EKO2111: Macroeconomics II

Problem Set 6
Due: May 16, 2019; 07:00 am.

1 Questions for Review (FYI. Not Graded)

1. Explain how monetary policy works in the New Keynesian sticky price model.

2. Suppose that the central bank increases its interest rate target in the New Keynesian model. Explain
what the equilibrium effects are.
3. Suppose that current total factor productivity falls in the New Keynesian sticky price model. Explain
what the central bank should do in response, and why.
4. Show that, if the central bank is passive–meaning it does not respond to shocks–then the New Keynesian
model will not replicate the key business cycle facts when there are total factor productivity shocks.
5. Discuss how the liquidity trap presents a problem in the New Keynesian sticky price model, and explain
what unconventional monetary policy could do about it.
6. Explain the Phillips curve relationship in the Basic New Keynesian model.

7. In the Basic New Keynesian model, what should the central bank do if the anticipated future rate of
inflation goes up? Explain.
8. Show that, in the New Keynesian Rational Expectations Model, if the nominal interest rate is constant,
there can be many equilibria, and explain.

9. Show the perils of Taylor rules given the Taylor principle, and the benefits of neo-Fisherian monetary
policy.

2 Problems (100 points)

1. (15 points) Suppose that initially, the output gap is zero in the New Keynesian sticky price model. Then,
there is news that total factor productivity will fall in the future. If monetary policy does not change, then
what should the fiscal authority do in response to this shock to the economy?
2. (20 points) Some macroeconomists have argued that it would be beneficial for the government to run a
deficit when the economy is in a recession, and a surplus during a boom. Does this make sense? Carefully
explain why or why not, using the New Keynesian model.
3. (15 points) In the New Keynesian model, how should the central bank change its target interest rate in
response to each of the following shocks? Use diagrams and explain your results.
a. There is a shift in money demand.

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 b. Total factor productivity is expected to decrease in the future.
c. Total factor productivity decreases in the present.

4. (30 points) In the basic New Keynesian model, suppose that there is an increase in the future marginal
product of capital.
a. Suppose that the central bank keeps the nominal interest rate at its initial value. What will be the
effect on current inflation and on output?

b. Suppose that the economy initially faces an increase in anticipated future inflation and a zero output
gap. When the shock occurs, what should the central bank do?
c. Explain your results in parts (a) and (b) with the aid of diagrams.

5. (20 points) Suppose initially that inflation is at the central bank’s target and the output gap is zero. Then,
government spending goes down. Determine, with the aid of diagrams, how the degree of price stickiness
affects the central bank’s optimal response, and explain your results.