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Intermediate Macroeconomics - Assessment 2
Intermediate Macroeconomics (EFB330)
Queensland University of Technology
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May Assessment 2 EFB330: Intermediate Macroeconomics Tutor: Sophie Willgoose Emily Hill Claire N9468005 Louis Chiesia N 16 Part A Question 1 1a Table 1: the Simulation Data Quarters Remainin Interest Unemploymen g Rate t Rate 67 4 4 66 5 4 65 5 4 64 5 5 63 6 6 62 4 6 61 4 7 60 3 5 59 3 4 58 4 4 57 5 4 56 6 4 55 5 4 54 5 5 53 5 5 52 5 5 51 4 5 50 4 4 49 5 4 48 4 4 47 4 4 46 6 3 45 8 3 44 9 3 43 8 4 42 7 5 41 6 6 40 4 6 39 38 37 36 35 34 33 2 0 1 3 5 4 5 6 6 5 4 3 4 4 Inflation Rate 2 2 2 2 3 3 3 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 3 3 3 3 2 1 1 0 0 0 1 1 2 Newspaper Headlines New chair appointed Fed raises funds rate Economy in good shape Fed sets rate increase Oil crisis hits economy Oil shortage continues Oil shortage subsiding Unemployment high Fed reduces funds rate Help wanted signs everywhere Fed pushes up funds rate Economy too hot Fed sets rate increase Economy in good shape Fed lowers benchmark rate Economy looks well balanced NA New chair appointed Fed raises funds rate Economy looks well balanced Fed cuts interest rate Millions get tax relief Retail spree continues Tax refunds ending Inflation above target Fed reduces funds rate High jobless rate Unemployment high Low inflation prompts deflation fears Fed cuts interest rate Inflation below target Fed sets rate increase Help wanted signs everywhere NA New chair appointed Graph 1: Federal Funds Rate Over Time Federal Funds Rate Over Time 12 Interest Rate 10 8 6 4 2 0 67 64 61 58 55 52 49 46 43 40 37 34 31 28 25 22 19 16 13 10 7 4 1 Quarters Remaining Analysis of the above graph, depicting the federal funds rate over time, reveals several noteworthy relationships. Most broadly, the trend line indicates that the interest rate oscillates around approximately shifting slightly higher as time progressed, with the largest deviations being and Specific observations are best examined through discussion of three points, indicated the circles on Graph 1, experienced during the game. Firstly, there was a significant hike in the interest rate to at 44 terms remaining. At this point in the game, there was a retail spending spree and significant tax relief in the economy. Unemployment was low at and inflation correspondingly high at Given the state of the economy, significant contractionary monetary policy, raising interest rates, was necessary. Similarly, at 10 terms remaining, interest rates were at their highest level of As was the case before, unemployment was low at and inflation, high at This was due to a significant decline in the US dollar and analogous appreciation of the Australian dollar. Once again, it was necessary to raise interest rates to guide the economy out of such an extreme expansion, back towards the growth line. In contrast to such situations, necessitating contractionary monetary policy, interest rates reached their lowest point, with 38 terms remaining. Unemployment was extremely high at and there were fears of deflation with inflation at Subsequently, strong expansionary policy was implemented to stimulate the economy. Evidently, the game reflected the expected relationship between interest rates and external shocks. 1b Fed fundsrate t t Fed fundsrate t The Taylor Rule provides a useful framework for examining monetary policy in the context of an interest rate rule. John Taylor argued that since it is the interest rate that directly affects spending, central banks should think in terms of setting an interest rate rather than the money supply or its rate of growth (text p). The estimated Taylor Rule conforms with the expected form, where there is a negative correlation between unemployment and the interest rate and positive correlation between inflation and the interest rate. Indeed, when inflation increases, the federal funds rate increases (contractionary monetary policy) and when unemployment increases, the interest rate decreases (expansionary In combination with the the F statistic indicates whether the model as a whole is statistically significant whether R2 is significantly different from 0 (B). The Taylor Rule regression reveals an of 98 and corresponding Sig. F of 0. Given that the Sig. F is less than 0, there is confidence that the model explains interest rates. It is an accurate representation of the phenomenon being studied. Ultimately, the model, as a whole, is statistically significant with the dependent variable (interest rates) able to be explained the explanatory variables (unemployment and interest rates). Finally, the can be used in conjunction with the to determine the reliability of the estimate for each individual coefficient. The greater the magnitude of the tstat, the greater evidence against the null hypothesis that there is no significant difference from the mean. The of and 12 for unemployment and inflation, respectively, are less than and greater than 1. There is sufficient evidence against the null hypothesis that there is no significant difference. More importantly, the for unemployment and inflation are and 0, respectively. Given that both values are low, less than 0, there is confidence in the values of the estimated coefficients. It is extremely unlikely the unemployment and inflation results happened chance (C). 1c i t a ( T n) a , i t ( t T ) n) It is expected that the estimated Taylor rule previously calculated would be as above if the form used were that of the alternate version used in class. In contrast to the earlier version of the Taylor Rule, this equation considers target inflation and the natural rate of unemployment. According to this specification, once the central bank has chosen a target rate of inflation, it should endeavor to achieve this rate manipulating the nominal interest rate (text). The rule implies that if inflation is equal to target inflation ( t T ), and the unemployment rate is equal to the natural rate of unemployment (ut ), the central bank should set the nominal interest rate (i t ) equal to its value (i n) (text). i t n T doing so, the central bank can ensure the economy stays on the same path, with unemployment equal to the natural rate of unemployment and inflation equal to target inflation. Ultimately, selecting an appropriate nominal interest rate, in this case, the economy can reach a equilibrium. If unemployment is Simple rules such as the Taylor Model only involve a small number of variables which cannot possibly capture the state of a complex economy (D). Indeed, the rule implies that the