This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON 279 0115 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route for
External Students

Monetary Economics

Thursday, 26 May 2011 : 10.00am to 1.00pm

Candidates should answer ELEVEN of the following SEVENTEEN questions: EIGHT

from Section A (5 marks each) and THREE from Section B (20 marks each). Candidates
are strongly advised to divide their time accordingly.

© University of London 2011

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SECTION A

Answer EIGHT questions from this section (5 marks each).

Consider the following statements, say whether they are true, false, or uncertain, and give a
brief reasoned explanation for their answer. Marks will not be awarded for answers
unsupported by a reasoned explanation.

1. A criticism of Tobin’s portfolio selection model of money demand is that it suggests

individuals are ‘all-or-nothing’ holders of money or bonds.

2. An increase in the mandatory reserve requirement will cause a fall in the aggregate
money supply.

3. A positive relationship between the nominal interest rate and anticipated inflation
implies that the rate of growth of money has no effect on the real economy.

4. Persistent high inflation can help explain a breakdown of the observed relationship
between inflation and unemployment.

5. Baseline Real Business Cycle theory predicts a negative correlation between output and
prices.

6. In a Keynesian model of sticky wages, expansionary monetary policy causes an

immediate increase in prices and output, but no effect in the long run.

7. The policy ineffectiveness proposition holds for all rational expectations models.

8. The expectations hypothesis is able to explain empirical evidence on the relative

volatility of long term bond yields.

9. Increases in long-term nominal interest rates can signal an increase in expected

inflation.

10. A depreciation of the domestic currency will raise the domestic price level in the short-
run.

11. Country A and Country B are part of a currency union and an investor faces a choice
between a project in A and a project in B. Expected returns on the Country A project are
two percentage points higher than the Country B project. The investor should invest in
Country A.

12. Fiscal synchronisation is necessary for a currency union to be sustainable.

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SECTION B

Answer THREE questions from this section (20 marks each).

13. There are three figures below related to monetary variables in the US for the period
January 1999 to May 2009. Figure 1 presents the evolution of M1, M2, and monetary
base; Figure 2 the evolution of the money multipliers; and Figure 3 the evolution of the
cash and reserves coefficients i.e. the currency-deposit ratio and the reserve-deposit
ratio respectively.

(a) Explain the link between the monetary base and the money supply M1.

(b) Explain the behaviour of the money multiplier m1 in Figure 2 from that of the
behaviour of the cash and reserve coefficients in Figure 3.

(c) The money supply M1, M2 go up even as the money multipliers m1, m2 fall
towards the end of the period. What does this tell you about Federal Reserve
policy at the time?

Figure 1: M1, M2 and monetary base in the US, Figure 2: Money multipliers in the US,
January 1999-May 2009 (Jan 1999=100) January 1999-May 2009 (Jan 1999=100)

m2
Base

M2 m1

M1

Figures continue on following page.

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 Figure 3: Cash and reserves coefficients in the US,
January 1999-May 2009

k (cash)

r (reserves)

Source: Von Hagen, J. (2009) The Monetary Mechanics of the Crisis, Bruegel Policy Contribution, Issue 2009/08, August.

14. During the 1980s and 1990s many Latin American countries experienced episodes of
high inflation which in some cases resulted in a process of hyperinflation. Figures 4 and
5 below present information on the evolution of the annual inflation in Argentina and
Bolivia respectively for the period 1981-2001.

(a) Explain the concept of seignorage.

(b) Is it possible to establish when a very rapid and continuing inflationary process
becomes a hyperinflation?

(c) Which models might best describe the situation of Argentina and Bolivia? Explain
your answer.

Figure 4 Figure 5
Annual Inflation in Argentina Annual Inflation in Bolivia
1981-2001 1981-2001
14,000 14,000
12,000 12,000
10,000 10,000
Inflation (%)
Inflation (%)

8,000 8,000
6,000 6,000

4,000 4,000

2,000 2,000

0 0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
-2,000
Year Year

Source: World Bank

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15. Figure 6 below presents information on the monthly per cent change in the dollar-pound
exchange rate and monthly inflation differentials between the US and the UK for the
period 1973 - 2005.

(a) How accurate is Purchasing Power Parity as a theory to explain exchange rate
movements?

(b) Explain why the exchange rate seems to be more volatile than inflation.

