2. Topics in Monetary Policy: Extra Questions

Question 1

Outline 6 challenges that are faced by monetary policy makers

Answer 1

Trade-off between output and inflation

Problems with the Talor rule:

• Omitted variables
• Measuring inflation and the output gap
• yn and rn are not directly observable
• Linearity (no consideration for zero lower bound)
• Lack of consideration for shocks (not forward-looking)

Question 2

What does Taylor estimate γπ and γY to be?

Answer 2

γπ=1.5

γY=0.5

Question 3

Why must nominal interest rates be increased by more than 1:1 in the event of an inflation increase?

Answer 3

Note: Fisher eqn i=r+π

If π goes up then i should be raised firstly to ensure that r doesn’t fall (this would cause output to rise off target), and further to make the real interest rate rise so that inflation goes back towards target

Question 4

What is the Taylor principle?

Answer 4

Says that the nominal interest rates be increased by more than 1:1 in the event of an inflation increase

Question 5

What does the Taylor principle say regarding γπ?

Answer 5

It must be more than 1 in order to stabilise the economy

Question 6

What do MP rules say in terms of how the CB should react to deviations in variables from their targets?

Answer 6

It says that CBs should act in such a way that the variable levels are pushed back towards their target values

Question 7

What values for γπ and γY do Clarida, Gali & Gertler (2000) find for Pre-Volcker and Volcker-Greenspan periods?

What are the implocations of the value of γπ in the Pre-Volcker period

Answer 7

Pre-Volcker: γπ=0.83 γY=0.27

Volcker-Greenspan: γπ=2.15 γY=0.93

γπ this is theoretically a destabilising policy => Pre-volcker MP might have contributed to destabilisation of the US economy at that time

Question 8

What is the key issue with the zero lower bound?

Answer 8

At the zero-lower bound, MP becomes ineffective

Question 9

What 4 things can be done when the zero lower bound is hit?

2 main ones, 1 alternative one

Answer 9

Main alternatives:

• Quantitative Easing
• Forward Guidance

Alternatives:
- Non-Conventional Fiscal Policy (not strictly MP)

Question 10

Give a definition for the natural real interest rate

Answer 10

Interest rate which causes neither overheating not recession in the economy

Question 11

What is the Bank of Englands target interest rate?

Answer 11

2% CPI