central bank only responds to the inflation rate and output gap (C). In fact, they respond to numerous other variables such as the exchange rate, asset prices and monetary aggregates to achieve price stability (C). Similarly, the model requires a single measure of inflation be used to obtain rule prescriptions (D). Furthermore, whilst linear models dominate empirical econometric research, some propose the Taylor Rule is better described a function (E). One argument for a nonlinear specification is that the preferences of policymakers may not be quadratic in output and inflation, with the central bank assigning equal weights to positive and negative deviations of key economic variables from target values (E). In fact, it is more likely that the central bank assigns different weights to upward and downward deviations of aggregates from their expected values (E). Perhaps the most significant case for is the substantial uncertainty surrounding monetary policy formulation. The model involves significant data uncertainty, for example, with both the equilibrium real interest rate and level of potential output being inferred from other information. Neither are observable variables. In accordance with this data uncertainty, William Brainard provides an explanation for the distinction between actual central bank behavior and the optimal parameters indicated the coefficients for unemployment and inflation. He argues that uncertainty about the effects of policy on the economy makes policymakers more conservative (C). Where data uncertainty in one variable increases, the central bank should respond less to movements in that variable, reducing its optimal coefficient (C). There is also significant uncertainty concerning the relationship between inflation and nominal interest rates with empirical studies observing both positive and negative relationships (C). Contrary to the positive relationship implied the Taylor Rule, Loanable Funds Theory suggests consumers increase savings to protect themselves against inflation, ultimately lowering the interest rate (C). Part B Question 2 2a i) t z ) ut t The original Phillips curve, as detailed above, is based on the assumption that average inflation is 0. Under these circumstances, it is reasonable for wage setters to ignore past inflation and assume that this price level would be roughly the same as last expected inflation is 0 e The model implies a negative relation between unemployment and inflation. Given an expected price level, which workers take to be last price level, lower unemployment leads to a higher nominal wage, which leads to a confidence in the value of the estimated coefficient. The reliability of the estimate for coefficient is extremely low. The Phillips Curve can be used to derive the natural rate of the unemployment rate such that actual price level (i. actual inflation rate) is equal to the expected price level (i. expected inflation rate) (text). Imposing this condition, implies that: z u t n 0 un This result is irrational, given that a negative natural rate of unemployment is not possible. Ultimately, it is a result of the positive relationship between unemployment and inflation implied the estimated model. This result should be disregarded given the overall statistical insignificance, demonstrating the breakdown of the original Phillips Curve. Furthermore, the sacrifice ratio can be calculated. The sacrifice ratio measures the percentage of a real GDP that must be forgone to reduce inflation 1 percentage point (Ahmad, 2016). It is measured as follows. sacrifice 1 sacrifice 1 0 sacrifice ratio As with the natural rate of unemployment, this result contradicts the expected relationship between unemployment and the inflation rate implied the Taylor Rule. It suggests that real GDP should be increased to reduce inflation 1 ii) t z ut t Although the original Phillips Curve provided a reliable guide to joint movements in unemployment and inflation throughout the 1960s, this relationship broke down during the 1970s. This was primarily due to a change in the way formed expectations. Rather than being sometimes positive and sometimes negative, the inflation rate became consistently positive. Furthermore, inflation became more persistent, with high inflation in 1 year more likely to be followed high inflation the next. Given these factors, it was now incorrect to expect that the price level this year would be the same as that last year (0 inflation). consideration of presence and persistence ultimately changed the nature of the relation between unemployment and resulting in the formation of a modified Phillips Curve. A numeric representation of this adaptation is given below. Given the modified Phillip higher R2 value, overall statistical significance, and significance of the individual unemployment coefficient, it can be concluded that the modified Phillips Curve is a far more accurate representation of the simulation data. The natural rate of unemployment can also be derived for the modified Phillips Curve. z u t un The sacrifice ratio is also calculated below. sacrifice 1 sacrifice 1 sacrifice ratio In contrast, to the sacrifice ratio calculated using the original Phillips Curve, this sacrifice ratio conforms with the expected relationship between output and unemployment as the modified Phillips curve demonstrated a negative relationship between the change in the inflation rate and the unemployment rate. In this case, real GDP must be decreased to decrease inflation 1 2b t z ut t t The above estimated Modified Phillips Curve was constructed using real world quarterly data. The R2 value of 0 is extremely low, indicating that only of the variation in the change in the inflation rate can be explained the unemployment rate. The model does not explain the data reported through the simulation accurately. In addition, the F statistic and corresponding Sig. F are 0 and 0, respectively. Given that the Sig. F is greater than 0, there is less than confidence that the model explains the change in the inflation rate. Ultimately, the model as a whole, is statistically insignificant, with the change in the inflation rate not able to be explained the unemployment rate. Finally, unemployment has a and of and 0, respectively. Given that the is not less than there is insufficient evidence against the null hypothesis that there is no significant difference. The greater than 0 also implies that there is less than confidence in the value of estimated coefficient.
Intermediate Macroeconomics - Assessment 2
Course: Intermediate Macroeconomics (EFB330)
University: Queensland University of Technology
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