CH26: Transmission Mechanisms of Monetary Policy

Question 1

Economic theory suggests that ________ interest rates are ________ important than ________ interest rates in explaining investment behavior.
A) nominal; more; real
B) real; less; nominal
C) real; more; nominal
D) market; more; real

Answer 1

C) real; more; nominal

Question 2

According to the traditional interest-rate channel, expansionary monetary policy lowers the real interest rate, thereby raising expenditure on
A) business fixed investment.
B) government expenditure.
C) consumer nondurables.
D) net exports.

Answer 2

A) business fixed investment.

Question 3

The monetary transmission mechanism that links monetary policy to GDP through real interest rates and investment spending is called the
A) traditional interest-rate channel.
B) Tobins’ q theory.
C) wealth effects.
D) cash flow channel.

Answer 3

A) traditional interest-rate channel.

Question 4

If the aggregate price level adjusts slowly over time, then an expansionary monetary policy lowers
A) only the short-term nominal interest rate.
B) only the short-term real interest rate.
C) both the short-term nominal and real interest rates.
D) the short-term nominal, the short-term real, and the long-term real interest rates.

Answer 4

D) the short-term nominal, the short-term real, and the long-term real interest rates.

Question 5

If monetary policy can influence ________ prices and conditions in ________ markets, then it can affect spending through channels other than the traditional interest-rate channel.
A) asset; labor
B) asset; credit
C) commodity; labor
D) commodity; credit

Answer 5

B) asset; credit

Question 6

An expansionary monetary policy lowers the real interest rate, causing the domestic currency to ________, thereby ________ net exports.
A) appreciate; raising
B) appreciate; lowering
C) depreciate; raising
D) depreciate; lowering

Answer 6

C) depreciate; raising

Question 7

An expansionary monetary policy increases net exports by ________ interest rates and ________ the value of the dollar.
A) lowering nominal; decreasing
B) lowering real; decreasing
C) raising nominal; increasing
D) raising real; increasing

Answer 7

B) lowering real; decreasing

Question 8

A contractionary monetary policy raises the real interest rate, causing the domestic currency to ________, thereby ________ net exports.
A) appreciate; raising
B) appreciate; lowering
C) depreciate; raising
D) depreciate; lowering

Answer 8

B) appreciate; lowering

Question 9

A contractionary monetary policy decreases net exports by ________ interest rates and ________ the value of the dollar.
A) lowering real; decreasing
B) lowering real; increasing
C) raising nominal; increasing
D) raising real; increasing

Answer 9

D) raising real; increasing

Question 10

Tobin’s q is defined as the market value of firms ________ the replacement cost of capital.
A) times
B) minus
C) plus
D) divided by

Answer 10

D) divided by

Question 11

Tobin’s q theory suggests that monetary policy may affect investment spending through its impact on
A) stock prices.
B) interest rates.
C) bond prices.
D) cash flow.

Answer 11

A) stock prices.

Question 12

In the late 1990s, the stock market bubble ________ the value of Tobin’s q, and caused ________ in business equipment.
A) increased; underinvestment
B) increased; overinvestment
C) decreased; underinvestment
D) decreased; overinvestment

Answer 12

B) increased; overinvestment

Question 13

During the Great Depression, Tobin’s q
A) rose dramatically, as did real interest rates.
B) fell to unprecedentedly low levels.
C) stayed fairly constant, in contrast to most other economic measures.
D) rose only slightly, in spite of Hoover’s attempts to prop it up.

Answer 13

B) fell to unprecedentedly low levels.

Question 14

According to Tobin’s q theory, ________ policy can affect ________ spending through its effect on the prices of common stock.
A) fiscal; consumption
B) fiscal; investment
C) monetary; consumption
D) monetary; investment

Answer 14

D) monetary; investment

Question 15

According to Tobin’s q theory, when q is ________, firms will not purchase new investment goods because the market value of firms is ________ relative to the cost of capital.
A) low; low
B) low; high
C) high; low
D) high; high

Answer 15

A) low; low

Question 16

According to Tobin’s q theory, if q is ________, new plant and equipment capital is ________ relative to the market value of business firms, so companies can buy a lot of new investment goods with only a ________ issue of stock.
A) high; dear; large
B) high; cheap; large
C) high; cheap; small
D) low; cheap; large
E) low; cheap; small

Answer 16

C) high; cheap; small

Question 17

According to Tobin’s q theory, when equity prices are low the market price of existing capital is ________ relative to new capital, so expenditure on fixed investment is ________.
A) cheap; low
B) dear; low
C) cheap; high
D) dear; high

Answer 17

A) cheap; low

Question 18

According to Tobin’s q theory, when equity prices are high the market price of existing capital is ________ relative to new capital, so expenditure on fixed investment is ________.
A) cheap; low
B) dear; low
C) cheap; high
D) dear; high

Answer 18

D) dear; high

Question 19

An expansionary monetary policy raises firms’ cash flows by ________ interest rates.
A) lowering real
B) lowering nominal
C) raising real
D) raising nominal

Answer 19

B) lowering nominal

Question 20

If a contractionary monetary policy lowers the price level by more than expected, it raises the real value of consumer debt. This reduces consumer expenditure through
A) the bank lending channel.
B) Tobin’s q.
C) the traditional interest-rate channel.
D) the household liquidity effect.

