monetary policy

Question 1

What are the 2 frameworks of monetary policy rules ?

Answer 1

Indirect approach - Money growth rate
Direct approach - Inflation targeting

Question 2

What is the money growth rate in terms of monetary policy ?

Answer 2

Until the 1990s, the design of monetary policy revolved around
nominal money growth
* Central banks chose a nominal money growth for the medium
run
* Considered short-run policy deviations from this stated target

Question 3

What is inflation targeting in terms of monetary policy ?

Answer 3

Central banks now tend to have adopted an inflation target rather than a nominal money growth rate
* In this case CBs consider short-run policy to move nominal
interest rate rather than movements in nominal money growth

Question 4

When were money growth rates stopped ??

Answer 4

In the 1990s

Question 5

How did money growth rates work as a policy

Answer 5

Central bank chose a target rate for nominal money growth corresponding to the inflation rate it wanted to achieve in the
medium run
* In the short-run, the central bank allowed for deviations of nominal money growth from the target
– E.g. in recession, increase nominal money growth, allow for a faster decrease in the interest rate.
* Central banks announced a range for the rate of nominal money growth

Question 6

What is the definition of inflation targeting ??

Answer 6

Central bank of many countries have defined their primary goal as the achievement of a low inflation rate, in the short and medium run.

Question 7

What is the equation for a banks inflation target ??

Answer 7

Question 8

What would happen if banks could achieve its target exactly in each period ??

Answer 8

• Unemployment would always be at its natural rate Ut = Un
• Output would always be equal to natural rate of output

Question 9

What does inflation targeting aim to do in the medium run ?

Answer 9

Lead the central bank to act in such a way to eliminate all deviations from its natural level

Question 10

Can the elimination of deviations from natural level be achieved, and if not why ??

Answer 10

No it is unlikely to follow in practise for 2 key reasons
1) Central banks cannot always achieve the rate of inflation it wants in the short run
2)Philips curve relationship does not hold exactly

Question 11

What length of time does inflation targeting make the most sense in ??

Answer 11

In the medium run, and allows monetary policy to stabilise output around its natural level in the short-run

Question 12

What is the Taylor Rule ??

Answer 12

That the CB should choose an interest rate rather than a rate of nominal money growth

Question 13

What is the taylor rule as an equation

Answer 13

Question 14

What are the notations of the Taylor rule equation

Answer 14

Question 15

What does the Taylor rule actually mean ??

Answer 15

-Once the central bank has chosen the target rate of inflation, it should try to achieve this by adjusting the nominal interest rate;
-Coefficients (a,b) show the relative importance given to the variables

Question 16

If u is at natural rate, and inflation is at target, what should the CB do?

Answer 16

Set It equal to its target value

Question 17

If inflation is above target, what should the CB do ?

Answer 17

Increase the nominal interest rate above i*

Question 18

If unemployment is above natural rate, what should the CB do ?

Answer 18

Decrease the nominal interest rate

Question 19

What are the 4 main costs of inflation ??

Answer 19

1. Shoe leather costs
2. Tax distortions
   £. Money illusion
3. Inflation variability

Question 20

What is shoe leather costs ??

Answer 20

The costs of making more trips to the bank in the presence of inflation, they reflect an increase in the opportunity cost of holding money
These costs would be avoided if inflation was lower

Question 21

What are tax distortions

Answer 21

-Taxation on capital gains, the higher the inflation rate the higher the tax
-these distortions occur when tax rates do not increase automatically with inflation
-Consider income tax brackets: if these are not inflation corrected, people will be pushed into higher brackets as their income is increased over time – but not necessarily their real income.

Question 22

What is money illusion ??

Answer 22

-The notion that people appear to make systematic mistakes in assessing nominal vs real changes
-When they compare their income to previous years, people fail to take into account inflations
-People also do this when they choose between different assets, consume or save

Question 23

What is inflation variability ?

Answer 23

Higher inflation is associated with more variable inflation, A more variable inflation rate means financial assets such as bonds, which promise a fixed nominal payment in the future – become riskier

Question 24

What are the 3 main benefits of inflation ??

Answer 24

1. Seignorage
2. The option of negative real interest rates
3. Money illusion revisited

Question 25

What is seignorage ??

Answer 25

Essentially, money creation, which is the ultimate source of inflation
It is an alternative to borrowing from public, or raising taxes

Question 26

Is there an optimal inflation rate ??