Lent - Lecture 3 - Adding Monetary Policy

Question 1

What are the two monetary policy instruments that central banks set? Which of these is more realistic?

Answer 1

• CB sets money supply M
• CB sets nominal interest rate, i

Question 2

What is the difference between the Keynesian assumption and the Classical assumption regarding the Fisher effect?

Answer 2

• the crucial Keynesian assumption is that changes to i influence r
• the classical model assumes changes in i have no effect on r

Question 3

At a given point in time, the central bank has a desired real interest rate, R. Given exogenous π(e), what is the relationship between R, i and π(e)?

Answer 3

i = R + π(e)

Question 4

IS-MP gives a unique (r, Y) with:

Answer 4

• goods market equilibrium (A = E in Keynesian Cross)
• money market equilibrium

Question 5

Define the ‘neutral real interest rate’, r̅

Answer 5

r̅ equates S and I when Y = Y̅ and there are no temporary shocks to planned expenditure

Question 6

When R = r̅, short-run policy is consistent with…?

Answer 6

short-run policy is consistent with long-run Classical equilibrium

Question 7

Why does there exists a ‘zero’ lower bound on i - at least for consumers?

Answer 7

• i is the nominal rate paid on risk-free assets
• suppose this were negative
• then cash dominates as an asset
• no-one would hold bonds or keep money in the bank
• so long as cash exists, a ‘zero’ lower bound on i - at least for consumers

Question 8

If there is a zero bound for i, then what does this mean about the value of r

Answer 8

• if there is a zero bound for i, then r is also constrained
• from the Fisher equation, if i >= 0
• then, r >= -π(e)

Question 9

Why might the neutral rate, r̅, be unattainable?

Answer 9

• as i >= 0, thus r >= -π(e) (from the Fisher equation)
• thus a desired real rate R may not be possible if R < -π(e)
• lower π(e), or expected deflation, is a particular worry (as it makes it more likely that R < -π(e), which is unattainable)
• thus, even without shocks, the neutral rate r̅ may be unattaianble

Question 10

As the zero-lower-bound means that the desired output level may be unattainable by conventional monetary policy, what other policies could be used?

Answer 10

• unconventional monetary policies, for example
• quantitative easing
• forward guidance

Question 11

What is the yield curve?

Answer 11

a plot of the nominal interest rate, i, against the borrowing horizon (how long you will be borrowing for)

Question 12

The policy interest rate that central banks control is an overnight i. Which is interest rate that usually matters most for borrowers? Why?

Answer 12

• the interest rates that matter for borrowers are usually more long-term
• as investment projects take time

Question 13

Define the long-term real interest rate, r(L)

Answer 13

the opportunity cost of investment

Question 14

Explain how unconventional monetary policy works, using the fact that I = I(rL) = I(r, θ)

Answer 14

• normally, changes to the overnight i (and r) will pass through into longer-term i (and r)
• so if π(e) exogenous, policy still influence investment. Changing short-term i changes short-term r, changing short-term r changes long-term rL
• investment varies in rL: I = I(rL)
• but other factor will matter for rL, as well as r
• for instance, expected future monetary policy, long-term vs short-term asset demand
• thus, we could write rL = rL(r, θ), with θ being ‘other factors’
• this means I = I(rL) = I(r, θ)
• so the idea behind unconventional policy is that if r is ZLB-constrained, why not change θ?

Question 15

Briefly summarise how quantitative easing and forward guidance work

Answer 15

• QE: CB buys long-term debt, with the aim of raising its price. Higher price for debt means lower interest rate for the borrower
• FG: CB promises that short-term rates will be kept low in the future
• BIG debates about the effectiveness of both