Final: Monetary Policy part 2

Question 1

Suppose money demand increases under nominal interest rate targeting

Answer 1

Excess demand for money at the existing level of nominal income
People try to build up their money balances by saving less

S(LF) curve shifts leftward

In the SR, interest rates increase, even though the underlying real interest rate hasn’t changed.

In the LR the nominal income effect will restore nominal interest rates to the initial position
However, this requires allowing a fall in nominal income and deflation, which may cause a recession

Question 2

The Taylor Rule

Answer 2

I = gP + 2% + 0.5(lny – lny(n)) + 0.5(gP – gP)
Where:
2% is the assumed real interest rate
y(n) is the assumed natural rate of real output growth
gP is the targeted inflation rate

If inflation (gP) rises by 1%, targeted nominal interest rate (i) increases by 1.5%

Question 3

Problems with iNterest Rate Targeting

Answer 3

It is possible to target the wrong nominal interest rate given
Changing inflation
And changes in the real interest rate

Question 4

Friedan’s optimum quantity of money

Answer 4

With positive nominal interest rates, money-holders opt to hold too little money.
More money reduces transaction costs

Given ZLB, 0 is as low as nominal interest rates can go
At zero, this maximizes the benefit to money-holders, as it reduces the opportunity costs of holding money.

Question 5

Friedman’s OQM: Lower i to 0. Money demand is a function of

Answer 5

Real income
Nominal interest rates (Opp cost.)
MP can’t increase y, but it can lower i.

Question 6

Friedman’s OQM: Lower i to 0. Why?

Answer 6

Externality argument: Higher money balances are a positive externality

Competitive pricing argument: Central banks should pay a competitive rather monopolistic rate of return on money. Aperfectly competitive fiat money would offer this rate of return
Practically, this means that currency should earn the same rate of return as the shortest duration risk free asset (T-Bills)
This can be achieved by bringing i to zero
Or, if i>0, paying the same return on currency as the shortest duration t-bills
This option was infeasible at the time of Friedman’s writing, and still is unless an interest bearing CBDC/private digital currencies can do this.

Question 7

Demand Driven Deflation

Answer 7

bad kind

Excess demand for money manifests

Nominal income falls (aggregate demand): Firms contract output, unemploy inputs, Monetarist Business Cycle, It takes time for the economy to adjust back to EQ, in the meantime, recession.

Question 8

Supply driven deflation

Answer 8

good kind

Positive supply shocks: Productivity increases, Selgin’s Productivity Norm

Question 9

Under deflation and inflation who gets defrauded?

Answer 9

Inflation defrauds lenders, enriches borrowers

Deflation defrauds borrowers , enriches lenders

Question 10

Inflation Targeting

Answer 10

1) Public announcement of medium-term numerical objectives (targets) for inflation

2) Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieving the goal

3) An information-inclusive approach where many variables are monitored (Not just monetary aggregates)

4) High transparency with the public
Expectations

5) Accountability for the CB

Question 11

Inflation Targeting Benefits

Answer 11

1) Reduction of time inconsistency (Transparency)

2) Increased transparency

3)Increased accountability
(Easily measured success
Like other rules, consistent with democratic principles)

Question 12

Inflation Targeting Costs

Answer 12

1) Loss of Discretion

2) Output swings
Tight MP when inflation is high and vice versa, may induce “mini recessions”

3) Delayed signals
Long and variable lags

4) No benign price level changes
Price changes due to real changes in output (negative shocks, increases in productivity) are “papered over” reduces the functionality of prices to propagate the market mechanism.
Key benefit of nominal income targeting

Question 13

Hayek’s Stable MV Norm. For a given M, if V increases or decreases…

Answer 13

For a given M, if V increases (fluidity decreases), excess supply of money, inflation
For a given M, if V decreases (fluidity increases), excess demand for money, deflation

Question 14

Dangers of monetary disequilibrium. Costs of Inflation (short-term non-neutrality of M on y,r)

Answer 14

Price system noise, shoe-leather costs, complicates financial planning, etc.
For Austrians, boom leads to bust, via liquidity effects of increased M on the real interest rate

Question 15

Dangers of monetary disequilibrium. Costs of deflation (short-term non-neutrality of M on y,r)

Answer 15

Business cycles and production incentives

Debt-deflation
Recall, deflation enriches creditors at the expense of debtors (i.e. increases the real value of debt)
What happens to the banking system if loans are defaulted upon on mass?

Question 16

Hayek’s stable MV norm solution for changes in V

Answer 16

If V increases (fluidity decreases), use monetary policy to decrease M.

If V decreases (fluidity increases), use monetary policy to increase M.

In other words, keep MV constant.

Question 17

What is the why behind the solutions for changing V under Hayek’s stable MV norm?

Answer 17

If MV is constant, changes in P only result from changes in y, or as a result of supply shocks/changes

Hayek viewed this as useful, as it conveyed information crucial to the operation of the market process
Concept of benign deflation

Question 18

Nominal Income Targeting targets what?

Answer 18

Shares the inclusion of the price level with the inflation target
Allows to fluctuations in real GDP

Question 19

NGPDLT is Rule-Based MP that mitigates what

Answer 19

Mitigates the time inconsistency problem
Mitigates public choice issues surrounding discretion

Question 20

NGPDLT is easier to implement than what and why?

Answer 20

Easier to implement than an inflation target
NGDPLT doesn’t have to worry about correcting for supply shocks
Less cases in which money growth is used to stabilize nominal income, income comparison to inflation targeting
Lower menu costs

Question 21

Costs of NGDP targeting

Answer 21

Accurate estimates of GDP growth

Less transparent/more complicated
Harder to be monitored by the public

Question 22

Explain Nominal Income Targeting Adjusts for Velocity

Answer 22

Changes in the demand for money are automatically offset by changes in the supply under NGPDLT

Looser money when people are inclined to hold more money
V decreases

Tighter money when spending is rapid
V increases

Question 23

NGDPLT and supply shocks

Answer 23

When price level changes reflect underlying changing in the productive capacity of an economy, it is good to let them persist.
Supply shocks

Question 24

What type of shocks should NGDPLT manage?

Answer 24

Demand shocks.
Demand shocks push economic activity and the price level in the same direction
Too much spending = inflation and vice versa. MP corrects both at once.

Question 25

Growth path vs growth rate targeting

Answer 25

NGDP level targets make up for past misses

Growth path anchors expectations
Public expects CB to restore the nominal income to its long-run path if there is a deviation
This stabilizes the path in its own right

Alternative?
The CB can implement a growth rate target which doesn’t make up for past misses.
Requires less drastic swings in MP, and therefore inflation/deflation

Question 26

Advantages of Selgin’s Productivity Norm

Answer 26

Lower costs of price adjustment
“Less likely to invite monetary misperception effects”
Less disturbing to fixed nominal contracts
“generally keeps the money stock closer to its “optimum” level”. `Reduces money disequilibrium.

Question 27

Menu Costs

Answer 27

Menu costs are the costs of nominal price adjustment
The more prices that need to be changed, the higher the costs.

Question 28

What happening for increases and decreases in V and y under zero inflation (Stable P) and productivity (stable py)

Answer 28

V increases -> zero inflation (M decreases) - > productivity (M decreases)

V decreases -> zero inflation (M increases) - > productivity (M increases)

y increases -> zero inflation (M increases) - > productivity (no change. let P fall)

y increases -> zero inflation (M decreases) - > productivity (no change. let P rise)

Question 29

The Taylor rule is an example of

Answer 29

inflation rate targeting