CH17: The Conduct of Monetary Policy Flashcards
1) The most common definition that monetary policymakers use for price stability is
A) low and stable deflation.
B) an inflation rate of zero percent.
C) high and stable inflation.
D) low and stable inflation.
D) low and stable inflation.
Inflation results in
A) ease of planning for the future.
B) ease of comparing prices over time.
C) lower nominal interest rates.
D) difficulty interpreting relative price movements.
D) difficulty interpreting relative price movements.
Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.
A) Inflation makes planning for the future more difficult, not easier, because it decreases the value of money over time. This uncertainty can make it challenging to plan long-term investments or savings.
B) Inflation complicates the comparison of prices over time. A product’s price may increase over time due to inflation, not necessarily because the product itself has become more valuable.
C) Inflation often leads to higher nominal interest rates, not lower. When inflation is high, lenders demand higher interest rates as compensation for the decrease in purchasing power repaid in the future.
D) Inflation can indeed make interpreting relative price movements more difficult. If all prices are rising, it can be hard to tell if the price of a specific product is increasing due to higher demand or just general inflation. Hence, option D is the correct answer.
Economists believe that countries recently suffering hyperinflation have experienced
A) reduced growth.
B) increased growth.
C) reduced prices.
D) lower interest rates.
A) reduced growth.
Hyperinflation is an extremely high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This creates a situation where the general price level within an economy increases rapidly and substantially, and such increases are often exponential.
A) Hyperinflation often leads to reduced economic growth. The rapid increase in prices makes the use of money as a medium of exchange unreliable. This can lead to a decrease in its demand, which in turn slows down economic activities and hence growth.
B) Hyperinflation does not lead to increased growth. On the contrary, it often leads to a contraction in economic activities.
C) Hyperinflation leads to an increase in prices, not a reduction. The term ‘hyperinflation’ itself refers to a situation where prices are increasing at an extremely high rate.
D) Hyperinflation does not lead to lower interest rates. In fact, to combat inflation, central banks often raise interest rates to decrease the money supply and stabilize the economy.
A nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability is called ________ anchor.
A) a nominal
B) a real
C) an operating
D) an intermediate
A) a nominal
A central feature of monetary policy strategies in all countries is the use of a nominal variable that monetary policymakers use as an intermediate target to achieve an ultimate goal such as price stability. Such a variable is called a nominal _______
A) anchor.
B) benchmark.
C) tether.
D) guideline.
A) anchor.
A nominal anchor promotes price stability by
A) outlawing inflation.
B) stabilizing interest rates.
C) keeping inflation expectations low.
D) keeping economic growth low.
C) keeping inflation expectations low.
Monetary policy is considered time-inconsistent because
A) of the lag times associated with the implementation of monetary policy and its effect on the economy.
B) policymakers are tempted to pursue discretionary policy that is more contractionary in the short run.
C) policymakers are tempted to pursue discretionary policy that is more expansionary in the short run.
D) of the lag times associated with the recognition of a potential economic problem and the implementation of monetary policy.
C) policymakers are tempted to pursue discretionary policy that is more expansionary in the short run.
The time-inconsistency problem with monetary policy tells us that, if policymakers use discretionary policy, there is a higher probability that the ________ will be higher, compared to policy makers following a behavior rule.
A) inflation rate
B) unemployment rate
C) interest rate
D) foreign exchange rate
A) inflation rate
The theory that monetary policy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes is referred to as the
A) adverse selection problem.
B) moral hazard problem.
C) time-inconsistency problem.
D) nominal-anchor problem.
C) time-inconsistency problem.
The ________ problem of discretionary policy arises because economic behavior is influenced by what firms and people expect the monetary authorities to do in the future.
A) moral hazard
B) time-inconsistency
C) nominal-anchor
D) rational-expectation
B) time-inconsistency
If the central bank pursues a monetary policy that is more expansionary than what firms and people expect, then the central bank must be trying to
A) boost output in the short run.
B) constrain output in the short run.
C) constrain prices.
D) boost prices in the short run.
A) boost output in the short run.
The time-inconsistency problem in monetary policy can occur when the central bank conducts policy
A) using a nominal anchor.
B) using a strict and inflexible rule.
C) on a discretionary, day-by-day basis.
D) using a flexible, discretionary rule.
C) on a discretionary, day-by-day basis.
Explain the time-inconsistency problem. What is the likely outcome of discretionary policy? What are the solutions to the time-inconsistency problem?
With policy discretion, policymakers have an incentive to attempt to increase output by pursuing expansionary policies once expectations are set. The problem is that this policy results not in higher output, but in higher actual and expected inflation. The solution is to adopt a rule to constrain discretion. Nominal anchors can provide the necessary constraint on discretionary behavior.
Even if the Fed could completely control the money supply, monetary policy would have critics because
A) the Fed is asked to achieve many goals, some of which are incompatible with others.
B) the Fed’s goals do not include high employment, making labor unions a critic of the Fed.
C) the Fed’s primary goal is exchange rate stability, causing it to ignore domestic economic conditions.
D) it is required to keep Treasury security prices high.
A) the Fed is asked to achieve many goals, some of which are incompatible with others.
High unemployment is undesirable because it
A) results in a loss of output.
