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Monetary Theory And Policy Question Paper

Monetary Theory And Policy

Course:Master Of Economics

Institution: Kenyatta University question papers

Exam Year:2009

KENYATTA UNIVERSITY
UNIVERSITY EXAMINATIONS 2009/2010
FIRST SEMESTER EXAMINATION FOR THE DEGREE OF MASTER OF
ECONOMICS
EAE 503: MONETARY THEORY AND POLICY

DATE: FRIDAY, 4TH DECEMBER 2009
TIME: 9.00 A.M. - 12.00 P.M.

INSTRUCTIONS:

Question One
a)
Graph the money market with the Baumol-Tobin (BT) money demand. Show on the

graph the effect of a decrease in the cost of withdraws.
(4
marks)
b)
Explain what happens to:
i. The
equilibrium
interest
rate.
(3
marks)
ii.
The
real
money
supply (3
marks)
iii.
The
number
of
withdraws
per
period
(3
marks)

iv.
Excess reserves

(3 marks)
v.
Consumption
velocity
(3
marks)
c)
Graph the money market ONLY, with money supply sensitive to interest rates.

Show on the graph an increase in high powered money. Label the trapped

liquidity. Where does most of the increase
in
H
go?
(4
marks)

Question Two
Suppose the Central Bank of Kenya (CBK) cares about low inflation and low
unemployment. Specifically, the CBK’s objective is:
?1 2
2
min? u + .
1 p
?2 t
t
i.e. the CBK wants to minimize squared inflation plus squared unemployment
(the CBK is twice as displeased by squared inflation versus squared unemployment).

Page 1 of 3

Unemployment evolves according to the Lucas Monetary misperceptions model
with k.a = 1 and NR = 2 : u = 2 + p + p
t
( et t )

a)
Compute the optimal rule and the optimal discretionary policy.

(9 marks)
b)
Calculate the long run unemployment and inflation under both the optimal

rule and discretion and compute the CBK’s long run objective for the

rule and discretion. Which better achieves the CBK objective of low

inflation and unemployment, the optimal rule or the optimal discretion? (6 marks)
c)
Suppose expectations rise (so that unemployment is above its natural

rate). Does the CBK raise or lower inflation? Why?

(2 marks)

Question Three
The CBK has increasingly moved towards more transparency about changes in
monetary policy. Let
3
k.a =
and
= 4 and let p = e
NR
p = .
4
2
Suppose further
0
0
the CBK plans to print money and increase the inflation rate to 6% in period one and
then keep inflation at 8% for periods 2 and 3.
a)
Suppose the CBK is transparent and credibly announces the change in policy.
Therefore
e
p
= p , so that no firms misperceive. Calculate inflationary
t 1
+
t 1
+

expectations and unemployment for periods 0-3 and graph the results on the

Phillips curve graph for the monetary misperceptions model.

(4 marks)
b)
Now suppose the CBK is not transparent and does not announce the policy,
so
that
e
p
= p Calculate inflationary expectations and unemployment for
t+1
t

periods 0-3 and graph the results on the Phillips curve graph for the monetary

misperceptions model.

(4 marks)
c)
Is it best for the CBK to be transparent in this example? Explain briefly. (2 marks)
d)
Is it best for the CBK to be transparent if the policy is to decrease inflation?

Explain briefly (you do not need to
use
graphs).
(2
marks)

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Question Four
Discuss (schematically) how monetary policy affects aggregate output through the
following channels:
i. Interest
rate
channel
(3
marks)
ii.
Credit channel

(3 marks)
a.
Balance
sheet
channel
(3
marks)
b.
Bank-lending
channel
(3
marks)
iii.
Exchange
rate
channel (3
marks)
iv.
Other
Asset
prices
channel
(3
marks)

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Monetary Theory And Policy Question Paper

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