Unit 6: Monetary policy, inflation and Unemployment

Question 1

What is meant by Adaptive expectations?

Answer 1

Individuals form their expectations about the future based on past experiences and historical data (if inflation has been higher than expected in the past, people will revise their future expectations of inflation upwards)

Question 2

What is meant by inflation inertia?

Answer 2

Workers incorporate past inflation into their current wage claim to make up for any erosion in real wages since the last time wages were negotiated. It gives a reason for why past inflation is included as a determinant of inflation in the PC is inertia

Question 3

What is the formula for the PC?

Answer 3

πt = π−1 + α(yt − yn)

Question 4

What was inflation like up until the 1960s?

Answer 4

It was small, and so in this case it could be approximated that inflation will be equal to π with bar on top, so new equation:

π = π¯ + α(yt − yn)

Question 5

When π = π¯ + α(yt − yn) what did this suggest about policymakers?

Answer 5

They faced a trade off between inflation and unemployment, if they were willing to accept more inflation, they could achieve lower unemployment

Question 6

True or false:

In the early 1960s, US Macroeconomic policy aimed at steadily decreasing unemployment

Answer 6

True, unemployment rate declined steadily while the inflation rate steadily increased

Question 7

When did the inverse relationship between inflation and unemployment?

Answer 7

In the 1970s when inflation became more persistent

Question 8

With the assumption that if inflation had been high last year, it was likely to be high this year as well, what would the PC look like?

Answer 8

πt = π−1 + α(yt − yn)

Question 9

The unemployment rate affects not the inflation rate but rather…

Answer 9

The change in inflation rate

Question 10

Why is the PC known as the accelerationist PC?

Answer 10

Because if employment is above its
equilibrium level, the inflation rate
increases, π − π−1 > 0, and thus the
increase in prices accelerates.

Question 11

What is an implication of the accelerationist PC?

Answer 11

To reduce inflation, unemployment must be higher than its equilibrium level

Question 12

What does a dovish approach mean?

Answer 12

Inflation is brought down gradually and the associated rise in unemployment in the short term is moderated

Question 13

What does a hawkish approach mean?

Answer 13

Inflation is brought down very fast, but at a much higher cost in terms of output

Question 14

True or false- The flatter the indifference curve, the more inflation-averse the CB

Answer 14

True

Question 15

What does the Monetary rule show?

Answer 15

The CBs preferred output-inflation combined for any PC it faces

Question 16

What equation can be used to show the MR equation?

Answer 16

y − ye = −b(π − πT)

Question 17

True or False:

Given the inflation gap, π − πT, the MR determines the output gap the CB wants to achieve

Answer 17

True

Question 18

What does b capture in the MR rule

Answer 18

How inflation averse the CB is

Question 19

What does a larger b indicate?

Answer 19

The CB is willing to generate a high level of unemployment to achieve a given reduction in inflation

Question 20

What does a small b reflect in the MR rules?

Answer 20

A less inflation averse CB

Question 21

Is the CB susceptible to the time-inconsistency problem?

Answer 21

Yes whereby it may pursue short term objectives at the expense of long term ones

Question 22

Why is a nominal anchor needed?

Answer 22

1. It helps promote price stability since it sets a constraint on the value of domestic money
2. It is also one way of avoiding the time-inconsistency problem

Question 23

What was used as a target during the 1970s and 1980s? and what is it now

Answer 23

The growth rate of money supply and now many countries have adopted inflation targeting as their monetary policy regime

Question 24

Why is the relationship between money supply and inflation not very strong

Answer 24

Due to changes in demand for money

Question 25

What advantage does inflation targeting have over using the growth rate of money supply?

Answer 25

Monetary policy no longer relies on a stable money-inflation relationship

Question 26

The CBs goals are to:

Answer 26

Minimise fluctuations of inflation from its target and to reduce the size of the output gap
Minimise its loss function

Question 27

What can the CB objective function be represented as?

Answer 27

L = β(πt − πT )^2 + (yt − ye )^2

Question 28

What does the parameter β capture?

Answer 28

The relative importance that the CB places on deviations of inflation from its target

Question 29

True or false: A steeper PC makes things easier for the CB?

Answer 29

True since a smaller rise in unemployment is required to achieve any desired fall in inflation