Keynesian Models with Money Supply as a Policy Instrument (Set 2)
EC3115 Monetary Economics Exam Preparation
1. In the expectations-augmented Phillips curve $ \Delta w_t = f(UN_{t-1}) + \alpha \Delta p_t^e$, the Friedman-Phelps natural rate hypothesis is equivalent to the assertion that $\alpha = 1$.
Correct Answer: True
Explanation: The natural rate hypothesis asserts that there is no long-run trade-off between inflation and unemployment. This requires that the long-run Phillips curve be vertical. This verticality is achieved in the model only if the coefficient on expected inflation, $\alpha\$, is exactly equal to one. If $\alpha < 1\$, a permanent trade-off would exist.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 182.
2. According to the Brainard uncertainty principle, if a central bank is uncertain about the true value of a policy multiplier, it should always act more aggressively to ensure its policy target is met.
Correct Answer: False
Explanation: The Brainard principle suggests the opposite. Parameter uncertainty induces caution. A risk-averse central bank, uncertain about the effect of its policy instrument (e.g., the interest rate) on output, will act less aggressively than it would under certainty. It trades off fully closing the output gap for reducing the volatility of output that could arise from overshooting the target due to a larger-than-expected policy multiplier.
Source: EC3115 Lecture Slides, "Monetary Policy Under Parameter Uncertainty", p. 21, 27.
3. In John Taylor's staggered contracts model, the wage chosen by workers setting their contract in the current period depends on the wages set by other workers in the previous period and the wages expected to be set in the next period.
Correct Answer: True
Explanation: This is the central mechanism of the Taylor model. Because contracts are staggered and last for more than one period, workers care about their wage relative to others. The wage-setting equation, \(w = (1/2)[w(-1)+E(w(+1)|-1)] + ...\), explicitly shows that the new wage \(w\) is an average of the wage that is already in place \(w(-1)\) and the wage expected to be set by the other group in the future \(E(w(+1)|-1)\).
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 36-37.
4. The policy ineffectiveness proposition holds true in models with multi-period staggered contracts, such as Fischer's model.
Correct Answer: False
Explanation: Models with multi-period staggered contracts are precisely the environment where the policy ineffectiveness proposition *fails*. Because some nominal wages are locked in from previous periods, systematic and anticipated monetary policy can be used to influence the price level and thereby affect the real wage of those locked-in contracts. This allows the central bank to systematically stabilize output against shocks, a role that is denied by the policy ineffectiveness proposition.
Source: McCallum, B. T. (1989). Chapter 11, "Analysis of Alternative Policy Rules", p. 225.
5. One of the main criticisms of the Real Business Cycle (RBC) approach is the lack of a convincing description of the unobservable, economy-wide technology shocks that are supposed to drive fluctuations.
Correct Answer: True
Explanation: A significant problem for RBC models is that they rely on large, aggregate technology shocks (the Solow residual) to generate business cycles. Critics argue that it is implausible for technology to suddenly regress or for shocks to be so large and widespread across all industries simultaneously. The nature and origin of these initiating shocks remain a major point of contention.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 195.
6. In a Keynesian model with sticky prices, the long-run effect of a permanent increase in the money supply is a permanently higher level of real output.
Correct Answer: False
Explanation: While the short-run effect is an increase in real output, the principle of long-run neutrality of money is generally maintained. In the long run, prices and wages fully adjust to the change in the money supply. The final result is a higher price level but no change in real variables like output, which return to their "natural" or potential levels.
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 216.
7. The intellectual crisis of the 1970s for Keynesian economics came not from the inability of the prevailing wage-price models to explain the facts, but from the weakness of their theoretical foundations.
Correct Answer: True
Explanation: The empirical wage-price models of the early 1970s (like the augmented Phillips curve) actually tracked the data reasonably well. The crisis, spurred by the rational expectations revolution, was theoretical. These models lacked strong microeconomic foundations and were at odds with the idea that rational agents would not make systematic forecasting errors or be fooled by predictable inflation in the long run.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 6, 19.
