Suppose the US economy is in recession. The unemployment rate is 7% and the Federal Reserve Bank is considering using monetary policy to expand output. Assume the bank knows, with certainty, that:

i.absent changes in monetary policy, unemployment will still be 7% next year;

ii.the natural rate of unemployment is 5%;

iii.from Okun's law, 1% more output growth for a year leads to a 0.4% reduction in the unemployment rate.

Also assume the bank can effectively use monetary policy to increase output growth rates as desired, i.e., the interest rate is sufficiently far away from the zero lower bound. However, the bank is uncertain about the effect that changes in its policy rate, the Official Cash Rate (OCR), have on output growth. To inform its decisions, the monetary policy committee summons the research department to produce predictions of the one-year response of US output growth to a decrease of 1% in the OCR. The research department, using three different macroeconometric models, presents the results from three different models:

Model (a): output growth is predicted to increase by 1.0% (moderate monetary transmission channel)

Model (b): output growth is predicted to increase by 0.6% (weak monetary transmission channel)

Model (c): output growth is predicted to increase by 2.0% (strong monetary transmission channel)

The research department further informs that each model prediction is equally likely, and that effects for OCR changes different than -1% are proportional to these predictions, e.g.: a decrease of 2% in the OCR is predicted to increase output growth by 2% according to model (a), 1.2% according to model (b), and 4% according to model (c), and so on.

Using the scenario information above answer the following questions.

Note:for the numerical questions, please provide a numerical answer in percentage points, e.g., 1 for 1%, -2 for -2%, etc.

QUESTION 1

What is the output growth rate needed to lower the unemployment rate to the natural rate of unemployment?

QUESTION 2

1)Calculate how much the Federal Reserve Bank shouldchange the OCRin order to lower unemployment to its natural rate under the predictions ofModel (a).

2)Calculate how much the Federal Reserve Bank should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (b).

3)Calculate how much the Federal Reserve Bank should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (c).

4)Calculate how much the Federal Reserve Bank should change the OCR in order to lower unemployment to its natural rate under the predictions of Models' average.

QUESTION 3

1)Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes. (note the above statement is equal across the next 5 questions)

Calculate the potential effects of this policy on output growth according to the prediction of Model (a).

2)Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on output growth according to the prediction of Model (b).

3)Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on output growth according to the prediction of Model (c).

4)Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on unemployment according to the prediction of Model (a).

Please answer with the resulting unemployment rate, not the change.

5)Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on unemployment according to the prediction of Model (b).

Please answer with the resulting unemployment rate, not the change.

6)Say the monetary policy committee decides to set the OCR on the basis of the average of model predictions of output growth response to interest rates changes.

Calculate the potential effects of this policy on unemployment according to the prediction of Model (c).

Please answer with the resulting unemployment rate, not the change.

QUESTION 4

1)What is the risk of creating inflationary pressures in the economy by following the average of model predictions?

2)What should the Federal Reserve Bank do to avoid any risk of increasing inflation? Should the OCR be decreased by more or less than the change implied by the average of model predictions?

QUESTION 5

Discuss the implications of a higher degree of uncertainty about the effects of monetary policy on output. What would happen if the range of model predictions increased?