Figure 6
Monthly per cent changes in the dollar–pound ($/£) exchange rate and
monthly inflation differentials between the US and the UK
(1973-2005)

Source: Pilbeam, K. (2006) International Finance, Palgrave MacMillan, London.

16. Consider a world in which PPP holds only for traded goods:

(1) PT SPT*

where S is the exchange rate PT is the price of traded goods in the domestic country,
and PT* is the price of traded goods in the foreign country.

In addition, it is assumed that an aggregate price index for the domestic economy P is
constructed as the weighted average of the price levels of traded and non-traded goods
in the domestic economy. In the same way, an aggregate price index for the foreign

Question continues on following page.

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 country P* is calculated as the weighted average of traded and non-traded goods in the
foreign economy:

(2) P D PN  1  D  PT where D   0,1

(3) P* E PN*  1  E  PT* where E   0,1

(a) Calculate the exchange rate as a function of the relative prices of non-traded with
respect to traded goods.

(b) Using your answer to (a) explain why, or why not, Purchasing Power Parity holds
in terms of aggregate price indices.

(c) Calculate the real exchange rate, Q, and discuss the effects of an increase in
productivity in the traded goods sector in the domestic economy.

17.
(a) Using a suitable model, demonstrate the inflation bias of discretionary monetary
policy.

(b) Explain how an anti-inflation reputation of the central banker can reduce this
inflation bias of discretionary monetary policy.

END OF PAPER

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 This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON 279 0115 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route for
External Students

Monetary Economics

Thursday, 26 May 2011 : 10.00am to 1.00pm

Candidates should answer ELEVEN of the following SEVENTEEN questions: EIGHT

from Section A (5 marks each) and THREE from Section B (20 marks each). Candidates
are strongly advised to divide their time accordingly.

© University of London 2011

UL11/0184 PLEASE TURN OVER
D01 Page 1 of 6
SECTION A

Answer EIGHT questions from this section (5 marks each).

Consider the following statements, say whether they are true, false, or uncertain, and give a
brief reasoned explanation for their answer. Marks will not be awarded for answers
unsupported by a reasoned explanation.

1. Fiat money has no commodity backing, but it does have intrinsic value.

2. A reduction in the minimum reserve requirement will lead to an increase in aggregate

money supply.

3. Empirically, changes in monetary policy produce hump-shaped movements in the price

level and output.

4. The marginal efficiency of general taxation has no bearing on the optimal amount of
seigniorage revenue.

5. The less frequently firms can set prices, the larger the real effect of systematic monetary
policy changes.

6. The policy ineffectiveness proposition continues to hold even where the government has
better information than private agents.

7. Inflation bias exists even when policy makers target the market clearing level of output.

8. An inverted yield curve can signal that the market predicts a recession.

9. If bonds of different maturities are not perfectly substitutable then a demand for
liquidity will produce a downward sloping yield curve.

10. Relative purchasing power parity states that higher domestic inflation relative to abroad
will be reflected an appreciation in the domestic exchange rate.

11. Assuming risk neutrality and rational expectations, market efficiency implies that
forward exchange rates are positively correlated with future spot exchange rates.

12. Stable exchange rates and convergent inflation are necessary and sufficient for two
countries to form a successful currency union.

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SECTION B

Answer THREE questions from this section (20 marks each).

13. There are two figures below related to monetary variables in the UK for the period
January 2001 to May 2009. Figure 1 presents the evolution of monetary base and M4.
M4 is the Bank of England’s preferred indicator of broad money; it includes a broader
range of bank deposits with long maturities compared to M2. Figure 2 presents the
evolution of the corresponding m4 multiplier and Figure 3 the evolution of the cash and
reserves coefficients i.e. the currency-deposit ratio and the reserve-deposit ratio
respectively.

(a) What is the difference between monetary base and money supply M1? Derive the
corresponding money multiplier.

(b) Assume that the same factors as the m1 multiplier govern the behaviour of the m4
multiplier as well. Explain the behaviour of the m4 multiplier in Figure 2 from
that of the behaviour of the cash and reserve coefficients in Figure 3.

(c) The money supply M4 goes up even as the money multiplier m4 falls towards the
end of the period. What does this tell you about the policy of the Bank of England
at the time?