8. The optimal monetary policy in the Phelps (1967) model is always to maintain unemployment at the natural rate \(u^*\) to ensure price stability.
Correct Answer: False
Explanation: The optimal policy depends on society's time preference (discount rate). If society discounts the future, it may be optimal to have a period of over-employment (\(y > y^*\)) to reap present benefits, even at the cost of higher inflation in the future steady state. Only if there is no time discounting do future considerations dominate, making it optimal to achieve the lowest sustainable inflation rate, which may involve a period of under-employment to reduce inflation expectations.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time", p. 256.
9. In the menu-cost model of monopolistic competition, the private incentive for a firm to adjust its price in response to a nominal demand shock is smaller than the social incentive.
Correct Answer: True
Explanation: This is due to the aggregate demand (or pecuniary) externality. When a firm cuts its price, it experiences only a second-order loss in profit (as it was already at its profit-maximizing price). However, this price cut contributes to lowering the overall price level, which increases real balances and aggregate demand, benefiting all other firms. This social benefit is a first-order gain. Because the private cost is smaller than the social gain, firms under-invest in price adjustment from a social perspective.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 47-48.
10. The 1979-1982 period of U.S. monetary policy, which used a nonborrowed reserves target, was successful in achieving tighter control over the money stock compared to the previous interest-rate targeting regime.
Correct Answer: False
Explanation: According to the analysis in McCallum, this policy was likely to *weaken* monetary control. The procedure was based on lagged reserve requirements, meaning required reserves in a given period depended on deposits from two weeks prior. This breaks the contemporaneous link between the policy instrument (reserves) and the target (money). The model predicts that this procedure would lead to larger, not smaller, control errors for the money stock, a conclusion consistent with the actual experience of increased monetary volatility during that period.
Source: McCallum, B. T. (1989). Chapter 11, "Analysis of Alternative Policy Rules", p. 233-234.
11. The term "nominal rigidities" refers to the slow adjustment of nominal variables like prices and wages, whereas "real rigidities" refers to situations where real variables, like the real wage, do not respond much to shifts in demand or supply.
Correct Answer: True
Explanation: This is the standard distinction. Nominal rigidity (e.g., menu costs, staggered nominal contracts) is about the stickiness of variables measured in units of money. Real rigidity (e.g., a flat marginal cost curve, or an efficiency wage that is insensitive to employment levels) is about the stickiness of relative prices. New Keynesian models often require both types of rigidity to generate large and persistent real effects from monetary shocks.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 38.
12. The optimal monetary policy in the Phelps (1967) model is always to maintain unemployment at the natural rate \(u^*\) to ensure price stability.
Correct Answer: False
Explanation: The rate of time preference is crucial. A higher discount rate means society values present gains more than future losses. This makes policymakers more willing to engage in over-employment today (accepting higher inflation tomorrow) to get the immediate utility gain. Therefore, the optimal employment path is an increasing function of the discount rate. A more patient society (lower discount rate) will choose a path closer to the natural rate to keep long-run inflation low.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time", p. 257.
13. The wage-price mechanism of the early 1970s generally modeled prices as a markup over standard unit costs, implying prices were not very responsive to short-term demand fluctuations.
Correct Answer: True
Explanation: A consensus view in the large macroeconometric models of that era was that prices were set as a relatively stable markup over unit labor costs, calculated at a standard or normal level of capacity utilization. This meant that short-run changes in demand had little direct effect on prices; instead, prices primarily changed in response to changes in wages.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 11.
14. In a model with rational expectations and one-period preset nominal wages, an announced and credible future monetary expansion will have no effect on current output.
Correct Answer: False
Explanation: This is incorrect. In Fischer's model, for example, an announced future policy is anticipated by wage-setters. When setting the wage for the future period, they will account for the announced policy. This means the future price level will be higher, and the wage set for that period will also be higher. This can have effects on investment and other variables even in the current period. The key is that only *unanticipated* shocks cause deviations from the natural rate, but *anticipated* shocks are still incorporated into agents' decisions and affect outcomes.
Source: Fischer, S. (1977) as discussed in Blanchard, O. J. (1987), p. 33-34.
