Money and interest rates + Central Banking

Question 1

What is the Fisher equation?

Answer 1

i = r + Π

Question 2

What is the Taylor rule equation?

Answer 2

i = r + Π + a(Π - Π) + b(y - y)

Question 3

Why were interest rates so high in the start of the 80’s?

Answer 3

The interest rate were below the Taylor rule in the 70’s leading to strong increase of inflation. In the 80’s interest rate were increased to reduce inflation.

Question 4

Rule vs Discretion - list pros and cons

Answer 4

Pro Rule:

• Insulate CB from political pressure
• Overcome time inconsistency
• Expectations, knowing how CB will react

Pro Discretion:

• Easier to act on changes in the economy
• No rule can capture the complexity of the real economy

Question 5

What should the CB do to hit the interest target if money demand decrease? You should be able to draw

Answer 5

Sell bonds and accept money.

Vertical axis - interest rate (i)
Horistonal axis - money in the economy (M)
Downward facing line - Money demand (MD)
Vertical line - Money supply (MS)

MD shift to the left
CB sell bonds to shift MS to the left
New equlibrium at same interest target with less money in the economy.

Question 6

Taylor rule:
i = r + Π + a(Π - Π) + b(y - y)
Positive supply shock - what changes?

Answer 6

Π decrease, interest rate decrease by more than the supply shock

Question 7

Fed primarily controls the U.S monetary stock through which three mechanisms?

Answer 7

Setting the Federal Funds Rate
Buying U.S. Government Treasuries
Adjusting the Reserve Ratios

Question 8

What is the lower bound of the interest rate and why?

Answer 8

The lower bound of the interest rate is zero in the long-term, while some economies have had a negative interest rate for a shorter amount of time.

The lower bound is zero because a lower interest rate would mean that people pay money in order to save in the bank.

Question 9

What is quantitative easing?

Answer 9

CB print money, and use large scale open market operations in order to burst money into the economy. Quantitative easing is an unconventional monetary policy used when the interest rate is close to zero, as regular open market operations will not be able to boost the economy by lowering the interest rate.

Question 10

What is credit easing?

Answer 10

An unconventional monetary policy where CB buy private assets in order to boost liquidity in the economy.

Question 11

What is forward guidance?

Answer 11

CB try to impact real interest rate by managing ecpectations about current interest rate and future evolvement.

Question 12

What are the traditional mandates of Central Banks(CB)?

Answer 12

• Price stability
• Economic stability; employment and growth
• Exchange rate stability

Question 13

What are the newly emphasized topics for Central Banks?

Answer 13

• Financial stability; regulation
• Communication
• Customer protection

Question 14

What is Fed’s mandate?

Answer 14

• Maximum employment
• Stable prices; inflation of around 2%
• Moderate long-term interest rates

Question 15

How does a Central Bank set/peg an exchange rate?

Answer 15

Buying and selling as much foreign currency as individuals demand given the stated rate.

Question 16

What is the benefit of pegging currency?

Answer 16

• Creating credibility - pegging to $ would mean that the foreign CB would behave more like the Fed
• Fixed rates at import/export goods

Question 17

What is the effect of abandoning local currency?

Answer 17

Pros
- CB can not finance govern deficits printing new money
Cons
- Less scope to react on economic shocks

Question 18

What is the quantity theory of money?

Equation and definintion

Answer 18

The more currency in circulation, the less each unit is worth

M * V = P * Y
M - stock of money in circulation
V - velocity (how often a unit of currency is used)
P - price level
Y - real GDP

Question 19

The two hypotheses of Quanitity theory of money is:
- V is constant (growth of V = 0)
- Y not affected by changes in M
These two hypothesis leads to the similar conclusion which is?

Answer 19

Money growth causes inflation:

Growth in P = Growth in M - Growth in Y

Question 20

Quantity theory of money predicts that money growth causes inflation. Is this consistent with data?

Answer 20

Cross-country data: Correlation between money and inflation

Time-series data: Not a clear relationship

Question 21

CB can only effect the short-term interest rate through money supply.
How do CB’s try to effect the more important long-run interest rate?

Answer 21

Through expectations.

Norges Bank for example publish fan-charts predicting the future short-run interest rate.

Empirics show that after Norges Bank started publishing the fan-charts, absolute change of short-term interest rates have declined; less volatility.

Question 22

Why is central bank independence important?

Answer 22

• Prevent CB from political inteference

- Solve some of the issue of time inconsistency (through different political opininons, especially near elections)

Question 23

How is the interbank interest rate related to the Financial Crisis?

Answer 23

Banks lost trust to eachother, risk of lending priced in the interbank interest rate.

• > Liquidity started drying up
• -> Financial markets froze
• –> The real economy got effected

Question 24

Explain how hyperinflation starts, and how to stop it.

Use a developing country as an example

Answer 24

1. Fiscal policy with large budget deficits
2. Government need to issue new debt
3. Government bonds of a developing country not necessarily desirable
4. Pressure on CB to print more money to buy newly issued debt
5. Inflation keeps rising, as the ficscal disipline is bad

The country can fix the inflation by stopping with the budget deficits.
Alternatively; give up local currency so that the CB can not print money