Chapter 16: The Conduct of Monetary Policy - Strategy and Tactics

Question 1

The Price Stability Goal and Nominal anchor - Objective 1 of monetary policy

Answer 1

A nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability

Question 2

Other Goals - Objective 2 of monetary policy

Answer 2

Five goals of central bank officials for monetary policy:

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 3

Should price stability be primary goal - Objective 3 of monetary policy

Answer 3

1) Hierarchical Versus Dual Mandates:
- Hierarchical mandates = put price stability goal first and then other goals
- Dual mandates = aimed two achieve the coequal objectives of price stability and maximum employment (output stability)
2) Price stability as the primary, long-run goal:
- Either type of mandate is acceptable if it operates to make price stability the primary goal in the LR, not SR

Question 4

Inflation targeting

Answer 4

1) Public announcement of medium-term numerical target for inflation
2) Institutional commitment to price stability as primary goal in LR and commitment to the inflation goal
3) Info-inclusive approach using many variables to make decisions
4) Increased transparency of the strategy
5) Increased accountability of the central bank

Question 5

Inflation targeting - New Zealand (1990)

Answer 5

• Inflation brought down and remained in target range most of the time
• High growth and significantly decreased unemployment

Question 6

Inflation targeting - Canada (1991)

Answer 6

• Inflation decreased

- Some costs in terms of unemployment

Question 7

Inflation targeting - United Kingdom (1992)

Answer 7

• Inflation close to target

- Strong growth and decreasing unemployment

Question 8

Inflation targeting - Objective 4 of monetary policy

Answer 8

Advantages:
-Does not rely on one variable to achieve target
-Easily understood
-Helps avoid time-inconsistency trap
-Stresses transparency and accountability
Disadvantages:
-Delayed signaling
-Too much rigidity
-Potential for increased output fluctuations
-Low economic growth during disinflation

Question 9

Evolution of the Fed’s strategy - Objective 5 of monetary policy

Answer 9

1) No explicit nominal anchor
2) Periodic preemptive strikes
3) Goal is to prevent inflation from getting started
Advantages:
-Uses many sources of info, demonstrated success
Disadvantages:
-Lack of accountability, inconsistent w/ democratic principles

Question 10

Fed’s “Just Do It” Strategy

Answer 10

Advantages:
-Forward looking behavior and stress on price stability helps discourages overly expansionary monetary policy => ameliorates the time-consistency problem
Disadvantages:
-Lack of transparency, strong dependence on preferences, skills, and trustworthiness of those in charge of central bank

Question 11

Lessons from Global Financial Crisis - Objective 6 of monetary policy

Answer 11

1) Developments in the financial sector have a greater impact on economic activity than earlier realized
2) Zero-lower-bond on interest rates can be a problem
3) Cost of cleaning up after a financial crisis are high
4) Price and output stability do not ensure financial stability

Question 12

Asset-price bubble

Answer 12

pronounced increase in asset prices that depart from fundamental values, which eventually burst; types include:
-Credit-driven bubbles
+Subprime financial crisis
-Bubbles driven solely by irrational exuberance

Question 13

Should central banks respond to bubbles - Objective 8 of monetary policy

Answer 13

• Strong argument for not responding to irrational bubbles
• Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same time
• Monetary policy should not be used to prick bubbles

Question 14

Macroprudential policy

Answer 14

regulatory policy to affect what is happening in credit markets in the aggregate

Question 15

Monetary policy

Answer 15

Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction

Question 16

Tactics - Objective 9 of monetary policy

Answer 16

Tools:
-Open market operation
-Reserve requirements
-Discount rate
Policy instruments (operating):
-Reserve aggregates
-Interest rates
-May be linked to an intermediate target
**Interest rates and aggregate targets are incompatible (one or the other)

Question 17

Result of Targeting on Nonborrowed Reserves

Answer 17

SEE FIGURE 3

Question 18

Result of Targeting on the Federal Funds Rate

Answer 18

SEE FIGURE 4

Question 19

Criteria for choosing the policy instrument

Answer 19

• Observability and Measurability
• Controllability
• Predictable effect on Goals

Question 20

The Taylor Rule - Objective 10 of monetary policy

Answer 20

Federal funds rate target = inflation rate + equilibrium real fed funds rate + 1/2 (inflation rate) + 1/2 (output gap)

Question 21

Output gap

Answer 21

An indicator of future inflation as shown by Phillips curve

Question 22

NAIRU

Answer 22

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