15. The term "inflationary bias" in discretionary monetary policy refers to the tendency for policymakers to produce a higher rate of inflation than is optimal in the long run, without achieving any permanent gains in employment.
Correct Answer: True
Explanation: This is the essence of the time-inconsistency problem. A discretionary policymaker, re-optimizing each period, is always tempted to create surprise inflation to get a short-run output boost. The public anticipates this temptation and adjusts its inflation expectations upwards. The result is an equilibrium with a positive rate of inflation (the "bias") but with unemployment at its natural rate, as the inflation is fully anticipated.
Source: McCallum, B. T. (1989). Chapter 12, "Rules Versus Discretion in Monetary Policy", p. 245.
16. The persistence of monetary shocks in the Taylor model decreases as the sensitivity of desired real wages to employment (the parameter 'a') decreases.
Correct Answer: False
Explanation: The persistence *increases* as the parameter 'a' decreases. A smaller 'a' signifies greater real wage rigidity—meaning desired real wages don't change much when employment changes. This makes newly-set nominal wages more sensitive to the existing wages of other workers and less sensitive to current economic conditions. This increased dependence on past wages slows down the adjustment of the aggregate wage level, making the effects of a monetary shock last longer (i.e., more persistent).
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 37.
17. According to Gordon's empirical research, the inertia in U.S. wage and price behavior is a distinctly postwar phenomenon, with behavior being much more flexible in earlier periods like World War I and its aftermath.
Correct Answer: True
Explanation: Gordon's historical analysis shows that the significant inertia (i.e., the strong dependence of current inflation on past inflation) observed in the U.S. is a feature of the post-1950 period. In earlier periods, prices and wages were much more responsive to nominal GNP changes. For example, during WWI, the division of nominal GNP change was heavily skewed towards price changes, indicating high flexibility, in sharp contrast to the postwar era.
Source: Gordon, R. J. (1982). "Wages and Prices Are Not Always Sticky", p. 14, 29.
18. The Lucas misperceptions model and the Fischer/Taylor sticky-contract models are fundamentally similar because they both rely on imperfect competition as the source of monetary non-neutrality.
Correct Answer: False
Explanation: They rely on fundamentally different mechanisms. The Lucas model assumes perfect competition but imperfect *information*, where producers cannot distinguish aggregate from relative price changes. The Fischer and Taylor models assume imperfect competition (or at least non-market-clearing behavior) and nominal *rigidities* in the form of preset multi-period contracts. The source of non-neutrality is informational confusion in one, and institutional stickiness in the other.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 19, 21.
19. In the Phelps (1967) model, if society has a positive rate of time preference (discounts the future), it will be willing to trade off a permanently higher future inflation rate for a temporary period of higher employment in the present.
Correct Answer: True
Explanation: A positive discount rate means that future utility is valued less than present utility. Therefore, policymakers will be tempted to exploit the short-run Phillips curve to gain the immediate utility from higher employment (lower unemployment), even though this action will raise inflation expectations and lead to a less favorable (higher inflation) steady state in the future. The present gain is worth the discounted future cost.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time", p. 257.
20. The introduction of rational expectations into macroeconomic models proves that systematic monetary policy has no effect on real output.
Correct Answer: False
Explanation: This is a common misinterpretation. Rational expectations, when combined with perfectly flexible prices and no other frictions (as in the Lucas model), leads to the policy ineffectiveness proposition. However, when rational expectations are combined with nominal rigidities like staggered contracts (as in the Fischer and Taylor models), systematic monetary policy *can* and *does* affect real output. The key is the interaction of expectations with the institutional structure of the economy.
Source: McCallum, B. T. (1989). Chapter 11, "Analysis of Alternative Policy Rules", p. 225.
21. In a model with multi-period price setting, a previously unexpected monetary shock in period \(t-1\) can continue to affect output in period \(t\).
Correct Answer: True
Explanation: Yes, this is a key feature of models with overlapping contracts. For example, in a model with two-period contracts, the price level in period \(t\) is an average of prices set at the start of \(t\) and prices set at the start of \(t-1\). A shock at \(t-1\) influences the prices that were set then and are still in effect at \(t\). Therefore, the output equation in period \(t\) will depend on the monetary shock from period \(t-1\) (\(e_{t-1}\)) as well as the current shock (\(e_t\)).
