CH16: Tools of Monetary Policy

Question 1

The most common definition that monetary policymakers use for price stability is
A) low and stable deflation.
B) an inflation rate of zero percent.
C) high and stable inflation.
D) low and stable inflation.

Answer 1

D) low and stable inflation.

Question 2

Inflation results in
A) ease of planning for the future.
B) ease of comparing prices over time.
C) lower nominal interest rates.
D) difficulty interpreting relative price movements

Answer 2

D) difficulty interpreting relative price movements.

Question 3

Economists believe that countries recently suffering hyperinflation have experienced
A) reduced growth.
B) increased growth.
C) reduced prices.
D) lower interest rates.

Answer 3

A) reduced growth

Question 4

A nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability is called ________ anchor.
A) a nominal
B) a real
C) an operating
D) an intermediate

Answer 4

A) a nominal

Question 5

A central feature of monetary policy strategies in all countries is the use of a nominal variable that monetary policymakers use as an intermediate target to achieve an ultimate goal such as price stability. Such a variable is called a nominal
A) anchor.
B) benchmark.
C) tether.
D) guideline.

Answer 5

A) anchor.

Question 6

Monetary policy is considered time-inconsistent because
A) of the lag times associated with the implementation of monetary policy and its effect on the economy.
B) policymakers are tempted to pursue discretionary policy that is more contractionary in the short run.
C) policymakers are tempted to pursue discretionary policy that is more expansionary in the short run.
D) of the lag times associated with the recognition of a potential economic problem and the implementation of monetary policy.

Answer 6

C) policymakers are tempted to pursue discretionary policy that is more expansionary in the short run.

Question 7

The time-inconsistency problem with monetary policy tells us that, if policymakers use discretionary policy, there is a higher probability that the ________ will be higher, compared to policy makers following a behavior rule.
A) inflation rate
B) unemployment rate
C) interest rate
D) foreign exchange rate

Answer 7

A) inflation rate

Question 8

The theory that monetary policy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes is referred to as the
A) adverse selection problem.
B) moral hazard problem.
C) time-inconsistency problem.
D) nominal-anchor problem.

Answer 8

C) time-inconsistency problem.

Question 9

If the central bank pursues a monetary policy that is more expansionary than what firms and people expect, then the central bank must be trying to
A) boost output in the short run.
B) constrain output in the short run.
C) constrain prices.
D) boost prices in the short run.

Answer 9

A) boost output in the short run.

Question 10

Explain the time-inconsistency problem. What is the likely outcome of discretionary policy? What are the solutions to the time-inconsistency problem?

Answer 10

With policy discretion, policymakers have an incentive to attempt to increase output by pursuing expansionary policies once expectations are set. The problem is that this policy results not in higher output, but in higher actual and expected inflation. The solution is to adopt a rule to constrain discretion. Nominal anchors can provide the necessary constraint on discretionary behavior.

Question 11

High unemployment is undesirable because it
A) results in a loss of output.
B) always increases inflation.
C) always increases interest rates.
D) reduces idle resources.

Answer 11

A) results in a loss of output.

Question 12

When workers voluntarily leave work while they look for better jobs, the resulting unemployment is called
A) structural unemployment.
B) frictional unemployment.
C) cyclical unemployment.
D) underemployment.

Answer 12

B) frictional unemployment.

Question 13

Unemployment resulting from a mismatch of workers’ skills and job requirements is called
A) frictional unemployment.
B) structural unemployment.
C) seasonal unemployment.
D) cyclical unemployment.

Answer 13

B) structural unemployment.

Question 14

The goal for high employment should be a level of unemployment at which the demand for labor equals the supply of labor. Economists call this level of unemployment the
A) frictional level of unemployment.
B) structural level of unemployment.
C) natural rate level of unemployment.
D) Keynesian rate level of unemployment.

Answer 14

C) natural rate level of unemployment.

Question 15

Supply-side economic policies seek to
A) raise interest rates through contractionary monetary policy.
B) increase federal government expenditures.
C) increase consumption expenditures by increasing taxes.
D) increase saving and investment using tax incentives.

