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The document is a guide for a Monetary Economics seminar, focusing on two main questions regarding central bank policies and the Seigniorage Laffer curve. It discusses how central banks can achieve commitment gains through loss function redesign and explores the relationship between seigniorage, money growth, and inflation using Cagan's model. Additionally, it highlights the importance of policy inertia and critiques Cagan's model for its assumptions about real effects of inflation.

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8 views5 pages

seminar 4

The document is a guide for a Monetary Economics seminar, focusing on two main questions regarding central bank policies and the Seigniorage Laffer curve. It discusses how central banks can achieve commitment gains through loss function redesign and explores the relationship between seigniorage, money growth, and inflation using Cagan's model. Additionally, it highlights the importance of policy inertia and critiques Cagan's model for its assumptions about real effects of inflation.

Uploaded by

saadlamrini9
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Monetary Economics Seminar 4

Xiaoshan Chen

This document provides a short answer guide for each question. You
will need to …nalise the answer by incorporating more details.

Question 1 Without commitment technology, discuss why the central


bank can obtain the gains of commitment in forward looking models by
redesigning its loss function.
Hint: See Walsh, C. (2003). "Speed Limit Policies: The Output Gap
and Optimal Monetary Policy," The American Economic Review, 93(1),
265-278. Sections 2 and 3.
Answer guide:

First, students are expected to discuss the full commitment solutions.


Under the unconstrained commitment solution, the central bank …nds
sequences of the output gap and in‡ation that minimize the loss function.
Set up the Lagrange function:

1 X
1
i
min L = Et [ x2t+i + 2
t+i
xt+i ; t+i 2 i=0
+2 t+i ( t+i xt+i t+1+i ut+i )];

where 2 t+i is the multiplier on the Phillips curve. Optimal paths are
solutions to
@L @L
= 0 and = 0; where i = 0; 1; 2:::
@xt+i @ t+i
Combined the FOCs with respect to xt+i and t+i , we obtain:

xt = t; i = 0; and

1
xt+i xt+i 1 = t+i ; i 1

Under commitment in‡ation and output gap exhibit history depen-


dence. This is known as policy inertia. Policy inertia improves pre-
dictability of future policy, and in‡ation is easier to a¤ect by smaller
output adjustments. Gertler et al (1999) state that "the globally opti-
mal policy rule under commitment has the central bank partially adjust
demand in response to in‡ationary pressures. The idea is to exploit the
dependence of current in‡ation on expected future demand." Students
can demonstrate this point using the FOCs at t and t + 1 periods:
Period t :

xt = t
|{z}
Marginal cost
| {z }
marginal bene…t in reduction of t

Period t + 1 :
xt+1 xt = t+1

Combining the FOCs at t and t + 1 yields,

Et xt+1 = (Et t+1 + t)

Combining the FOCs at t, t + 1 and t + 2 yields,

Et xt+2 = (Et t+2 + Et t+1 + t)

The general rule is for period t + n

Et xt+n = (Et t+n + ::: + Et t+1 + t)

Therefore, the current in‡ation can be stabilised by the expectiation of


lowering future demand.

Second, students should point out that a central bank is concerned


with social loss but operating under discretion will fail to introduce any
inertia. Students should discuss the intuition of speed limit targeting.
The central bank stabilizes the change in the output gap, this introduces
inertia into monetary policy even under discretion. This can be shown
that a central bank faces the single-period problem of minimizing 2t +
zt2 : If zt denotes the output gap, this gives xt = t ; which is the FOC
obtained under discretion. If zt is the changes of output gap, xt xt 1 ;
then the FOC becomes xt xt 1 = t ; the condition that holds along

2
the timeless perspective optimal precommitment path. [Demonstrate
SLT and PLT under discretion in Seminar]

***For an excellent answer, students should be able to discuss other


forms of central bank’s objective functions. Walsh (2003) also discuss the
intuition of price level target. In addition, an excellent answer should
reference nominal income target. Finally, students should discuss the
…ndings in Walsh (2003) such as the speed limit targeting yields the
lowest loss; Price level targeting and NIT2 out performed in‡ation tar-
geting.

Question 2 Explain the concept of the Seigniorage La¤er curve.


Answer guide:

Students are expected to use Cagan’s (1956) model in David Romer.


"Advanced Macroeconomics" Chapter 11.9 to discuss the concept of
Seigniorage La¤er curve.
In order to demonstrate seigniorage La¤er curve, students need to
discuss the following elements:

The real money demand function


Mt e
= L (r + ; Yt )
Pt
where L1 < 0 and L2 > 0:
Real seigniorage equals the increase in the nominal money stock
divided the price level
Mt Mt Mt Mt
s= = = gM
Pt Mt Pt Pt

The relationship between seigniorage, money growth and


in‡ation in the steady-state economy

– Put it together at steady-state:

s = gM L r + gM ; Y

The FOC with respect to gM


@s
= L r + gM ; Y + gM L1 r + gM ; Y
@gM >0 <0

Now interprete the this FOC - This gives the shape of the
La¤er curve.

3
Draw the La¤er curve and point out the corresponding
in‡ation rate/money growth rate at the peak of the curve

The following will domonstrate your detailed and compre-


hensive knowledge of the topic:

– Using Cagan’s (1956) money demand function

L r + gM ; Y = ea b(r+gM )
Y

– The peak of the La¤er curve corresponds gM = = 1=b;


– The maximum amount of seigniorage revenue is
1 h a b(r+ 1b ) i
sM AX = e Y
b

– Cagan’s estimates suggest that b is between 12 and 13 ; a contin-


uously compounded rate of money growth/the rate of in‡a-
tion is 200 to 300 percent per year. Cagan, Sachs and Larrain
(1993) suggest that for most countries, seigniorage at the peak
of the La¤er curve is about 10 percent of GDP.

Caveat of Cagan (1956) Model (critical analysis)

– The standard approach underlying “Cagan’s rule” is partial


equilibrium and abstracting from the real e¤ects of in‡ation:
r and Y are assumed to be constant; the in‡ation tax does
not a¤ect real variables, such as consumption and output.

4
– It assumes that a government whose sole concern is with rev-
enues from the in‡ation tax. In reality, government is also
concerned with consumption and welfare (see Kimbrough,
2006).
– Calvo model implies that in‡ation and output are negatively
related and that output is falling in price stickiness. Dam-
janovic and Nolan (2009) using the Calvo model …nd that
the revenue-maximizing in‡ation is very close to in‡ation ob-
served recently in advanced economies.

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