Policies for Economic Stability

Question 1

what is “Zero inflation” target?

Answer 1

• The lower the inflation rate, the smaller these distortions
• Inflation has harmful effects on the economy (variability in relative prices, and its interaction with the tax system discourages saving).

Question 2

what are the arguments in favor of “Positive inflation”?

Answer 2

• Costs of Disinflation
• Avoiding Liquidity Traps

Question 3

what is a “Explicit inflation target”?

Answer 3

• It is a rate or range that a central bank announces as its long-run goal for inflation

Question 4

what is “Implicit inflation target”?

Answer 4

• It is an inflation level that policymakers seek without a formal announcement

Question 5

Why is unstable inflation costly?

Answer 5

• Variability in inflation causes variability in ex post real interest rates, which increases risk for both borrowers and lenders.
• exacerbates the problem of relative price variability

Question 6

what is the main principle of long-run neutrality?

Answer 6

• monetary policy does not affect these variables in the long run
• Only Fiscal Policies

Question 7

what monetaries policies can change? (times and variables)

Answer 7

• It’s affect short-run movements in output and employment
• • Central banks try to dampen the business cycle.

Question 8

why the central banks recall the Okun’s law ?

Answer 8

• output and unemployment move together closely over the business cycle.
• Reducing fluctuations in output automatically reduces fluctuations in unemployment.
• If the Central banks want to stabilize unemployment as well as output.

Question 9

what is the “Taylor rule”?

Answer 9

• formula for adjusting the interest rate to stabilize the economy
• The Taylor rule also prescribes interest rate adjustments when the inflation rate departs from its long-run level.
• Once again, the central bank leans against the wind, raising the real interest rate when inflation rises and reducing it when inflation falls.

Question 10

Taylor Rule Formula: (LONG)

Answer 10

• “r” is the ex-ante real interest rate
• The neutral real interest rate, rⁿ: this term is the _interest rate that makes output (Y ) equal potential output (Y * )._
• The output gap, Y~: this variable is the percentage deviation of output from potential, Y~ =􏰀 (Y -􏰅 Y*)/􏰋Y *.
• The inflation gap, p 􏰅- p^T: the central bank’s long-run inflation target—either explicit or implicit. The inflation gap is the current deviation of inflation from the target.
• The coefficients a_y and a_p: positive constants that measure how strongly the interest rate responds to the output and inflation gaps, respectively.

Question 11

The Fed and the Taylor Rule (graph)

Answer 11

Question 12

When is the taylor rule use ?

Answer 12

• when a shock pushes the economy away from long-run equilibrium, the Taylor rule guides it back.

Question 13

what is a mayor dilema for the central bank in change of interest rate?

Answer 13

• central banks face a trade-off between output stability and inflation stability
• The Taylor rule that is best for achieving one of these goals is not best for achieving the other. (choose one goal , both goals are very difficult to do with the taylor rule).

Answer 14

Question 15

why running monetary policy in a real economy is much harder than analyzing policy with a model?

Answer 15

• A major reason is uncertainty about the economy’s behavior. (not knowing the extact numbers)
• When we examine policy options, we usually assume that we know the precise AE** and **Phillips curves that determine output and inflation
• These misestimates can lead to policy mistakes
• so well-intentioned policies can backfire

Question 16

what mismeasurements can trick the central bank in taking certain kinds policies?

Answer 16

• Mismeasurement about the Aggregate demand.
• Mismeasurement about the Output Gap

Not knowing the real AE and Output, furtheremore the difficulty of determine the Potential Output

Question 17

Mistake commited by the Fed during the “Great Inflation” ? (Perverse Inflation Responses)

Answer 17

• Fed policy followed his rule in the 1970s but with inappropriate coefficients.
• the response to inflation, was negative. This rise in inflation caused the Fed to reduce the real interest rate.
• The Fed was leaning with the wind rather than against it.
• the negative a_p (inflation) created an inflationary spiral

Question 18

Mistake commited by the Fed during the “Great Inflation” ? (Mismeasurement of the Output Gap)

Answer 18

• the Fed’s estimate of the natural rate of unemployment was too low
• This mistake led to overexpansionary policy, which pushed inflation above the Fed’s target.
• Economists had not yet developed methods for estimating the natural rate
• The natural rate was 5 percent or less in the 1960s but rose to about 6 percent in the 1970s as the majority of baby boomers entered the labor force and productivity growth slowed

Question 19

What is “Interest rate smoothing”?

Answer 19

• central banks’ practice of moving interest rates through a series of small changes

Question 20

How the central bank deal with uncertainty?

Answer 20

• Learning About the Economy ( A lot of research and invesment)
• Cautious Interest Rate Movements

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• Smaller Responses to Output Gaps (somes central banks)

Some economist: a small a_{y (output coeficient)} would prevent the kind of mistake the Fed made in the 1970s

Other economist: output gap would allow recessions to drag on for a long time

Most central banks have not been convinced to deemphasize output gaps (responden immediatamente)

Question 21

what is the “Teel Book”?

Answer 21

• It is the report to the FOMC on “Economic Conditions and Monetary Policy”
• It is better known as the “Teal Book” because of the color of its cover

Question 22

What is the content of the “Teel Book”? and its important?

Answer 22

1. Monitor of the state of the economy
2. Forecasting the economy
3. Evaluating Polcies options
4. FOMC meeting (and decision making)

The teel book present current economic information that can not be found elsewhere, it is posted months after (quartely)

It is the main tool to determine future monetaries polices

Question 23

Why do central banks respond aggressively when they fear a financial crisis? (ouput explanation)

Answer 23

• A financial crisis is likely to reduce output in the near future.
• Among other reasons, a crisis shakes consumer confidence, reduces bank lending, and causes asset prices to fall.
• These events lead to lower consumption and investment.
• The process takes time to unfold. Given the lags in policy effects, the central bank wants to act preemptively.
• It lowers rates when it sees a financial crisis developing rather than waiting for output to fall.

Question 24

Why do central banks respond aggressively when they fear a financial crisis? (expectative explanation)

Answer 24

• During a financial crisis, the risk that the crisis will suddenly worsen always looms. (telar, comenzar a preparar)
• The failure of one financial institution can trigger a loss of confidence that causes other failures. Because of such risk, a central bank is likely to respond more strongly than is justified by the current situation.
• Also, Policymakers provide extra stimulus to the economy as insurance against worst-case scenarios.
• Recent history vividly illustrates this rationale, as we discuss in the following case study.

Question 25

Deviating from the Taylor Rule, 2007–2010 (graph)

Answer 25

Question 26

Why Respond to Asset Prices?

Answer 26

• The affirmative argument is based on the link between asset-price bubbles and subsequent declines in asset prices
• Rather than react to asset price declines, central banks would do better to prevent them from occurring
• A bubble is driven by self-fulfilling expectations of rising prices
• At some point, expectations shift and prices fall, sometimes rapidly.

When such decreases in asset prices occur, the central bank lowers interest rates. But this response may be too late to prevent a recession because of the lags in policy effects

Question 27

Why Not Respond to Asset Prices?

Answer 27

• To respond to bubbles, central banks must identify them. This is difficult
• Rapid increases in asset prices might reflect bubbles, or they might reflect increases in expected earnings
• The effects of interest rates on bubbles are unpredictable
• A policy tightening aimed at asset prices has adverse side effects