Answer 15

D) increase saving and investment using tax incentives.

Question 16

Having interest rate stability
A) allows for less uncertainty about future planning.
B) leads to demands to curtail the Fed’s power.
C) guarantees full employment.
D) leads to problems in financial markets.

Answer 16

A) allows for less uncertainty about future planning.

Question 17

Foreign exchange rate stability is important because a decline in the value of the domestic currency will ________ the inflation rate, and an increase in the value of the domestic currency makes domestic industries ________ competitive with competing foreign industries.
A) increase; more
B) increase; less
C) decrease; more
D) decrease; less

Answer 17

B) increase; less

Question 18

Which set of goals can, at times, conflict in the short run?
A) high employment and economic growth
B) interest rate stability and financial market stability
C) high employment and price level stability
D) exchange rate stability and financial market stability

Answer 18

C) high employment and price level stability
This is because in the short run, policies aimed at reducing unemployment can often lead to increased inflation, and vice versa. This is known as the Phillips curve trade-off.

For example, if a government uses expansionary policies to stimulate the economy and reduce unemployment, it could result in increased demand for goods and services. If the demand grows faster than the economy’s ability to produce these goods and services, it can lead to increased prices, or inflation.

On the other hand, if the government uses contractionary policies to reduce inflation, it could slow down the economy and increase unemployment.

Therefore, the goals of high employment and price level stability can conflict in the short run.

Question 19

The primary goal of the European Central Bank is
A) price stability.
B) exchange rate stability.
C) interest rate stability.
D) high employment.

Answer 19

A) price stability.

Question 20

The mandate for the monetary policy goals that has been given to the European Central Bank is an example of a ________ mandate.
A) primary
B) dual
C) secondary
D) hierarchical

Answer 20

D) hierarchical

Question 21

Either a dual or hierarchial mandate is acceptable as long as ________ is the primary goal in the ________.
A) price stability; short run
B) price stability; long run
C) reducing business-cycle fluctuations; short run
D) reducing business-cycle fluctuations; long run

Answer 21

B) price stability; long run

Question 22

The type of monetary policy that is used in Canada, New Zealand, and the United Kingdom is
A) monetary targeting.
B) inflation targeting.
C) targeting with an implicit nominal anchor.
D) interest-rate targeting.

Answer 22

B) inflation targeting.

Question 23

Which of the following is NOT an element of inflation targeting?
A) a public announcement of medium-term numerical targets for inflation
B) an institutional commitment to price stability as the primary long-run goal
C) an information-inclusive approach in which only monetary aggregates are used in making decisions about monetary policy
D) increased accountability of the central bank for attaining its inflation objectives

Answer 23

C) an information-inclusive approach in which only monetary aggregates are used in making decisions about monetary policy

Question 24

The first country to adopt inflation targeting was
A) the United Kingdom.
B) Canada.
C) New Zealand.
D) Australia.

Answer 24

C) New Zealand.

Question 25

In both New Zealand and Canada, what has happened to the unemployment rate since the countries adopted inflation targeting?
A) The unemployment rate increased sharply.
B) The unemployment rate remained constant.
C) The unemployment rate has declined substantially after a sharp increase.
D) The unemployment rate declined sharply immediately after the inflation targets were adopted.

Answer 25

C) The unemployment rate has declined substantially after a sharp increase.

Question 26

Which of the following is NOT an advantage of inflation targeting?
A) reduction of the time-inconsistency problem
B) increased monetary policy transparency
C) There is an immediate signal on the achievement of the target.
D) consistency with democratic principles

Answer 26

C) There is an immediate signal on the achievement of the target.

Question 27

Which of the following is NOT a disadvantage to inflation targeting?
A) There is a delayed signal about achievement of the target.
B) Inflation targets could impose a rigid rule on policymakers.
C) There is potential for larger output fluctuations.
D) There is a lack of transparency.

Answer 27

D) There is a lack of transparency.