B) always increases inflation.
C) always increases interest rates.
D) reduces idle resources.
A) results in a loss of output.
When workers voluntarily leave work while they look for better jobs, the resulting unemployment is called
A) structural unemployment.
B) frictional unemployment.
C) cyclical unemployment.
D) underemployment.
B) frictional unemployment.
Unemployment resulting from a mismatch of workers’ skills and job requirements is called
A) frictional unemployment.
B) structural unemployment.
C) seasonal unemployment.
D) cyclical unemployment.
B) structural unemployment.
The goal for high employment should be a level of unemployment at which the demand for labor equals the supply of labor. Economists call this level of unemployment the
A) frictional level of unemployment.
B) structural level of unemployment.
C) natural rate level of unemployment.
D) Keynesian rate level of unemployment.
C) natural rate level of unemployment.
Supply-side economic policies seek to
A) raise interest rates through contractionary monetary policy.
B) increase federal government expenditures.
C) increase consumption expenditures by increasing taxes.
D) increase saving and investment using tax incentives.
D) increase saving and investment using tax incentives.
Having interest rate stability
A) allows for less uncertainty about future planning.
B) leads to demands to curtail the Fed’s power.
C) guarantees full employment.
D) leads to problems in financial markets.
A) allows for less uncertainty about future planning.
Foreign exchange rate stability is important because a decline in the value of the domestic currency will ________ the inflation rate, and an increase in the value of the domestic currency makes domestic industries ________ competitive with competing foreign industries.
A) increase; more
B) increase; less
C) decrease; more
D) decrease; less
B) increase; less
A decline in the value of the domestic currency means that it now takes more of the domestic currency to buy goods and services. This can lead to imported inflation as the cost of imported goods and services goes up, which can increase the inflation rate.
On the other hand, an increase in the value of the domestic currency makes domestic goods and services more expensive relative to foreign goods and services. This can make domestic industries less competitive with competing foreign industries as foreign buyers would find foreign goods cheaper.
Therefore, option B is the correct answer.
Which set of goals can, at times, conflict in the short run?
A) high employment and economic growth
B) interest rate stability and financial market stability
C) high employment and price level stability
D) exchange rate stability and financial market stability
C) high employment and price level stability
The primary goal of the European Central Bank is
A) price stability.
B) exchange rate stability.
C) interest rate stability.
D) high employment.
A) price stability.
The mandate for the monetary policy goals that has been given to the European Central Bank is an example of a ________ mandate.
A) primary
B) dual
C) secondary
D) hierarchical
D) hierarchical
The mandate for the monetary policy goals that has been given to the Federal Reserve System is an example of a ________ mandate.
A) primary
B) dual
C) secondary
D) hierarchical
B) dual
Either a dual or hierarchial mandate is acceptable as long as ________ is the primary goal in the ________.
A) price stability; short run
B) price stability; long run
C) reducing business-cycle fluctuations; short run
D) reducing business-cycle fluctuations; long run
B) price stability; long run
The type of monetary policy that is used in Canada, New Zealand, and the United Kingdom is
A) monetary targeting.
B) inflation targeting.
C) targeting with an implicit nominal anchor.
D) interest-rate targeting.
B) inflation targeting.
Which of the following is NOT an element of inflation targeting?
A) a public announcement of medium-term numerical targets for inflation
B) an institutional commitment to price stability as the primary long-run goal
C) an information-inclusive approach in which only monetary aggregates are used in making decisions about monetary policy
D) increased accountability of the central bank for attaining its inflation objectives
C) an information-inclusive approach in which only monetary aggregates are used in making decisions about monetary policy
The first country to adopt inflation targeting was
A) the United Kingdom.
B) Canada.
C) New Zealand.
D) Australia.
C) New Zealand.
Explain and demonstrate graphically how targeting nonborrowed reserves can result in federal funds rate instability.
When nonborrowed reserves are held constant, increases in the demand for reserves result in the federal funds rate increasing and decreases in the demand for nonborrowed reserves result in the federal funds rate declining. Since fluctuations in demand do not cause monetary policy actions, the result is the federal funds rate will fluctuate (assuming the equilibrium federal funds rate is below the discount rate).
Explain and demonstrate graphically how targeting the federal funds rate can result in fluctuations in nonborrowed reserves.
With a federal funds rate target, fluctuations in demand for reserves require similar changes in the nonborrowed reserves to keep the federal funds rate constant.
Explain the Taylor rule, including the formula for setting the federal funds rate target, and the components of the formula. If the Fed were to use this rule, how many goals would it use to set monetary policy?
Answer: The Taylor rule specifies that the target federal fund rates should be set to equal the equilibrium real federal funds rate, plus the rate of inflation (for the Fisher effect), plus one-half times the output gap, plus one-half times the inflation gap. The formula is (see attached).
The output gap is the percentage deviation of real GDP from potential full-employment real GDP. The inflation gap is the difference between actual inflation and the central bank’s target rate of inflation. The equilibrium real federal funds rate is the real rate consistent with full employment in the long run. The inflation rate is the actual rate of inflation. The Taylor rule sets the federal funds rate recognizing the goals of low inflation and full employment (or equilibrium long-run economic growth).
