Monetary Policy

Question 1

What are important roles of the central bank?

Answer 1

Monopoly supplier of the currency.
The banker to the government and other banks.
Lender of last resort.
Regulator and supervisor of the payment system.
Conductor of monetary policy.
Supervisor of the banking system.

Question 2

What are the three primary tools available to the central bank?

Answer 2

Open market operations
Refinancing rate
Reserve requirements

Question 3

What is legal tender?

Answer 3

Money must be accepted when offered in exchange for goods and services.

Question 4

What is fiat money?

Answer 4

Money that is not convertible into any other commodity

Question 5

Central banks play a crucial role in a system of fiat money, where acceptance as a medium of exchange gives the money value.

Question 6

Central banks are the sole suppliers of the domestic currency.

Question 7

Central banks also act as the banker to the government and other banks. Also, lender of the last resort since they can print money. It gives liquidity to other banks and governments, which creates trusts.

Question 8

What is monetary policy?

Answer 8

Central bank activities that are directed toward influencing the quantity of money and credit in an economy.

Question 9

What is the main goal of monetary policy?

Answer 9

Maintaining price stability

Question 10

What are open market operations?

Answer 10

The purchase and sale of government bonds from and to commercial banks to increase or reduce the amount of money in circulation.

Question 11

How can the central bank increase or decrease the money in circulation through open market operations?

Answer 11

If central banks buys government bonds from private sector banks, they have more reserves on asset sides, which they can use to give out more loans and credit and vice versa.

Question 12

The interest rate that a central bank sets is the rate at which it is willing to lend money to commercial banks.

Question 13

Why do commercial banks copy the base rate of the central bank?

Answer 13

Commercial banks do not want to lend at a rate of interest below that which they are charged by the central bank.

Question 14

Who is the FOMC?

Answer 14

Federal Open Market Committee, they seek to move the federal funds rate by adding or reducing reserves through open market operations.

Question 15

How can a high policy rate by the central bank manipulate the amount of money in the money markets?

Answer 15

The higher the policy rate, the higher the potential penalty that banks will have to pay to the central bank if they run short of liquidity, the greater their willingness will be to reduce lending, and the more likely it will be that broad money growth will shrink.

Question 16

What are reserve requirements as a tool of the central bank?

Answer 16

A central bank could restrict money creation by raising the reserve requirements of banks. Not used frequently anymore nowadays because changing the requirements is disruptive for banks.

Question 17

What is the transmission mechanism?

Answer 17

The process whereby a central bank’s interest rate is transmitted through the economy and ultimately affects the rate of increase of prices.

Question 18

Through which four interrelated channels does the implementation of an interest rate policy begin to work?

Answer 18

Market rates, asset prices, expectations, exchange rates.
Market rates should rise in response to increase in official rate. Then, private sector banks would increase the cost of borrowing for individuals and companies for both short and long term. Individuals and businesses then borrow less, asset prices fall because the discount rate for future cash flows rise.

Question 19

What is the best approach to control inflation and thereby maintain price stability?

Answer 19

Inflation-targeting frameworks.

Target a certain level of inflation and ensure this target was met by monitoring a wide range of monetary, financial and real economic variables.

Question 20

What are the three key concepts of inflation-targeting frameworks?

Answer 20

Central bank independence
Credibility
Transparency

Question 21

Why is central bank independence important for inflation-targeting?

Answer 21

With political dependence, there is a risk of keeping the rates too low in order to be elected. This might lead to higher inflation. Therefore, central bank independence, remote from electoral process, is believed to be important in this process.

Question 22

Complete central bank independence is desirable but not feasible, since important seats are still to be chosen by the president.

Question 23

What does a target independent central bank mean?

Answer 23

Central bank decides on interest rates but also inflation target.

Question 24

Why is credibility essential for central banks and their targets?

Answer 24

Central banks, their targets and their plans need to be credible, without a second agenda. When everyone believes the plans are credible, it is a self-fulfilling prophecy because businesses built the expectations into wage claims and other contracts.

Question 25

What is a good way for central banks to create credibility?

Answer 25

Transparency in the decision-making by making inflation reports

Question 26

How are inflation targets often set?

Answer 26

Central banks are to keep inflation between a range of 1% and -1% of the target based on a Consumer Price Index (CPI)

Question 27

What is the Consumer Price Index?

Answer 27

Measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

Question 28

Why are inflation targets never 0%?

Answer 28

An inflation target of 0% could result in negative inflation (deflation).

Question 29

Why is deflation bad?

Answer 29

It can lead to delayed spending, increased debt burden, lower profits, higher unemployment etc.

Question 30

Why does inflation targeting usually focus on inflation two years ahead?

Answer 30

Because an inflation rate is lagging, it is about history. Also, interest changes made today will take some time to have their full effect on the real economy.