Question 28

The decision by inflation targeters to choose inflation targets ________ zero reflects the concern of monetary policymakers that particularly ________ inflation can have substantial negative effects on real economic activity.
A) below; high
B) below; low
C) above; high
D) above; low

Answer 28

D) above; low

Question 29

Inflation targets can increase the central bank’s flexibility in responding to declines in aggregate spending. Declines in aggregate ________ that cause the inflation rate to fall below the floor of the target range will automatically stimulate the central bank to ________ monetary policy without fearing that this action will trigger a rise in inflation expectations.
A) demand: tighten
B) demand; loosen
C) supply; tighten
D) supply; loosen

Answer 29

B) demand; loosen

Question 30

Explain what inflation targeting is. What are the advantages and disadvantages of this type of monetary policy strategy?

Answer 30

There are five main elements to inflation targeting:
1. a public announcement of a medium-term target for the inflation rate;
2. a commitment to price stability as the primary long-term goal of policy;
3. many variables are used in making decisions about policy moves;
4. increased transparency about policy strategy with the public;
5. the central bank has increased accountability for attaining policy goals.
The advantages of inflation targeting include:
1. the simplicity and clarity of a numerical target for the inflation rate;
2. there is increased accountability of the central bank;
3. reduces the effects of inflationary shocks.
The disadvantages of inflation targeting include:
1. there is a delayed signal about the achievement of the target;
2. it could lead to a rigid rule where the only focus is the inflation rate (has not happened in practice);
3. if sole focus is the inflation rate, larger output fluctuations can occur (has not happened in practice).

Question 31

When asset prices increase above their fundamental values it is called an
A) asset-price bubble.
B) irrational bubble.
C) asset-price spike.
D) irrational spike.

Answer 31

A) asset-price bubble.

Question 32

Suppose interest rates are kept very low for a long time such that there is a spike in the amount of lending. Everything else held constant, this could cause ________ bubble.
A) an irrational exuberance
B) a credit-driven
C) a stock
D) a debt-driven

Answer 32

B) a credit-driven

Question 33

A credit-driven bubble arises when ________ in lending causes ________ in asset prices which can cause ________ in lending.
A) a decrease; a decrease; an increase
B) a decrease; an increase; an increase
C) an increase; an increase; a further increase
D) a decrease; a decrease; a further decrease

Answer 33

C) an increase; an increase; a further increase

Question 34

________ bubble is driven entirely by unrealistic optimistic expectations.
A) An irrational exuberance
B) A credit-driven
C) A stock
D) A debt-driven

Answer 34

A) An irrational exuberance

Question 35

Everything else held constant, a credit-drive bubble is generally considered to have the potential to cause ________ damage to an economy compared to an irrational exuberance bubble.
A) less
B) about the same amount of
C) more
D) either more, less, or the same amount of

Answer 35

C) more
A credit-drive bubble is generally considered to have the potential to cause more damage to an economy compared to an irrational exuberance bubble, because it involves a positive feedback loop that amplifies the effects of a credit contraction. When asset prices fall and defaults rise, lenders become more cautious and tighten their credit conditions, reducing the demand for loans and further depressing asset prices. This creates a vicious cycle that can lead to a deep recession and a prolonged deleveraging process.

An irrational exuberance bubble, on the other hand, is driven by excessive optimism and speculation, without any underlying economic fundamentals or productive investment. When asset prices fall sharply, investors panic and sell their assets, causing a sharp decline in wealth and confidence. This reduces consumer spending and business investment, leading to lower economic growth and higher unemployment. However, unlike a credit-drive bubble, an irrational exuberance bubble does not involve a self-reinforcing mechanism that amplifies the effects of a credit contraction. Therefore, it is less likely to cause severe and prolonged economic distress.

Question 36

A central bank has ________ chance to identify a credit-driven bubble compared to an irrational exuberance bubble.
A) a greater
B) less of a
C) about the same level of a
D) a greater, less or about the same level of a

Answer 36

A) a greater

Question 37

Which of the following is NOT an operating instrument?
A) nonborrowed reserves
B) monetary base
C) federal funds interest rate
D) discount rate

Answer 37

D) discount rate

Question 38

Which of the following is a potential operating instrument for the central bank?
A) the monetary base
B) the M1 money supply
C) nominal GDP
D) the discount rate

Answer 38

A) the monetary base

Question 39

If the central bank targets a monetary aggregate, it is likely to lose control over the interest rate because
A) of fluctuations in the demand for reserves.
B) of fluctuations in the consumption function.
C) bond values will tend to remain stable.
D) of fluctuations in the business cycle.