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 212.
22. The main reason for the Great Depression in the 1930s was that the original Phillips curve relationship broke down.
Correct Answer: False
Explanation: This reverses the causality. The Great Depression, with its extraordinarily high and persistent unemployment, was the historical event that motivated Keynes to develop a framework where labor markets do not clear. The Phillips curve is a later (1958) attempt to model the *dynamics* of wage adjustment within such a Keynesian framework. The Depression was a cause for the development of Keynesian theory, not a consequence of the failure of a later-developed empirical relationship.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 175.
23. If a central bank targets the interest rate, it gives up control of the money supply.
Correct Answer: True
Explanation: A central bank can choose to control a price (the interest rate) or a quantity (the money supply), but not both simultaneously. To peg the interest rate at a target level, the bank must be willing to supply whatever quantity of money is demanded at that rate. If money demand shifts, the central bank must change the money supply to prevent the interest rate from moving. Thus, the money supply becomes endogenous.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part I, p. 4.
24. The theory of hysteresis suggests that after a recession, the unemployment rate will always quickly return to its original, pre-recession natural rate.
Correct Answer: False
Explanation: Hysteresis is the opposite idea. It posits that the natural rate of unemployment can be permanently or persistently affected by the history of actual unemployment. A deep recession might lead to a higher natural rate because unemployed workers lose skills or union insiders prioritize their own jobs over the jobs of the unemployed. In this case, the economy does not automatically return to the old equilibrium.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 71.
25. In the basic model of monopolistic competition with menu costs, a proportional fall in all nominal prices would increase social welfare if output is initially below the socially optimal level.
Correct Answer: True
Explanation: Under monopolistic competition, the equilibrium level of output is inefficiently low (price exceeds marginal cost). A proportional fall in all nominal prices, given a fixed nominal money stock, would increase real money balances, raise aggregate demand, and move output closer to the socially optimal (competitive) level. This creates a first-order increase in welfare.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 48.
26. The primary policy implication of the Lucas misperceptions model is that central banks should actively use monetary policy to manage aggregate demand.
Correct Answer: False
Explanation: The policy implication is nearly the opposite. The model suggests that since only unanticipated money affects output, and since a central bank is unlikely to have an information advantage over the public, any activist policy would simply add noise to the economy, making signal extraction harder for firms and reducing allocative efficiency. The role for monetary policy is drastically reduced, pointing towards stable, predictable rules rather than activism.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 26.
27. The existence of long-term employment relationships, as observed in the U.S. and Japan, is the primary cause of nominal wage stickiness according to Gordon's analysis.
Correct Answer: True
Explanation: Gordon argues that the unique institution of three-year overlapping nominal wage contracts in the postwar U.S. is a key factor explaining its higher degree of wage inertia compared to the U.K. and Japan, where contracts are typically shorter and more synchronized. While long-term employment relationships exist in all three countries, it is the specific *form* of the nominal wage contract that creates the stickiness.
Source: Gordon, R. J. (1982). "Wages and Prices Are Not Always Sticky", p. 32.
28. In the Phelps (1967) model, the optimal policy is to immediately move the unemployment rate to its long-run steady-state level.
Correct Answer: False
Explanation: The model calls for a gradual, asymptotic approach to the long-run steady state. If the initial expected inflation rate is different from the long-run optimal rate, the policymaker must engineer a period of over- or under-employment to gradually adjust expectations. For example, if initial expected inflation is too high, a period of under-employment (\(y < y^*\)) is necessary to drive expectations down towards the optimal long-run level.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time", p. 274.
29. A key finding from empirical macroeconometric models is that the real effects of a monetary shock on GNP can last for several years.
Correct Answer: True
Explanation: Dynamic simulations of large-scale models, like the DRI model cited by Blanchard, consistently show that a monetary shock has a hump-shaped and long-lasting effect on real output. For example, a 1% increase in M1 can increase GNP for 3 to 4 years, with the peak effect occurring after about two years, followed by a slow return to the baseline, often with oscillations.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 12, 16 (Table 1).
