EP607: Ekonomi Makro III

Problem Set 5
Due: May 17, 2022 no later than 07:30AM (GMT+7)

1 Questions for Review (FYI. Not Graded)

1. What is the main argument of Keynesians in favor of sticky prices?

2. How is monetary policy determined in the New Keynesian model? What is the central bank’s target, and
what does the central bank control directly?
3. Why is monetary policy not neutral in the New Keynesian model? What are the effects of a change in
the central bank’s target interest rate?

4. How do Keynesians justify intervention in the economy through monetary and fiscal policy?
5. Explain why the Phillips curve relationship in the basic New Keynesian model takes the form it does.
6. Explain the concept of rational expectations. If the nominal interest rate increases permanently, what
effect does this have in the NKRE model in the long run?

7. What is the Taylor principle, and how does the Taylor principle go awry?
8. What is the basic neo-Fisherian idea? Explain how the neo-Fisherian monetary policy rule acts to achieve
good economic results.

2 Problems (100 points)

1. (10 points) Suppose that real output decreases temporarily in the New Keynesian model.
a. What are the effects on government spending, consumption, investment, price level, employment, and
real wage?

b. Are these effects consistent with the key business cycle facts from Chapter 11? What does this say
about the ability of firms to deal with this temporary shock?

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. (30 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. (20 points) In the basic New Keynesian model, suppose that there is an increase in the future marginal
product of capital. Explain your results with the aid of diagrams.
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 inlation and a zero output
gap. When the shock occurs, what should the central bank do?

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.