Chapter 10 Flashcards
what is considered the main objective of monetary policy and why?
price stability as monetary policy cant permanently change employment or production levels
what is flexible inflation targeting?
when the CB tries to stabilise production and the temporary deviations from inflation target is allowed
what does the central bank do?
- decides about interest rate
- adjust supply of the monetary base by buying and selling government securities to keep interest rates at the decided level
- they accomdate shocks to money demand
how can the central bank accommodate a positive demand shock?
increase interest rates so the real = natural
production and inflation are stabilised
in real terms the outcome is the same as if prices had been flexible
monetary policy can compensate for the lack of price and wage flexibility
what creates a dilemma for the central bank?
cost push shocks eg. unexpected increase in oil price
what must the central bank do to counter the increase in inflation?
must increase IR to generate negative output gap or it can stabilise production and accept the temporary increase in inflation
what does an unexpected and permanent productivity shock effect do?
affects supply and demand depending on the relative shifts the CB may increase or decrease IRs
what happens if expected inflation rises above the target level? what should the CB do in response?
IS curve shifts up as expected real interest rates go down for a given nominal IR
PC shifts up because wage and price increases depend on expected wage and price increases
to reduce inflation the CB must raise the IR more than the increase in expected inflation
how do the CB monetary policy repsonses differ with interpretation?
if high inflation is result of strong demand or high expected inflation the CB will likely raise IR. if due to temporary shock - less reason to
what is the Taylor rule?
the IR set by CB should increase by 1.5% when inflation increase by 1%. if the output gap increases by 1% the rates should increase by 0.5%
what is the shortest market interest rate?
interest rate on overnight loans in the interbank market where banks with excess reserves lend to banks with a shortage of reserves
what do standing facilities do? what do the rates for this set?
allows banks to deposit money or borrow from CB overnight. the rates for such borrowing and lending sets a ceiling and floor for interest rate in the interbank market
how does the central bank keep the interbank rate inside the interest rate corridor?
open market operations eg. repurchase agreements
what are repurchase agreements? what is the annualised cost for these loans?
CB buys government securities with a contract to resell them in a short time - typically one week
why is the overnight interest rate normally very close to the repo rate?
repurchase agreements are close substitutes for loans in the interbank market
how can the CB control the interest rates?
CB can control the interest rate on short term government securities eg. 3 month treasury bills. CB has much less control over long term interest rates