30. The main difference between the original Phillips curve and the expectations-augmented version is that the latter assumes rational expectations.
Correct Answer: False
Explanation: The crucial difference is the inclusion of an inflation expectations term (\(\Delta p^e\)). The augmented curve can be used with various theories of expectation formation, including adaptive expectations or rational expectations. The original Phillips curve simply omitted expectations entirely. The move to the augmented curve was about recognizing the importance of expectations in principle, while the debate over how those expectations are formed (e.g., adaptive vs. rational) came later.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 181-182.
31. In a model with sticky prices, the effectiveness of monetary policy in stabilizing output depends on the source of economic shocks (i.e., whether they originate in the goods market or the money market).
Correct Answer: True
Explanation: This is the central finding of Poole's (1970) analysis. The choice between targeting the money supply versus targeting the interest rate depends on the relative variance of shocks to the IS curve (goods market) and the LM curve (money market). As a rule, if IS shocks dominate, targeting the money supply is better. If LM shocks dominate, targeting the interest rate is better.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part I & II.
32. The concept of "real wage rigidity" means that nominal wages are fixed by long-term contracts.
Correct Answer: False
Explanation: Fixed nominal wages are a form of *nominal rigidity*. Real wage rigidity refers to a situation where the *real* wage (the nominal wage adjusted for the price level, W/P) is insensitive to the level of employment or other labor market conditions. For example, if the desired real wage has a low elasticity with respect to employment, this is a real rigidity. It is a distinct concept from the stickiness of the nominal wage itself.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 7.
33. In the Fischer model with two-period contracts, an unanticipated monetary shock in period \(t\) will affect output in both period \(t\) and period \(t+1\).
Correct Answer: True
Explanation: The shock affects output in period \(t\) because all wages for that period were set based on information from \(t-1\) or earlier. The effect persists into \(t+1\) because half of the labor force is still working under contracts that were negotiated at \(t-1\), before the shock was known. Only the half that renegotiates at the start of \(t\) can incorporate the new information. The effect disappears by \(t+2\), when all contracts have been renegotiated.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 34.
34. The existence of a stable, downward-sloping Phillips curve for the U.K. between 1861-1913 proves that there is always a permanent trade-off between inflation and unemployment.
Correct Answer: False
Explanation: The stability of the curve during that period is likely because inflation expectations were largely stable and anchored (close to zero) under the gold standard. The Friedman-Phelps critique argues that such a curve is only a short-run relationship that is stable only as long as expectations are stable. If policymakers tried to exploit this trade-off, expectations would shift, and the curve itself would move, revealing the absence of a *permanent* trade-off.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 178, 181.
35. In a model with sticky prices, the price level is a predetermined variable, but the level of output is not.
Correct Answer: True
Explanation: In sticky-price models, the price level for the current period, \(p_t\), is set based on information from the previous period (\(E_{t-1}ar{p}_t\)). It is therefore "predetermined" and cannot react to unexpected shocks within the current period. Output, \(y_t\), however, is determined by the interaction of aggregate demand with this preset price and is therefore a "jumping" or non-predetermined variable that responds immediately to current-period shocks.
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 204.
36. The primary difference between discretionary policy and a policy rule is that discretionary policy is always activist, while a rule is always non-activist.
Correct Answer: False
Explanation: The distinction is about the *process* of policymaking, not its form. A policy can be activist (reacting to the state of the economy) and still be a rule, if the policymaker is committed to following a pre-determined formula (e.g., the Taylor rule). Conversely, a policymaker could, in principle, choose a constant money growth rate (a non-activist outcome) on a period-by-period discretionary basis. Discretion means re-optimizing each period; a rule means committing to a formula for an extended time.
Source: McCallum, B. T. (1989). Chapter 12, "Rules Versus Discretion in Monetary Policy", p. 238-239.
37. The persistence of unemployment in Europe in the 1980s, even after the initial disinflationary policies, led some economists to question the standard natural rate hypothesis and explore theories of hysteresis.
