International College of Economics and Finance NRU Higher School of Economics

International College of Economics and Finance
NRU Higher School of Economics

Prof Sylvain Carre
Aleksandr Shirobokov
6th February 2021

Students should attempt the problem set before the tutorial. All the questions depend only
on UoL material.
Monetary Economics — Class 15 Solution

Study Guide Reading
• Chapter 9
Additional Reading
Please see the Study Guide or the Syllabus.
Discussion Question
1. Augmented Phillips Curve and Okun’s Law
Solution:
Standard Phillips curve can be represented as:
lnWt = η(ut−1 ) + lnWt−1 (1)

Respressing we get:
∆wt = η(ut−1 ) (2)

As changes in nominal wage are closely linked to changes in inflation in competitive markets,
the last equation can be expressed as:
∆pt = η(ut−1 ) (3)

Augmented Phillips curve (people care about purchasing power of their income):
∆wt − ∆pt = η(ut−1 ) (4)

As inlfation is not known at the time of negotiation, people form their expectations:
∆wt = η(ut−1 ) + ∆pet (5)

Okun’s law:
1
∆pt = γ(yt − y ∗ ) + ∆pet (6)
1
yt = y ∗ + (∆pt − ∆pet ) (7)
γ
Note that the last equations is similar to Lucas aggregate supply curve.
UoL: A model of sticky prices [60 min]

1. Outline the model of sticky prices as presented in the SG.
Answer: in this model we have AD expression, which we get after combining IS and LM
curves:
yt = β0 + β1 (mt − pt ) + β2 Et−1 (pt+1 − pt ) + υt (8)
By p∗t we denote price level at time t that clears the market. Price stickiness comes from the
assumption that that the prices the firms set at date t − 1, to be operational in the market at
date t, pt , are the prices they expect to clear the market at date t: pt = Et−1 [p∗t ].
In a similar manner we denote by yt∗ the output level that clears the market at time t. The
full employment (equilibrium) level of output yt∗ is represented by:
yt∗ = δ0 + δ1 t + δ2 yt−1
∗
+ ut , (9)
2. Find the equilibrium price and output.

In the equilibrium the AD equation could be rewritten as:
yt∗ = β0 + β1 (mt − p∗t ) + β2 Et−1 (pt+1 − p∗t ) + υt (10)
From the previous expression we can get p∗t :
β0 − yt∗ + β1 mt + β2 Et−1 [pt+1 ] + υt

p∗t = (11)
β1 + β2
Note that we used the fact that Et−1 [p∗t ] = pt , which in case of market clearing becomes:
pt = p∗t .
If we take the expectation of the equilibrium level of output conditional on information avail-
able at date t − 1, we get:
Et−1 [yt∗ ] = δ0 + δ1 t + δ2 yt−1

∗
(12)
2
⇒ Et−1 [yt∗ ] = yt∗ − ut (13)
If we take the expectation of the equilibrium level of demand conditional on information

available at date t − 1, we get:
Et−1 [yt∗ ] = β0 + β1 Et−1 [(mt − p∗t )] + β2 Et−1 [(pt+1 − p∗t )] (14)
If we equate equilibrium levels of demand and output, we get:
yt∗ = β0 + β1 Et−1 [(mt − p∗t )] + β2 Et−1 (pt+1 − p∗t ) + ut (15)
Taking into account that Et−1 [p∗t ] = pt , the previous expression becomes:
yt∗ = β0 + β1 (Et−1 [mt ] − pt ) + β2 (Et−1 [pt+1 ] − pt ) + ut (16)
3. What is the expression for the deviations of output from the equilibrium level?
Answer:
yt − yt∗ = β1 (mt − Et−1 [mt ]) + υt − ut . (17)
4. Explain the role for the monetary policy in this model.

Answer:
Imagine that the money supply set by the authorities changes according to:
mt = µ0 + µ1 mt−1 + et (18)
where et is a zero mean, random error representing monetary policy shocks. Taking expecta-
tions of the money suuply conditional on information at date t−1 will give us an expression for
the unexpected money supply at date t, mt − Et−1 [mt ], which simply equals et . Substituting
this into the deviation of output from its equilibrium leve will give us a solution for the output
deviation, yt − yt∗ .
yt − yt∗ = β1 et + υt − ut . (19)
Notice that the systematic component of monetary policy (µ0 + µ1 mt−1 ) does not have any
real effects here. This is because at date t − 1, when prices for date t are set, firms take into
consideration what they expect the monetary authorities will do. If they expect the money
supply to increase, knowing that money should have no real effects, they will increase their
prices for date t accordingly. Only the random component of monetary policy, the monetary
policy shock et , will have real effects since this is realised after the prices have been set.
Note that this result is similar to the result of the Lucas Island’s model in a sense that only
unanticipated monetary policy has real effects.
3
5. Multi-period pricing.
Answer:
Multi-period pricing could be demonstrated as Figure above.
The average price in this case becomes:
Et−1 [p∗t ] + Et−2 [p∗t ]

