Chapter 16: Conduct of Monetary Policy

Question 1

price stability

Answer 1

low and stable inflation

Question 2

hyperinflation

Answer 2

unstable prices that are damaging to the economy

Question 3

nominal anchor

Answer 3

a nominal variable that ties down the price level to achieve price stability
ex. inflation rate or money supply

Question 4

time inconsistency problem

Answer 4

monetary policy conducted on a discretionary day-to-day basis that leads to poor long term outcomes

Question 5

five goals of central banks apart from price stability

Answer 5

1. high employment and output stability
2. economic growth
3. stability of financial markets
4. interest rate stability
5. stability in foreign exchange markets

Question 6

why is high employment important

Answer 6

1. unemployment causes human misery
2. unemployment causes idle workers and idle resources

Question 7

frictional unemployment

Answer 7

searches by workers and firms to find suitable matchups

Question 8

structural unemployment

Answer 8

a mismatch between job requirements and the skills of availability of local workers

Question 9

natural rate of unemployment

Answer 9

a level above zero that is consistent with full employment where demand for labor equals supply of labor

Question 10

natural rate of output/potential output

Answer 10

a particular level of output produced at the natural rate of unemployment

Question 11

supply side economics

Answer 11

spur economic growth by providing tax incentives for business to invest in facilities and equipment and for taxpayers to save more

Question 12

why is interest rate stability important

Answer 12

fluctuations in interest rate can create uncertainty

Question 13

why is stability in Foreign Exchange Markets important?

Answer 13

makes it easier for firms and individuals to purchase or sell goods abroad to plan ahead

Question 14

hierarchical mandates

Answer 14

putting the goal of price stability first and then pursue other goals after price stability is achieved
- price stability should only be a long-term goal

Question 15

dual mandate

Answer 15

achieve price stability and maximum employment together
- might lead to overly expansionary policies

Question 16

inflation targeting

Answer 16

recognition that price stability should be a primary long-term goal and a nominal anchor can help goal

Question 17

elements of inflation targeting

Answer 17

1. public announcement of medium-term numerical objectives for inflation
2. an institutional commitment to price stability as the primary, long run goal and a commitment to achieving the inflation goal
3. an information inclusive approach where many variables are used to make decisions about monetary policy
4. increased transparency of monetary policy objectives
5. increased accountability of the central bank

Question 18

advantages of inflation targeting

Answer 18

• reduction of time-inconsistency problem
• increased transparency
• increased accountability
• consistency with Democratic Principles
• Improved performance

Question 19

disadvantages of inflation targeting

Answer 19

• delayed signaling
• too much rigidity
• potential for increased output fluctuations
• low economic growth

Question 20

four basic lessons for economists and policymakers on how the economy works

Answer 20

1. developments in the financial sector have a greater impact on economic activity
2. zero lower bound on interest rates can be a problem
3. the cost of cleaning up after financial crises is high
4. price and output stability do not ensure financn

Question 21

asset-price bubbles

Answer 21

pronounced increases in asset prices

Question 22

Types of asset-price bubbles

Answer 22

1. one type driven by credit
2. second type drive by overly optimistic expectations

Question 23

credit-driven bubbles

Answer 23

credit boom causes bubble
- more lending, increases price
- people can’t pay, creates less lending, decreases prices

Question 24

overly optimistic expectations (irrational exuberance) bubbles

Answer 24

less dangerous than credit-driven bubbles

Question 25

Pro central banks popping bubbles

Answer 25

specially for credit-driven bubbles
- costly and difficult to clean up

Question 26

Con central banks popping bubbles

Answer 26

• bubbles are hard to identify
• interest rates may be ineffective in restraining bubbles
• a bubble may be present in only a fraction of asset markets
• can have harmful effects on aggregate economy
• harmful effects of bubbles can be kept at a manageable level

Question 27

macroprudential regulation

Answer 27

supervision and regulations on credit risks

Question 28

what can be used to restrain bubbles?

Answer 28

• macroprudential regulation
• monetary policies

Question 29

policy instrument/operating instrument

Answer 29

a variable that responds to the central bank’s tools and indicates the stance of monetary policy

Question 30

types of policy instruments

Answer 30

reserve aggregates (total reserves, nonborrowed reserves, MB, MB_n) and interest rates (fed funds rate, etc.)

Question 31

intermediate target

Answer 31

stand between the policy instrument and the goals of monetary policy and are not as directly affected by tools of monetary policy
ex. money aggregates (M1, M2) and interest rates

Question 32

criteria for choosing the policy instrument

Answer 32

1. observability and measurability
2. controllability
3. predictable effect on goals

Question 33

Taylor rule

Answer 33

fed funds rate = inflation rate + equilibrium real feds fund rate + 1/2 (inflation rate - inflation target) + 1/2 ((Y_t - Y_pot)/(Y_pot))

Question 34

Taylor principle

Answer 34

The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate

Question 35

Phillips curve theory

Answer 35

changes in inflation are influenced by the state of the economy relative to its productive capacity, as well as by other factors

Question 36

nonaccelerating inflation rate of unemployment (NAIRU)

Answer 36

the rate of unemployment at which there is no tendency for inflation to change

Question 37

Is the Fed holding the policy rate below r* by to large of a margin?

Answer 37

No, if investors thought low policy rate was unsustainable the expected future interest rates will rise

Question 38

Why has r* lowered?

Answer 38

• aging demographics, safer assets
• slower rate of technical progress, lower long term growth, weaker investment demand
• global saving glut from emerging markets

Question 39

Monetary policy tools to prevent deflation

Answer 39

1. quantitative easing
2. purchase of private sector debt
3. forward guidance
4. Riase LR inflation target to encourage borrowing and discourage cash hoarding
5. reduce interest rate paid on ER
6. move from inflation targeting to price level targeting

Question 40

If UR < NAIRU

Answer 40

GDP growth > potential GDP
- inflation rises

Question 41

If UR > NARIU

Answer 41

GDP growth < potential GDP
- inflation falls

Question 42

if policy rate > r*

Answer 42

then recession

Question 43

if policy rate < r*

Answer 43

borrowing increases, credit increases, money increases, inflation increases, and policy rate increases

Question 44

Why is it bad to have a high inflation target?

Answer 44

• when nominal interest rates = 0, real interest rates will be negative
• when inflation is too high, it’s harder to stabilize

Question 45

disadvantage of macroprudential polices

Answer 45

subjected to more political pressure than monetary policies

Question 46

Monetary policy options to prevent deflation and increase expectations

Answer 46

1. QE
2. buy private sector debt
3. Forward guidance
4. Raise long run inflation target
5. reduce interest rate on reserves
6. move from inflation targeting to price level targeting