Correct Answer: True
Explanation: The standard model predicts that unemployment should return to its natural rate once inflation stabilizes. The prolonged period of high unemployment in Europe, which seemed to have little effect on further disinflation, suggested that the natural rate itself might have increased. This led Blanchard and Summers, among others, to explore hysteresis theories, where the natural rate is path-dependent and can be permanently raised by a deep recession.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 70.
38. In the Phelps (1967) model, the optimal path for employment is the one that maximizes the instantaneous rate of social utility at every point in time.
Correct Answer: False
Explanation: This describes a myopic, statical approach. The Phelps model is dynamical and forward-looking. The optimal policy maximizes the *integral* of discounted future utility. This requires balancing the current utility gain from a particular employment level against the future consequences for inflation expectations and, therefore, future utility possibilities. Maximizing utility at each instant ignores this crucial intertemporal trade-off.
Source: Phelps, E. S. (1967). "Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time", p. 256.
39. The assumption of staggered or overlapping wage contracts is a form of nominal rigidity.
Correct Answer: True
Explanation: Staggered contracts, as modeled by Taylor and Fischer, are a specific institutional arrangement that causes the aggregate nominal wage level to adjust slowly. Because some contracts are fixed at any given time, the overall wage level cannot jump to a new equilibrium level in response to a shock. This slow adjustment of a nominal variable is the definition of nominal rigidity.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 32.
40. If a central bank is uncertain about the structure of the economy (parameter uncertainty), the optimal response is to use larger and more frequent policy interventions to probe the economy's reactions.
Correct Answer: False
Explanation: Brainard's analysis shows that parameter uncertainty should lead to more cautious, not more aggressive, policy. The risk of making a large error by overstimulating or over-contracting the economy (because the policy multiplier is different than expected) leads a risk-averse policymaker to make smaller adjustments. The central bank trades off achieving its mean target exactly for a reduction in the variance of outcomes.
Source: EC3115 Lecture Slides, "Monetary Policy Under Parameter Uncertainty", p. 21, 28.
41. In the Barro-Gordon model of discretionary policy, the equilibrium inflation rate will be higher when the policymaker places a greater weight on reducing unemployment (i.e., the parameter 'b' is larger).
Correct Answer: True
Explanation: In their model, the discretionary equilibrium inflation rate is \(\Delta p = b/a\). The parameter 'b' represents the weight the policymaker puts on the unemployment objective in their loss function. A larger 'b' means the temptation to create surprise inflation for an employment gain is stronger. Rational agents anticipate this stronger temptation and expect higher inflation, and in equilibrium, the policymaker validates this by creating more inflation.
Source: McCallum, B. T. (1989). Chapter 12, "Rules Versus Discretion in Monetary Policy", p. 241.
42. The key insight of the Lucas misperceptions model is that money is non-neutral because of multi-period wage contracts.
Correct Answer: False
Explanation: The Lucas model assumes fully flexible prices and wages with no contracts. The non-neutrality of money arises purely from an *information problem*: producers in decentralized markets cannot perfectly distinguish between a change in the aggregate price level (due to a monetary shock) and a change in the relative price of their own good. Multi-period contracts are the central feature of the Fischer and Taylor models, not the Lucas model.
Source: McCallum, B. T. (1989). Chapter 9, "Inflation and Unemployment: Alternative Theories", p. 185.
43. The term "destabilizing price flexibility" refers to the idea that, in some circumstances, more rapid price adjustment could actually increase output volatility in response to nominal shocks.
Correct Answer: True
Explanation: This idea, dating back to Fisher and Keynes and re-examined by DeLong and Summers, suggests that while perfect price flexibility is stabilizing (money is neutral), starting from a position of some stickiness, *more* flexibility could be destabilizing. For example, a negative demand shock could lead to deflation. This deflation raises the real interest rate (the Mundell-Tobin effect), which can further depress aggregate demand and worsen the output decline. In this case, some price stickiness would have been preferable.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 68-69.