pt = (20)
2
Let AD in this case be:
yt = β0 + β1 (mt − pt ) + υt (21)
The market clearing level of output is given as:
ytd = d0 + d1 t (22)
Equilibrium aggregate demand:
yt∗ = β0 + β1 (mt − p∗t ) + υt (23)
Forming expectation we get:
Et−1 [yt∗ ] = β0 + β1 Et−1 [mt − p∗t ] (24)
Et−2 [yt∗ ] = β0 + β1 Et−2 [mt − p∗t ] (25)
4
As output is deterministic, we get: Et−1 [yt∗ ] = Et−2 [yt∗ ] = yt∗
So, AD becomes:
1 1
yt∗ = β0 + β1 (Et−1 [mt ] + Et−2 [mt ]) − β1 (Et−1 [p∗t ] + Et−2 [p∗t ]) (26)
2 2
Note that the last term in brackets is pt .
Expressing output deviation we get:
1 1
yt − yt∗ = β1 (mt − Et−1 [mt ]) + β1 (mt − Et−2 [mt ]) + υt (27)
2 2
Monetary policy is:
mt = µ0 + µ1 mt−1 + et = µ0 + µ1 (µ0 + µ1 mt−2 + et−1 ) + et (28)
So, we get that:
mt − Et−1 [mt ] = et (29)
mt − Et−2 [mt ] = et + µ1 et−1 (30)
Hence expression for output deviation becomes:
1
yt − yt∗ = β1 et + β1 µ1 t−1 + υt (31)
2
Note that now both systematic and shock components of money supply have real effects.

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International College of Economics and Finance

NRU Higher School of Economics

6th February 2021

Monetary Economics — Class 15 Solution

lnWt = η(ut−1 ) + lnWt−1 (1)

∆wt = η(ut−1 ) (2)

∆pt = η(ut−1 ) (3)

∆wt − ∆pt = η(ut−1 ) (4)

∆wt = η(ut−1 ) + ∆pet (5)

UoL: A model of sticky prices [60 min]

yt = β0 + β1 (mt − pt ) + β2 Et−1 (pt+1 − pt ) + υt (8)

2. Find the equilibrium price and output.

yt∗ = β0 + β1 (mt − p∗t ) + β2 Et−1 (pt+1 − p∗t ) + υt (10)

From the previous expression we can get p∗t :

β0 − yt∗ + β1 mt + β2 Et−1 [pt+1 ] + υt

Et−1 [yt∗ ] = δ0 + δ1 t + δ2 yt−1

If we take the expectation of the equilibrium level of demand conditional on information

Et−1 [yt∗ ] = β0 + β1 Et−1 [(mt − p∗t )] + β2 Et−1 [(pt+1 − p∗t )] (14)

If we equate equilibrium levels of demand and output, we get:

yt∗ = β0 + β1 Et−1 [(mt − p∗t )] + β2 Et−1 (pt+1 − p∗t ) + ut (15)

yt∗ = β0 + β1 (Et−1 [mt ] − pt ) + β2 (Et−1 [pt+1 ] − pt ) + ut (16)

yt − yt∗ = β1 (mt − Et−1 [mt ]) + υt − ut . (17)

4. Explain the role for the monetary policy in this model.

Et−1 [p∗t ] + Et−2 [p∗t ]

The market clearing level of output is given as:

Equilibrium aggregate demand:

yt∗ = β0 + β1 (mt − p∗t ) + υt (23)

Forming expectation we get:

Et−1 [yt∗ ] = β0 + β1 Et−1 [mt − p∗t ] (24)

Et−2 [yt∗ ] = β0 + β1 Et−2 [mt − p∗t ] (25)

mt = µ0 + µ1 mt−1 + et = µ0 + µ1 (µ0 + µ1 mt−2 + et−1 ) + et (28)

So, we get that:

mt − Et−1 [mt ] = et (29)

mt − Et−2 [mt ] = et + µ1 et−1 (30)

Hence expression for output deviation becomes:

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