Module 15.2 - Monetary Policy Effects Flashcards
(29 cards)
What are the three essential qualities for a central bank to succeed in its inflation targeting policies?
Independence, Credibility, Transparency
These qualities enable a central bank to effectively manage inflation and maintain economic stability.
Why is independence important for a central bank?
It should be free from political interference to effectively manage inflation and economic growth
Politicians may interfere with central bank activities, compromising its ability to manage inflation.
What are the two types of independence for a central bank?
Operational independence, Target independence
Operational independence allows the bank to set policy rates, while target independence involves defining inflation metrics and goals.
Define operational independence in the context of a central bank.
The central bank independently determines the policy rate
This allows the bank to respond effectively to economic conditions without political pressure.
Define target independence in the context of a central bank.
The central bank defines how inflation is computed, sets target inflation levels, and determines the target horizon
This helps in establishing clear inflation goals.
What is the role of credibility for a central bank?
To follow through on stated intentions, making targets self-fulfilling prophecies
A credible central bank’s inflation targets influence market behavior and expectations.
How does transparency aid a central bank’s credibility?
By periodically disclosing the state of the economic environment through inflation reports
Transparency helps the public understand the bank’s policy decisions and economic indicators.
What is the most widely used tool for making monetary policy decisions?
Inflation targeting
This method is required by law in some countries and aims to keep inflation within a specific range.
What is the common inflation rate target for central banks?
2%, with a permitted deviation of ±1% (target band of 1% to 3%)
This target helps prevent deflation, which can disrupt economic stability.
Why do central banks not target 0% inflation?
To avoid negative inflation (deflation), which is disruptive
Maintaining a slight inflation target allows for better economic functioning.
What do some developing countries use instead of inflation targeting?
Exchange rate targeting
This involves maintaining a specific exchange rate between their currency and another currency, often the U.S. dollar.
What happens if the foreign exchange value of a domestic currency falls below the target rate?
The monetary authority must use foreign reserves to purchase domestic currency
This action reduces money supply growth and increases interest rates to maintain the target exchange rate.
What is a potential consequence of exchange rate targeting?
Greater volatility of the money supply
Maintaining a stable foreign exchange rate may require frequent adjustments in domestic monetary policy.
True or False: A targeting country can indefinitely influence its currency’s exchange rate through market purchases or sales.
False
There are limits to how much influence can be exerted, especially if foreign reserves run low.
What is the net effect of exchange rate targeting on inflation rates?
The targeting country will have the same inflation rate as the country with the targeted currency
This requires the targeting country to align its monetary policy with that of the foreign currency’s country.
What is a limitation of the monetary policy transmission mechanism?
Long-term rates may not rise and fall with short-term rates due to expected inflation effects.
Long-term bond yields include a premium for expected inflation.
What happens to long-term bond yields if individuals expect lower future inflation rates?
Long-term bond yields could fall, potentially increasing economic growth.
This occurs even while the central bank increases short-term rates to slow economic activity.
What is a liquidity trap?
A situation where individuals willingly hold more money without a decrease in short-term rates.
In a liquidity trap, increasing the money supply does not lower short-term rates.
What is the central bank’s limitation in a deflationary environment?
The central bank can only reduce the nominal policy rate to zero.
After reaching zero, further stimulation of the economy becomes limited.
What occurred during the credit bubble collapse in 2008?
Banks decreased lending despite increased money supplies and falling short-term rates.
This was due to banks wanting to rebuild equity capital.
What is quantitative easing?
A policy where the central bank purchases assets to increase the money supply and stimulate the economy.
This includes buying government bonds and mortgage securities.
In the United Kingdom, what was the goal of quantitative easing?
To reduce interest rates, encourage borrowing, and generate excess reserves in the banking system.
This was aimed at promoting lending amidst economic uncertainty.
What was the aim of the Fed’s second round of quantitative easing (QE2)?
To bring down longer-term interest rates and increase lending and economic growth.
The Fed purchased hundreds of billions of dollars in long-term Treasury bonds.
What challenges do developing countries face in implementing monetary policy?
Lack of liquid markets in government debt, distorted interest rate information, and loss of central bank credibility.
Rapid development can complicate determining the neutral rate of interest.