Answer 39

A) of fluctuations in the demand for reserves.

Question 40

Real interest rates are difficult to measure because
A) data on them are not available in a timely manner.
B) real interest rates depend on the hard-to-determine expected inflation rate.
C) they fluctuate too often to be accurate.
D) they cannot be controlled by the Fed.

Answer 40

B) real interest rates depend on the hard-to-determine expected inflation rate.

Question 41

Which of the following is NOT a requirement in selecting a policy instrument?
A) measurability
B) controllability
C) flexibility
D) predictability

Answer 41

C) flexibility

Question 42

Explain and demonstrate graphically how targeting nonborrowed reserves can result in federal funds rate instability.

Answer 42

When nonborrowed reserves are held constant, increases in the demand for reserves result in the federal funds rate increasing and decreases in the demand for nonborrowed reserves result in the federal funds rate declining. Since fluctuations in demand do not cause monetary policy actions, the result is the federal funds rate will fluctuate (assuming the equilibrium federal funds rate is below the discount rate).

Question 43

Explain and demonstrate graphically how targeting the federal funds rate can result in fluctuations in nonborrowed reserves.

Answer 43

With a federal funds rate target, fluctuations in demand for reserves require similar changes in the nonborrowed reserves to keep the federal funds rate constant.

Question 44

Explain the Taylor rule, including the formula for setting the federal funds rate target, and the components of the formula. If the Fed were to use this rule, how many goals would it use to set monetary policy?

Answer 44

The Taylor rule specifies that the target federal fund rates should be set to equal the equilibrium real federal funds rate, plus the rate of inflation (for the Fisher effect), plus one-half times the output gap, plus one-half times the inflation gap. The formula is
Federal funds rate target =
equilibrium real federal funds rate + inflation rate + 1/2 (output gap) + 1/2(inflation gap)
The output gap is the percentage deviation of real GDP from potential full-employment real GDP. The inflation gap is the difference between actual inflation and the central bank’s target rate of inflation. The equilibrium real federal funds rate is the real rate consistent with full employment in the long run. The inflation rate is the actual rate of inflation. The Taylor rule sets the federal funds rate recognizing the goals of low inflation and full employment (or equilibrium long-run economic growth).

Question 45

The European Central Bank (ECB) pursues a hybrid monetary policy strategy that has elements in common with the ________-targeting strategy previously used by the Bundesbank but also includes some elements of ________ targeting.
A) monetary; inflation
B) inflation; monetary
C) monetary; exchange rate
D) monetary; nominal GDP

Answer 45

A) monetary; inflation

Question 46

Which of the following is an advantage to money targeting?
A) There is an immediate signal on the achievement of the target.
B) It does not rely on a stable money-inflation relationship.
C) It implies lack of transparency.
D) It implies smaller output fluctuations.

Answer 46

A) There is an immediate signal on the achievement of the target.

Question 47

Which of the following is a disadvantage to monetary targeting?
A) It relies on a stable money-inflation relationship.
B) There is a delayed signal about the achievement of a target.
C) It implies larger output fluctuations.
D) It implies a lack of transparency.

Answer 47

A) It relies on a stable money-inflation relationship.

Question 48

If the relationship between the monetary aggregate and the goal variable is weak, then
A) monetary aggregate targeting is superior to exchange-rate targeting.
B) monetary aggregate targeting is superior to inflation targeting.
C) inflation targeting is superior to exchange-rate targeting.
D) monetary aggregate targeting will not work.

Answer 48

D) monetary aggregate targeting will not work.

Question 49

The monetary policy strategy that relies on a stable money-income relationship is
A) exchange-rate targeting.
B) monetary targeting.
C) inflation targeting.
D) the implicit nominal anchor

Answer 49

B) monetary targeting.