QUESTION 1 (20 MARKS)

Milton Friedman, the leader for Monetarism had proposed several important arguments regarding the implementation of Monetary Policy. The arguments were listed as:

Proposition 1: Monetary Policy has powerful short-run effects on the real economy. In the long run, however, changes in the money supply have their primary effect on the price level.

Proposition 2: Despite the powerful short-run effect of money on the economy, there is little scope for using Monetary Policy actively to try to smooth business cycle.

Proposition 3: Even if there is some scope for using Monetary Policy to smooth business cycles, the Central Bank (the Federal Reserve) cannot be relied on to do so effectively.

Proposition 4: The Central Bank (the Federal Reserve) should choose a specific monetary aggregate (such as M₁ or M₂) and commit itself to making that aggregate grow at a fixed percentage rate, year in and year out.

Keynesians economists' response to the above propositions with this statement:

"Monetary policy may have performed badly in the past. However as time passes we learn more about the economy and the use of policy gets better. Imposing rigid rules just as we beginning to learn how to use activist policy properly would be foolish. We just have to trust on the democratic process to ensure that policymakers will take actions that for the most part are in the best interests of the country."

Based on the debate above, discuss on the conduct of Monetary Policy whether it should be conducted by rules or by discretion.

QUESTION 2 (20 MARKS)

Automatic stabilizers came to the interest of policy makers as they have zero inside lag. With appropriate example, explain how income tax and unemployment benefit work as automatic stabilizers.

QUESTION 3 (20 MARKS)

Automatic adjustment and policy implementation can be applied to overcome internal and external disequilibrium in a country that adopts fixed exchange rate. Discuss with the help of appropriate diagrams how these two mechanism can be implemented to solve this disequilibrium.

QUESTION 4 (20 MARKS)

"The short run effect of a decrease in money supply or contractionary Monetary Policy on real variables under Lucas Rational Expectation model, would be different if the decrease is expected as compared when it is not."

Explain the above statement with the help of appropriate diagrams.