Monetary Policy Flashcards
The Federal reserve can in theory shift the AD curve back up to the right by encouraging bank lending and investor borrowing by reducing interest rates. Name two difficulties why this might be harder to do in reality:
- The federal reserve must operate in real time when much of the data about the state of the economy is unknown. It takes time for data to be gathered
- The Federal reserves control of the money supply is incomplete and subject to uncertain lags.
What makes a monetary policy credible?
A monetary policy is credible when it is expected that a central bank will stick with its policy.
What’s the difference between disinflation and deflation?
Disinflation is a significant reduction in the rate of inflation.
Deflation is a decrease in prices, like a negative inflation rate.
What’s the bandwagon effect?
Example: I am uncertain so i delay my investments, you follow suit not because of uncertainty alone but because your investment is less likely to work well if it doesn’t happen at the same time as my investment.
Why is the ability to boost market confidence important to the Fed?
Fear and confidence are some of the most important shifters of aggregate demand.
Explain the negative real shock dilemma
The Fed’s dilemma occurs when they respond to a real shock tat shifts the long run aggregate supply curve to the left, moving the economy to a higher inflation rate and lower real growth rate. The Fed responds with a cut in the money supply to reduce aggregate demand, reducing the inflation rate but also reducing the growth rate.
In the example of the housing bubble crisis, it’s easy to say that the Fed should have raised rates sooner, but there are several problems with this line of thinking. Name 3:
- Few people expected that a fall in housing prices would wreak as much havoc as it did on financial intermediaries and the general economy.
- It’s not always easy to identify when a bubble is present.
- Monetary policy is a crude means of popping a bubble. Monetary policy can influence aggregate demand, or target credit markets at the aggregate level. but monetary policy can’t push the demand for housing down and keep the demand for everything else up.
Economists advocate a strict rule in which when the money supply would grow by 3% per year every year. This means the Fed has to ignore changes in the velocity of money, why?
Because Money supply x Velocity of money equals PxY. Changes in V can cause P and Y to lower, meaning a recession.
What’s Monetary Neutrality?
Monetary neutrality is an economic concept that suggests changes in the money supply only affect nominal variables (such as the price level, wages, or nominal GDP) and have no impact on real variables (like real GDP, employment, or real wages) in the long run.
What was Milton Friedman’s reasoning behind the 3% growth rule for money supply?
Monetary neutrality.
Friedman believed that in the long run, changes in the money supply only affect nominal variables and not real variables. Thus, steady and predictable growth in the money supply would avoid causing economic distortions allowing the economy to operate efficiently
What happens to GDP if the Fed is too responsive to changes in the aggregate demand?
If the Fed is too responsive to changes in aggregate demand, its frequent interventions can lead to overreacton or policy lags causing unnecessary fluctuations in GDP
Explain policy lags
Monetary policy takes time to affect the economy due to recognition, decision making and implementation lags.
Low interest rates are in essence a signal to market participants that credit is?
Easy and it is a good idea to borrow money.
When a bubble arises, what are asset prices driven by?
Shifts in market psychology and successive waves of irrational exuberance
Explain what irrational exuberance means
This term describes overly optimistic market behavior where investors speculate excessively, believing that prices will continue to rise indefinitely