44. The empirical evidence on the cyclicality of the real wage in the U.S. shows a clear and strong procyclical pattern, strongly supporting efficiency wage models.
Correct Answer: False
Explanation: The empirical evidence is mixed and a subject of much debate. While some studies find a weakly procyclical real wage, there is no consensus on a strong, clear pattern. Blanchard notes that there is "no clear correlation at any lag between product wages and employment in the US." The lack of a strong procyclical real wage is actually a puzzle for many business cycle models, including both classical and some Keynesian variants.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 18.
45. In a model with multi-period price setting, the current price level can depend on expectations formed in several previous periods.
Correct Answer: True
Explanation: If prices are set for, say, four periods, and the setting is staggered, then the current aggregate price level will be an average of prices set at the beginning of the current period, the previous period, two periods ago, and three periods ago. Each of these price-setting decisions was based on expectations formed at that time. Therefore, the current price level \(p_t\) will depend on expectations formed at \(t, t-1, t-2, \text{ and } t-3\).
Source: McCallum, B. T. (1989). Chapter 10, "Money and Output: An Analytical Framework", p. 212-213.
46. The existence of a "liquidity trap" strengthens the case for using monetary policy over fiscal policy to combat a deep recession.
Correct Answer: False
Explanation: A liquidity trap is a situation where nominal interest rates are at or near zero, and monetary policy becomes ineffective because injecting more money into the economy doesn't lower interest rates any further. In this scenario, the LM curve is horizontal. This situation weakens the case for monetary policy and strengthens the case for using fiscal policy (e.g., government spending) to stimulate aggregate demand, as fiscal policy would not be subject to "crowding out" via higher interest rates.
Source: General Keynesian Principles, discussed in McCallum (1989), Chapter 9.
47. The "wage-price spiral" refers to a dynamic where wage increases lead to price increases, which then feed back into higher wage demands and expectations, potentially leading to accelerating inflation.
Correct Answer: True
Explanation: This feedback loop is a central concept in the dynamics of inflation. It can be triggered by a demand or supply shock. For example, an expansionary policy might lower unemployment, leading to higher wage demands. Firms pass these higher wage costs on as higher prices. Workers, seeing higher prices, demand even higher wages in the next round to protect their real income, and the spiral continues. Staggered contract models show how this dynamic can arise formally.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 54.
48. The main advantage of a discretionary policy regime is that it allows the central bank to credibly commit to low long-run inflation.
Correct Answer: False
Explanation: The lack of credible commitment is the central *disadvantage* of a discretionary regime. Because a discretionary policymaker re-optimizes every period, they cannot credibly commit to not using surprise inflation in the future. The public knows this, leading to an inflationary bias. A policy *rule*, in contrast, is a mechanism for commitment. By tying its own hands, the central bank can anchor expectations at a low level and achieve a better long-run outcome.
Source: McCallum, B. T. (1989). Chapter 12, "Rules Versus Discretion in Monetary Policy", p. 242.
49. In the IS-LM framework, if the central bank holds the money supply constant, the LM curve is upward sloping.
Correct Answer: True
Explanation: The LM curve represents equilibrium in the money market for a given money supply. An increase in income (Y) raises the transactions demand for money. With a fixed money supply, the interest rate (i) must rise to reduce the speculative demand for money and restore equilibrium. This positive relationship between Y and i for money market equilibrium results in an upward-sloping LM curve.
Source: EC3115 Lecture Slides, "Why Did Central Banks Switch...", Part I, p. 6.
50. The empirical success of the original Phillips curve in the 1960s demonstrated that nominal wages are completely insensitive to expected inflation.
Correct Answer: False
Explanation: The apparent stability of the Phillips curve in the 1960s was likely due to the fact that inflation and inflation expectations were low and stable during that period. When inflation began to rise and become more volatile in the late 1960s and 1970s, expectations adjusted, and the simple, stable Phillips curve relationship broke down. This breakdown was strong evidence that expectations *do* matter for wage setting, leading to the widespread adoption of the expectations-augmented model.
Source: Blanchard, O. J. (1987). "Why Does Money Affect Output? A Survey", p. 8, 10.