Managment Engineering - Macroeconomics of finance

Full exam

Part I Exercise 1 a) Define and explain the neutral (or natural) rate of interest, both in the neo-classical theory and in the Taylor rule. 4 points Explain and draw the goods and bonds market equilibria in the neoclassical model and explain why that interest rate is the one that brings in equilibrium both markets. Explanation of the Taylor rule where that rate is the one where the two inflation and output gaps close. b) Explain why, with a lower neutral interest rate, the policy rate will hit more often the effective (or zero) lower bound. 3 points In order to have an easy monetary policy, the policy rate must be lower than the neutral interest rate: the lower is the neutral rate the smaller will be the monetary space to act over the ZLB. c) Explain which are the innovations in the revisions to the Fed’s monetary policy framework and the motivations for such innovations. 4 points “The revised statement emphasizes that - maximum employment is a broad and inclusive goal. This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. Recognizing the economy's ability to sustain a robust job market without causing an unwanted increase in inflation, the statement says that our policy decisions will be informed by our "assessments of the shortfalls of employment from its maximum level" rather than by "deviations from its maximum level."This means that we will not tighten monetary policy solely in response to a strong labor market. - To counter the adverse economic dynamics that could ensue from declines in inflation expectations in an environment where our main policy tool is more frequently constrained, we now explicitly seek to achieve inflation that averages 2 percent over time. This means that following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time in the service of keeping inflation expectations well anchored at our 2 percent longer-run goal.” The same day on the Financial Times you could read this comment to Powell’s speech: “The job of the Federal Reserve, the central bank’s former chair Bill Martin once said, is to take away the punchbowl just as the party is getting started. With the prospect of a rapid economic bounceback in the US in the latter half of 2021 thanks to the combination of vaccines and fiscal stimulus, many are now asking whether the Fed’s commitments to keep rates low through to 2022 will mean that it could, in fact, be spiking the punch. (…) The Federal Reserve must be mindful of these risks. (…)” d) What’s the meaning of the following sentence: “The job of the Federal Reserve is to take away the punchbowl just as the party is getting started”? Provide an interpretation. 2 points The more punch you give to your guests in a party, the more the party works…The sentence means that if, as the party (the economy) overheats, you put away the punchbowl (the Fed begins to rise its policy rate), you cool down your party (the economy). So it refers to the fact that the Fed could begin to increase the policy rate as the economy exits from the recession. e) “The Federal Reserve must be mindful of these risks”: Which are these risks? Explain. 3 points If the Fed increases interest rates too much as it sees some inflation(once the recession ends) it could bring immediately the economy back into recession. If the Fed does too much (keeps interest rates low for a long period) there is the potential for the kind of high inflation. Part II Exercise 2 a) According to the balance sheet channel, how does the bankruptcy costs vary with the net worth? 3 points If interest rates go up, net worth decreases and this worsens asymmetric information problems. Since collateral is lower this increases the probability to go bankrupt and its cost. b) Employing the production function and the parameters in the text, write down the firms’ labour demand curve when there is bankruptcy risk. 3 points The labour demand curve has to be derived from firm’s profit maximization. Doing that, one obtains: w=(1-gp(a))/(2(1+r)n^0.5)) that is a negative relationship between w and n c) Write down the firms’ labour demand curve when there is not bankruptcy risk. Draw on the same graph this curve and the one at point b). 3 points w=1/(2(1+r)n^0.5)). They are two downward sloping curves with the one without bankruptcy risk that is higher. d) For each level of real wage, do firms demand more or less labour if going into bankrupt is costly? Why? Does the Modigliani – Miller theorem hold? Why? 4 points For each level of real wage, firms demand less labour if going into bankrupt is costly. This is due to the negative dependence under a), and thus the firm can afford a lower level of employment. The Modigliani Miller theorem does not hold because in that case financial choices do not affect real decision. Here it is not so. e) Employing the production function and the parameters in the text, determine the relationship between the firm’s net worth (a) and the quantity produced (q): is it a positive or negative? Show it graphically and comment. 3 points q= (1-gp(a))/2w(1+r): it is a positive relationship. If a increases, the probability to go bankrupt decreases, the demand for labour shifts up, employment increases and, given the production function, output increases.