Scenario Suppose the New Zealand economy is booming. The unemployment
rate is 3.5% and the Reserve Bank of New Zealand (RBNZ) is considering using
monetary policy to reduce inflationary pressures. Assume the RBNZ knows, with
certainty, that:
(i) absent changes in monetary policy, unemployment will still be 3.5% 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 0.5% reduction
in the unemployment rate.
Also assume the RBNZ can effectively use monetary policy to increase/decrease
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 increase of
1% in the OCR. The research department, using three different macroeconometric
models, presents the following results:
Model (a): output growth is predicted to decrease by 1.0%
(moderate monetary transmission channel);
Model (b): output growth is predicted to decrease by 0.5%
(weak monetary transmission channel);
Model (c): output growth is predicted to decrease by 3%
(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.: an increase of 2% in the OCR is predicted to decrease
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Case Study 2 ECON702 Applied Macroeconomics
output growth by 2% according to model (a), 1% according to model (b), and 6%
according to model (c), and so on.
[Note: Use at least 2 significant digits and include the sign in your calculations
and answers below.]
1. What is the output growth rate needed to increase the unemployment rate to
the natural rate of unemployment? [4 points]
2. Calculate how much the RBNZ should change the OCR in order to increase
unemployment to its natural rate under the predictions of: [3 points each
statistic = 12 points]
Model (a):
Model (b):
Model (c):
Models’ average:
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.
(a) Calculate the potential effects on output growth and unemployment rates
according to each model’s prediction. [3 points each statistic = 18 points]
Output growth Unemployment
Model (a):
Model (b):
Model (c):
(b) What is the risk of pushing the economy into a recession (specifically
that the unemployment rate goes above the natural rate) by following the
average of model predictions? [6 points]