation, which is not sustainable.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time".
48. The "coordination failure" argument for nominal rigidity suggests that no single firm will want to cut its price following a fall in aggregate demand unless other firms do so as well.
Correct Answer: True
Explanation: This is a core Keynesian idea. If all firms cut their prices and wages together, the economy could move to a new, lower-price equilibrium with the same level of output. However, if a single firm cuts its price while others do not, its relative price falls, but its costs (which depend on the prices set by other firms) do not. This could lead to losses. Therefore, no firm wants to be the first to adjust, leading to a "coordination failure" where a mutually beneficial adjustment does not occur, and prices remain sticky.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 45.
49. Empirical evidence from the United States strongly supports the Fischer model's prediction of counter-cyclical real wages.
Correct Answer: False
Explanation: This is a major empirical weakness of the Fischer model. The model predicts that real wages should be low when output is high (counter-cyclical). However, empirical studies, such as the one cited by McCallum, show that in the actual U.S. economy, there is no strong relationship of this type. If anything, real wages have a slight tendency to be pro-cyclical (rising when output is high).
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 191.
50. In the long run, the effects of monetary policy are primarily on nominal variables, such as the price level and inflation rate, rather than on real variables like output.
Correct Answer: True
Explanation: This is the principle of long-run monetary neutrality. While short-run non-neutralities are the focus of Keynesian models, it is a widely accepted principle that over a long enough horizon for all prices, wages, and expectations to adjust, changes in the quantity of money will be reflected proportionally in the aggregate price level, leaving real quantities (output, employment, real interest rates) unaffected.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 174.