Figure 1: Monetary base and M4 in the UK, Figure 2: m4 multiplier in the UK,
January 2001-May 2009 (Jan 2001=100) January 2001-May 2009 (Jan 2001=100)

Base

M4

Figures continue on following page.

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 Figure 3: Cash and reserves coefficients in the
UK, January 2001-May 2009

r (reserves)
k (cash)

Source: Von Hagen, J. (2009) The Monetary Mechanics of the Crisis, Bruegel Policy Contribution, Issue 2009/08, August.

14. Figures 4 and 5 present information on the evolution of inflation in Brazil and Bolivia
respectively for the period 1981-2001. These are just two examples of many Latin
American countries that have suffered high inflation during this period.

(a) Explain the concept of an inflation tax.

(b) Explain how hyperinflation affects money demand.

(c) Which models might best describe the situation of Brazil and Bolivia? Explain
your answer.

Figure 4 Figure 5
Annual Inflation in Brazil
1981-2001
14,000
12,000
10,000
Inflation (%)

8,000
6,000
4,000
2,000
0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
Year

Source: World Bank

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15. In the figures below you will find a plot of the actual exchange rate and the exchange
rate that would have satisfied the Purchasing Power Parity theory for the period 1973 –
1999. Figure 6 presents information about the Yen-deutschmark rates and Figure 7
about the French franc-deutschmark rates.

(a) Explain the Purchasing Power Parity (PPP) theory. How is the PPP rate obtained
in Figures 6 and 7?

(b) Evaluate the validity of the PPP theory using Figures 6 and 7.

Figure 6

Source: Pilbeam, K. (2006) International Finance, Palgrave MacMillan, London.

Figure 7

Source: Pilbeam, K. (2006) International Finance, Palgrave MacMillan, London.

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16. Consider the following flexible price monetary model in which the domestic and
foreign money demand functions are given by:

(1) m  p K y  V r K ,V >0
(2) m *  p* K y * V r *

Where m, p, and y, are logs of money supply, prices, and income respectively (similarly
with a star for the foreign country); and r and r* are the (nominal) domestic and foreign
interest rates.

It is assumed that purchasing power parity holds continuously, so:

(3) s p  p*

where s is the log of nominal exchange rate.

Uncovered interest parity is also assumed to hold continuously, thus:

(4) Es r r*

(a) Derive an expression for the exchange rate, s, in terms of relative money stocks,
relative income levels, and relative interest rates. Explain how these variables
affect the exchange rate.

(b) Assume that a negative supply shock reduces income in the foreign country
provoking an appreciation of the domestic currency. By how much will the
domestic central bank have to increase the money supply to prevent the exchange
rate movement?

(c) Assume that the Fischer equation holds (i.e., the nominal interest rate equals the
sum of the real rate of interest and expected rate of price inflation for both the
home and the foreign countries). Use the ‘reduced-form’ exchange rate equation
that you derived in (a) to investigate the effect on the exchange rate of a rise in
expected inflation in the domestic country.

17. Post May 1997, the Bank of England’s monetary framework is characterized by (a)
operational independence, and (b) transparency in the sense that the Bank’s Governor
has to write an open letter to the Chancellor if the Bank deviates significantly from its
inflation target. Link these features to theories that economists have used to address the
‘inflationary bias’ problem.

END OF PAPER

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 Examiners’ commentaries 2011

Examiners’ commentaries 2011

115 Monetary economics

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2010–11. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

General remarks

Format of the examination

This course is intended to take an analytical approach to monetary economics. Candidates are
expected to have mastered the main principles, in the form of a number of key theoretical models.
They should be able to use these flexibly, as tools to analyse economic issues and data. They are
also expected to have some knowledge of the empirical evidence on these models.

The format of the exam paper changed from the academic year 2010/11. The exam paper no longer
has a Section C; it consists of only two sections: A and B. The paper will contain seventeen
questions in total with twelve in Section A and five in Section B. The format of Section A remains
unchanged from previous years, each candidate will still be required to answer eight out of the
twelve questions provided. These questions are intended to test knowledge of important concepts
and understanding of key analytical points. A brief answer is expected, and candidates need to be
selective in focusing their answers on the most important points, since, for some of these questions, a
very long answer could be given.

