Conventional and unconventional Monetary Policy

Question 1

When is a policy is said to be time-inconsistent (2)

Answer 1

-The policymaker gains at the current time when the future policy action
is announced and believed by people
- But policymaker does not gain by implementing the policy when the time comes to do so in the future, even if nothing fundamental has changed

Question 2

What is a time-consistent policy

Answer 2

A time-consistent policy is one where there is no incentive ex post
to follow a different policy from the one announced earlier

Question 3

Why are some policies time inconsistent?

Answer 3

• Since expectations matter, the policymaker can achieve more at the current time if announcements of future policies are believed
• But that benefit lies in the past when the time comes to implement the announcement, so policymaker now sees a different policy as optimal

Question 4

what does it mean when MPN > MRSl,c

Answer 4

If the MPN is greater than the MRS_l, C, it means the worker could produce more by working an additional unit but chooses not to. This indicates an inefficient allocation of labor.

Question 5

what is inflation bias

Answer 5

In simple terms, the upward shift of the Phillips curve makes it much harder for the central bank to boost real GDP without also generating substantially higher inflation. This inflation bias arises because the public anticipates the central bank’s attempts to push output above the natural level, leading to rising inflation expectations that undermine real economic gains.

Question 6

What is the duration risk

Answer 6

Uncertainty about changes in future interest rates/yields 𝑖
′(duration risk)

Question 7

What will happen to the budget constraint with a higher risk premium

Answer 7

Steeper

Question 8

What will happen to the budget constraint with a lower risk premium

Answer 8

Flatter

Question 9

What is the portfolio balance effect

Answer 9

1. When the central bank purchases risky assets like long-term bonds from the market, it reduces the overall supply of those risky assets available to private investors.
2. To pay for these purchases, the central bank provides reserves (risk-free assets) to the sellers.
3. So the relative supply of risky assets falls, while the supply of risk-free reserves increases.
4. This represents a movement along the demand curve for private investors - they now face a lower supply of risky assets relative to risk-free assets.
5. With lower relative supply, the prices of the remaining risky assets are bid up higher by investors.
6. Higher risky asset prices translate to lower risk premiums or expected returns on those assets over the risk-free rate.
7. These declining risk premiums reduce the overall long-term borrowing costs in the economy.
8. This is known as the “portfolio balance effect” of quantitative easing (QE).

Question 10

Why does the money curve slope down

Answer 10

Money demand curve slopes down due to diminishing marginal benefit of real balances

Question 11

Factors that shift up the money curve (2)

Answer 11

It shifts up if money itself pays interest
It shifts up with higher real GDP increasing transaction needs

Question 12

What happens to money demand with higher interest rates

Answer 12

The interest rate (i) represents the opportunity cost of holding money instead of bonds
Higher i means higher cost of holding money
So higher i leads to lower demand for real balances M/P

Question 13

what is the best amount of money to hold

Answer 13

The best amount of money to have is when the extra benefit you get from having more money equals the cost of not earning interest on it (b×M/P)=(i−im) MP=MC

Question 14

Link of short-term interest rate and long-term

Answer 14

If investors only care about expected returns and are risk-neutral, then in equilibrium, all bonds must offer the same expected return. This means that long-term interest rates must be related to expected future short-term interest rates. This relationship between short-term and long-term rates is the basis of the expectations theory of the term structure of interest rates. If investors expect short-term interest rates to rise in the future, they’ll demand higher yields for longer-term bonds to compensate for the risk of locking in their money at lower rates. This pushes long-term bond yields higher relative to short-term yields.

Question 15

expectations theory of interest rates

Answer 15

Expectations theory of long-term interest rates

• Let’s think about investors that are risk neutral - only care about returns, don’t worry about risk
• Choose the bond with the highest expected return
• All bonds end up with expected returns as what would happen with the low return

1. However, in equilibrium, all bonds issued must be held by someone.
2. Therefore, bond prices (or equivalently, bond yields) must adjust so that all bonds have the same expected return.
3. This implies a connection between short-term and long-term interest rates, known as the “expectations theory of interest rates.”

In simple terms, if investors only care about expected returns and are risk neutral, then in equilibrium, all bonds must offer the same expected return. This means that long-term interest rates must be related to expected future short-term interest rates. This relationship between short-term and long-term rates is the basis of the expectations theory of the term structure of interest rates.

Question 16

What will happen to yields if investors expected higher short-term interest rates

Answer 16

If investors expect short-term interest rates to rise in the future, they’ll demand higher yields for longer-term bonds to compensate for the risk of locking in their money at lower rates. This pushes long-term bond yields higher relative to short-term yields.