ECON 3426 Winter 2021 Monetary policy Prof. James McNeil Assignment 2 Due: 26 February 2021 Please answer each of the questions below. Include all your final answers and plots in a single file. Submit also an excel file(s) showing your data and calculations for question 1. 1. [50 points) Suppose that the Bank of Canada considered adopting either a price level targeting regime or inflation averaging regime. At a monthly frequency the target price levels under these regimes would be: Price level targeting: (1 - 7 ) P+ + pot ( 1 + yt ) , (1) Inflation averaging: ( 1 - - )D+ + - Pers +- 12 ' (2) where pt is the natural log of the price level and * the long-run inflation target. (a) For a given period, t, for what values of y and s are the price level targets from these two rules the same? (b) Rewrite the price level targets above as inflation targets by subtracting the log of the price level in the same period of the previous year. To answer the questions below, set 7* = 0.02, s = 24 and y = 0.5. Go to the CANSIM database and download data for the Consumer Price Index (v41690914) from January 1992 until December 2020. Use this data to calculate annual inflation rates as log differences.(c) Starting from January 1995 (which will be period t = 0), calculate the inflation targets in each period using the rules from part (b). What is the average of each target between January 1995 and December 2020? How do these compare with the long-run inflation target * and the average of actual inflation? (d) Plot the two inflation targets along with actual inflation from January 1995 until December 2020. Be sure to label your figure. Which target do you think would be preferred by borrowers? What about lenders? (e) Repeat part (d) using y = 0.75. Comment on and explain any differences between the two figures. 2. [50 points) Consider the following table of interest rates on zero-coupon government securities of various maturities: Table 1: Interest rates maturity (years) interest rate 0% 0.25% 0.5% 1% 2% Use these values to answer the following questions: (a) Under the expectations theory, what are expected future interest rates on one- year bonds in one, two, three, and four years' time? NO(b) Suppose that, because interest rates are constrained at their zero lower bound, the central bank announces a forward guidance policy to say that it will not increase interest rates before year four. If the policy is believed by market participants, what will be the effect on the expectations of future interest rates you found in part (a)? What will happen to the interest rates in Table under the expectations theory? Is the policy effective at lowering longrun interest rates? (c) Suppose that, after the forward guidance policy is implemented, ination returns to its target and output returns to potential in period two, where they stay for the remaining periods. If the central bank follows a Taylor rule, what will it set the policy rate in periods two, three, four, and ve? What are the implications for the effectiveness of future forward guidance policy, do you think? [Assume that the ination target is 2% and the natural real interest rate is 4%.] (d) Using your results from part (b), calculate the price of veyear bonds in period one, after the forward guidance policy is introduced. Next, calculate the price of these same bonds in period 2 after the central bank implements the new Taylor rule policy. Using those prices, calculate the one-year return on these bonds. [Hintz see material from Chapter 4 for calculating returns] (e) Now suppose that, instead of the forward guidance policy, the central bank implements an asset purchase program, buying two and threeyear bonds. If these zerocoupon bonds have a face value of $100, what price would the central bank need to pay for yields on these bonds to match your ndings from part (b)? Do you think this policy would be more or less effective than the forward guidance policy