Answer 20

D) the household liquidity effect.

Question 21

An expansionary monetary policy may cause asset prices to rise, thereby reducing the likelihood of financial distress and causing consumer durable and housing expenditures to rise. This monetary transmission mechanism is referred to as
A) the household liquidity effect.
B) the wealth effect.
C) Tobin’s q theory.
D) the cash flow effect.

Answer 21

A) the household liquidity effect.

Question 22

According to the household liquidity effect, an expansionary monetary policy causes a ________ in the value of households’ financial assets, causing consumer durable expenditure to ________.
A) decline; rise
B) rise; rise
C) rise; fall
D) decline; fall

Answer 22

B) rise; rise

Question 23

According to the household liquidity effect, higher stock prices lead to increased consumption expenditures because consumers
A) feel more secure about their financial position.
B) want to sell stocks and spend the proceeds before stock prices fall.
C) believe that their wages will increase due to increased profitability of firms.
D) can now afford more expensive imports.

Answer 23

A) feel more secure about their financial position.

Question 24

The subprime financial crisis caused a recession because of the ________ in adverse selection and moral hazard problems and the ________ in housing prices.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease

Answer 24

B) increase; decrease

Question 25

Explain the traditional interest-rate channel for expansionary monetary policy. Explain how a tight monetary policy affects the economy through this channel.

Answer 25

In the traditional channel, a monetary expansion reduces real interest rates, lowering the cost of capital and increasing investment spending. The increase in investment increases aggregate demand. A monetary contraction has the opposite effect, raising real interest rates, lowering investment and aggregate spending.

Question 26

Explain how expansionary and contractionary monetary policies affect aggregate demand through the exchange rate channel.

Answer 26

An expansionary monetary policy reduces real interest rates, causing depreciation of the domestic currency. This depreciation increases net exports and aggregate spending. A monetary contraction increases real interest rates, causing appreciation of the domestic currency, reducing net exports and aggregate spending.

Question 27

Discuss three channels by which monetary policy affects stock prices and aggregate

Answer 27

The answer should include three of the following: In Tobin's q theory, a monetary expansion increases stock prices, increasing the value of the firm relative to the cost of new capital. This stimulates investment in new capital goods, which in turn increases aggregate spending. A monetary expansion increases stock prices, increasing wealth and stimulating consumption and aggregate spending. Expansionary monetary policy increases equity prices. This improves firms' balance sheets, reducing adverse selection and moral hazard and increasing lending for investment, which increases aggregate spending. In the household liquidity effect, the increase in equity prices due to a monetary expansion improves consumer balance sheets, reducing the probability of financial distress, and increasing consumer spending on durable goods and housing.

Question 28

Analysis of the transmission mechanisms of monetary policy provides four basic lessons for a central bank's conduct of monetary policy. These lessons include the following. A) Rising interest rates indicate a tightening of monetary policy, whereas falling interest rates indicate an easing of monetary policy. B) Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero. C) Avoiding fluctuations in the level of unemployment is an important objective of monetary policy, thus providing a rationale for interest-rate stability as the primary long-run goal for monetary policy. D) Other asset prices beside those on short-term debt instruments do not contain important information about the stance of monetary policy because they are not important elements in various monetary policy transmission mechanisms.

Answer 28

B) Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.

Question 29

Analysis of the transmission mechanisms of monetary policy provides four basic lessons for a central bank's conduct of monetary policy. Which of the following is NOT one of these lessons? A) Rising interest rates indicate a tightening of monetary policy, whereas falling interest rates indicate an easing of monetary policy. B) Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero. C) Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal for monetary policy. D) Other asset prices beside those on short-term debt instruments do not contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.

Answer 29

A) Rising interest rates indicate a tightening of monetary policy, whereas falling interest rates indicate an easing of monetary policy.

Question 30

From 1990s until 2012, the Japanese economy has experienced A) easy monetary policy as indicated by falling nominal interest rates. B) easy monetary policy as indicated by short-term interest rates near zero. C) tight monetary policy as indicated by falling asset prices. D) tight monetary policy as indicated by short-term interest rates near zero.

Answer 30

C) tight monetary policy as indicated by falling asset prices.

Question 31

________ examines whether one variable has an effect on another by simply looking directly at the relationship between the two variables. A) Reduced-form evidence B) Organizational-model evidence C) Direct-model evidence D) Structural-model evidence

Answer 31

A) Reduced-form evidence

Question 32

________ examines whether one variable affects another by using data to build a model that explains the channels through which this variable affects the other. A) Indirect-model evidence B) Organizational-model evidence C) Reduced-form evidence D) Structural-model evidence

Answer 32

D) Structural-model evidence

Question 33

The channels through which monetary policy affects economic activity are called the ________ of monetary policy. A) transmission mechanisms B) flow mechanisms C) distribution mechanisms D) allocational mechanisms

Answer 33

A) transmission mechanisms

Question 34

A model that is composed of many equations that show the channels through which monetary and fiscal policy affect aggregate output and spending is called a A) reduced-form model. B) median-voter model. C) informed median-voter model. D) structural model.

Answer 34

D) structural model.