In the new exam format, Section B consists of five questions, three of which must be answered by the
candidate. The questions in Section B can be of three different types. The first type will be similar
to the questions that have appeared in Section B in previous years, they will be intended to test the
candidate’s ability to understand and interpret empirical data and relate them to relevant theories
where possible. Some general knowledge of recent economic events is sometimes helpful in answering
these questions. The sub-sections of this type of question will typically relate to a single concept or
model. The second type of question that can appear in Section B will require the candidate to carry
out calculations and problem solving in relation to specific models. Finally, the third type of
question can be essay-type questions that test the candidate’s ability to discriminate and evaluate;
these will be intended to test whether the candidate has done further reading outside the core
text/guide. All the question types in Section B will typically relate to a single concept or model.

The subject guide contains brief notes on the main topics in the syllabus, and gives
recommendations on textbooks and other readings. It is very important that candidates study
widely, using textbooks and other reading, particularly those items marked Essential reading in the
subject guide, as it alone is not sufficient. It is not intended as a textbook, but as a guide to the
relevant literature. Candidates should aim to understand the key analytical principles with enough
confidence to be able to use them as a set of tools to apply to a wide range of economic questions.
General knowledge of recent events relating to macroeconomics is valuable, particularly when
commenting on economic data in Section B of the examination.

1
115 Monetary economics

Planning your time in the examination

The examination is divided into two parts. As mentioned above, Section A requires answers to eight
out of twelve questions and Section B requires answers to three out of five questions. Candidates
should allow for ten minutes in reading carefully and understanding the questions and making
appropriate choice of questions in Sections A and B. Each question in Section A is worth 5 marks,
and candidates should plan to spend ten minutes on each question, one hour and twenty minutes on
the section. Each question in Section B is worth twenty marks and these should be allowed thirty
minutes each, ninety minutes for the whole section. Planning time in an examination like this, where
there are different sections and questions of different lengths, is important. It is easy for candidates
to spend too long on Section A, and to have to skimp Section B. Section A answers have to be brief
and to the point.

What are the Examiners looking for?

The Examiners are looking for answers that show the understanding and application of economic
principles, combined, where appropriate, with factual knowledge. The use of diagrams to illustrate
points is welcomed by the Examiners. Candidates are expected to show independent critical
judgment, for example, in Section A where the statements given may be true or false or somewhere
in between. Candidates should be able to distinguish between true and false, or partially true and
partially false, claims. In the data-based questions in Section B, the Examiners are looking for
comments based on a close examination of the data provided. The comments should reflect
appropriate economic principles and theoretical ideas. Comments should, where this is relevant, be
supported by some knowledge of other facts and circumstances beyond those shown in the question
paper. It is not expected that candidates will have studied in detail the data for the countries, the
variables, or the time period that are mentioned in the question. But it is expected that they have
some general knowledge of a wide range of recent economic events. The essay-type questions in
Section B are intended to test whether the candidate has done further reading outside the core
text/guide.

Key steps to improvement

In general, in the examination scripts for the 2011 examinations, many candidates did not set out
their answers in as much depth as the Examiners expect for a final year optional course that forms
part of a degree programme. Candidates are encouraged to use diagrams to illustrate their
arguments where appropriate. They are also expected to explain in words the economic significance
of algebraic derivations. A significant group of candidates, of course, performed very well, and wrote
lucid, detailed, well-illustrated answers that showed good technical skills, understanding of the
economic principles, and good knowledge of relevant recent economic events.

Key steps for improvement then include:

• Allow yourself time to read the questions and carefully manage your time in the examination.
• Answer the question on the paper directly. Do not make use of set piece answers to other,
possibly similar, questions. Do not write irrelevant material just for the sake of lengthening your
answers.
• Make full use of diagrams where possible.
• Combine manipulations of algebraic models with explanations in words of relevant economic
principles.

2
 Examiners’ commentaries 2011

Question spotting
Many candidates are disappointed to find that their examination performance is poorer than
they expected. This can be due to a number of different reasons and the Examiners’ com-
mentaries suggest ways of addressing common problems and improving your performance. We
want to draw your attention to one particular failing – ‘question spotting’, that is, confining
your examination preparation to a few question topics which have come up in past papers for
the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the ‘Course information sheet’ in the section of the VLE dedicated
to this course. You should read the syllabus very carefully and ensure that you cover sufficient
material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions that
have not appeared in past papers – every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in
difficulties when you sit the examination paper. We strongly advise you not to
adopt this strategy.