Question 31

What are the four important features of an inflation-targeting framework?

Answer 31

Independent and credible central bank. Commitment to transparency. Decision-making framework that considers wide range of economic and financial market indicators. Clear, symmetric, and forward-looking medium-term inflation target, sufficiently above 0 percent to avoid the risk of deflation but low enough to ensure a significant degree of price stability.

Question 32

Which two central banks have not adopted the formal inflation target?

Answer 32

Bank of Japan US Federal Reserve System

Question 33

How does the Bank of Japan handle inflation?

Answer 33

No explicit target of inflation. They are consistently battling deflation and therefore, inflation-targeting would be not correct. However, economists argue that inflation-targeting would be appropriate because of its self-fulfilling prophecy. However, this may be a weak effect since the BoJ does not have a lot of credibility.

Question 34

Why doesn't the FED have an explicit inflation target?

Answer 34

Because they argue that a sole focus on inflation might compromise the goal of maximum employment.

Question 35

What are challenges for monetary policy in developing countries?

Answer 35

The absence of a sufficiently liquid government bond market and developed interbank market through which monetary policy can be conducted. Rapidly changing economy, making it difficult to understand what the neutral rate might be. Rapid financial innovation that frequently changes the definition of the money supply. Poor track record in controlling inflation in the past, making monetary policy intentions less credible. Unwillingness of governments to grant genuine independence to central bank.

Question 36

What approach do developing countries use instead of setting an inflation target?

Answer 36

Setting a target for their currency's exchange rate

Question 37

How does exchange rate targeting work?

Answer 37

Setting a fixed level or band of values for the exchange rate against a major currency, with the central bank supporting the target by buying and selling the national currency in foreign exchange markets.

Question 38

What is the huge disadvantage of targeting exchange rates?

Answer 38

When the central bank chooses to target an exchange rate, interest rates and conditions in the domestic economy must adapt to accommodate this target and domestic interest rates and money supply can become more volatile,

Question 39

How does exchange rate targeting work?

Answer 39

Under exchange rate targeting, a central bank sets a fixed or semi-fixed exchange rate for its currency against another currency or a basket of currencies. The central bank actively intervenes in foreign exchange markets to maintain the target exchange rate by buying or selling its own currency. If the domestic currency depreciates (falls below target), the central bank buys its own currency using foreign reserves. If the domestic currency appreciates, the central bank sells its currency and accumulates foreign reserves. Interest rates are adjusted to keep the exchange rate stable, rather than focusing directly on domestic inflation. Higher interest rate attracts foreign investors and vice versa!

Question 40

Most central banks will adjust liquidity conditions by adjusting their official policy rate!

Question 41

What will a central bank do with interest rates when inflation is rising?

Answer 41

Increase interest rates to reduce liquidity (contractionary approach)

Question 42

Cutting official rates is expansionary policy!

Question 43

When are policy rates high or low?

Answer 43

We use the neutral rate of interest as benchmark.

Question 44

What is the neutral rate of interest?

Answer 44

The rate of interest that neither spurs on nor slows down the underlying economy. Therefore, when the policy rates are below the neutral rate, monetary policy is expansionary and vice versa.

Question 45

What are the two components of the neutral rate of interest?

Answer 45

Real trend rate of growth of underlying economy and long-run expected inflation (inflation target)

Question 46

What are two potential reasons for a shock in inflation?

Answer 46

Demand shock, increase in customer and business confidence which increases consumption. Supply shock, increase in prices.

Question 47

There are different monetary approaches for demand and supply shocks!

Question 48

What are bond market vigilantes?

Answer 48

Bond market participants who might reduce their demand for long-term bonds, thus pushing up their yields, if they believe that the monetary authority is losing its grip on inflation.

Question 49

What is the liquidity trap?

Answer 49

Occurs when interest rates are near zero, and monetary policy (cutting rates or increasing money supply) fails to stimulate the economy. Consumers and businesses hoard cash instead of spending or investing, leading to stagnant growth and deflation.

Question 50

Why is it difficult to handle deflation?

Answer 50

Because monetary policy is less influential in that circumstance since you cannot cut back interest rates below zero. This can lead to a liquidity trap. The falling of prices may incentivize customers to delay spending.

Question 51

What is a solution for handling deflation?

Answer 51

Quantitative easing (QE)

Question 52

What is quantitative easing?

Answer 52

Quantitative easing (QE) is a monetary policy where a central bank buys long-term assets (like government bonds) to inject money into the economy, lower interest rates, and encourage lending and investment when conventional rate cuts are ineffective.

Question 53

What are gilts?

Answer 53

UK bonds

Question 54

The impact of monetary policy on aggregate demand may differ depending on fiscal policy stance.

Question 55

What happens when there is easy monetary policy and easy fiscal policy?

Answer 55

Very expansionary