Uncertainty and Policy

Scenario

Suppose the New Zealand economy is in recession. The unemployment rate is 7% and the Reserve Bank of New Zealand (RBNZ) is considering using monetary policy to expand output. Assume the RBNZ 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 RBNZ 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 RBNZ 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 NZ output growth to a decrease of 1% in the OCR. The research department, using three different macroeconometric models, presents the following results:

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% (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.

Flag question: Question 1

Question 1

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

Flag question: Question 2

Question

2a. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (a).

Flag question: Question 3

Question 3

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

Flag question: Question 4

Question 4

2c. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Model (c).

Flag question: Question 5

Question 5

2d. Calculate how much the RBNZ should change the OCR in order to lower unemployment to its natural rate under the predictions of Models' average.

Flag question: Question 6

Question 6

3a. 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 5questions)

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

Flag question: Question 7

Question 7

3b. 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 ofModel (b).

Flag question: Question 8

Question 8

3c. 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 ofModel (c).

Flag question: Question 9

Question 9

3d. 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 unemploymentaccording to the prediction ofModel (a).

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

Flag question: Question 10

Question 10

3e. 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 unemploymentaccording to the prediction ofModel (b).

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

Flag question: Question 11

Question 11

3f. 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 unemploymentaccording to the prediction ofModel (c).

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

Flag question: Question 12

Question 12

4. Discuss the risk of creating inflationary pressures in the economy by following the average of model predictions. How can a central bank reduce the risk of increasing inflation under uncertainty?.