1 ECON 400 Coursework Assignment
Consider the following loglinear equations of the NewKeynesian model
bbbbd
Yt EtYt1 RtEtbt1 bt 1
bt Etbt1p1 1Yt bst 2
Rbt bt yYbt; 1; y0 3
bdt dbdt1d;t; 4
bst sbst1 s;t 5
where Ybt is output, bt is inaation Rbt is the nominal interest rate and bdt and bst are the shock process for demand and supply shocks. The term 0:99 is the discount factor, p 6 is the price elasticity of substitution, 80 is an adjustment cost parameter and 5. Finally, d;t;s;t represent a meanzero, serially uncorrelated demand and supply shocks, respectively.
Please answer the following questions all parts carry equal weights:
1. Assume that the central bank belived that the Onancial crisis was caused by a negative demand shock d;t with persistence, d 0:7:
i Compare the dynamics of output, inaation and the policy rate for this adverse demand shock with a standard Taylor Rule weight of 1:5 but with y 0 use a 1 negative shock
ii Assume the central bank aims to only minimize inaation in the loss function such that:
L b 2t
is the weight of 1:5 and y 0 optimal? If not what weight would
you recomend? Explain your answer.
2. Suppose a collapse in the exchange rate follows more closely a supply shock,an increase in s;t with s 0:75. Find the optimal policy and plot the responses of output, inaation and the policy rate following a 1 shock when the central bank has a loss function of
L b 2t 0 : 1 Yb t 2 :
when
i is set optimally with y 0.
ii Both and y are set optimally.
iii Explain why your results change or instead why they do not change in parts i and ii.
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