Topic 7 unconventional monetary policy

Question 1

What is unconventional monetary policy?

Answer 1

A set of monetary policy tools used when traditional methods are ineffective.

Question 2

List three types of unconventional monetary policy tools.

Answer 2

• Quantitative easing
• Forward guidance
• Negative interest rates

Question 3

What is quantitative easing?

Answer 3

A monetary policy where a central bank purchases government securities to increase money supply.

Question 4

True or False: Forward guidance is a method to influence expectations about future interest rates.

Answer 4

True

Question 5

Fill in the blank: _______ involves lowering interest rates below zero to encourage borrowing and spending.

Answer 5

[Negative interest rates]

Question 6

What is the primary goal of unconventional monetary policy?

Answer 6

To stimulate economic growth during periods of low inflation or recession.

Question 7

True or False: Unconventional monetary policy is used only during times of economic stability.

Answer 7

False

Question 8

What can be a potential risk of quantitative easing?

Answer 8

Asset bubbles and increased inflation.

Question 9

What does forward guidance typically communicate?

Answer 9

The central bank’s future plans regarding interest rates.

Question 10

Fill in the blank: Unconventional monetary policy became more prevalent after the _______ financial crisis.

Answer 10

[2008]

Question 11

What is the effect of negative interest rates on bank reserves?

Answer 11

Banks are charged for holding excess reserves, incentivizing lending.

Question 12

List two potential benefits of unconventional monetary policy.

Answer 12

• Increased liquidity in the economy
• Lower borrowing costs for consumers and businesses

Question 13

What is a primary concern regarding the long-term use of unconventional monetary policy?

Answer 13

The potential for financial instability.

Question 14

What is the IR lower bound and the issues with it

Answer 14

Nominal IR are subject to a lower bound as physical cash guarantees a zero nominal return.

so experiment with ‘forward guidance’ and QE

FG: shifts expectations of future short term IR

QE: buy risky assets

Question 15

Consequences of IR lower bound for MP

Answer 15

• Cannot satisfy Taylor principle if economy faces severe deflation
• Cannot offset negative demand shocks if r * is too low to move i down

Question 16

Draw the IR lower bound and the impact of a large shock to the economy

Answer 16

Question 17

WHy use FG

Answer 17

Expectations theory ( I = (i + i’e)/2)

change i’e through FG

Question 18

Challenges of FG

Answer 18

Has to be credible, but:

• CB may have to convince people it will keep MP too loose given future conditions (time inconsistency)
• May also damage confidence if interpreted as saying economy is in worse condition than previously

Question 19

what are assumptons of the portfolio choice model

Answer 19

Safe asset with risk-free real return r1. Prob of t1

Risky asset with uncertain real return r2. Prob of t1

r2 > r1

Fraction x of funds to allocate t safe asset and 1-x to risky asset

wealth = 1

Question 20

WHat are the investment proceeds consumed in c1 and c2 given the assumptions

Answer 20

C1 = 1 + rfx + r1(1-x)

c2 = 1 + rfx + r2(1-x)

Question 21

Draw the indifference curve of risk averse investors

Answer 21

Question 22

What are the investors budget constraint

Answer 22

If choose axes, you get intercepts of:

x=1 –> (c1,c2) = (1 + rf, 1 + rf), on the no risk line (c2=c1)

x=0 –> (c1, c2) = (1 + r1, 1 + r2), lies above no risk line as r1>r2

choosing values of 0 < x < 1 get any (c1,c2) on straight line joining intercepts - (1 + r1, 1 + r2) and (1 + rf, 1 + rf)

Question 23

Draw the optimal portfolio choice

Answer 23

optimal point at tangency point of budget constraint and indifference curve

Question 24

what determines if risky asset held

Answer 24

Question 25

Impact of QE purchases on risky assets

Answer 25

In equilibrium: purchases of risky assets --> private investors hold a smaller fraction of risky assets and a larger fraction of risk free results in lower bond risk premium would reduce long term IR Higher asset prices boost collateral values, so easier to borrow

Question 26

What is the impact of the prices of risky assets going up

Answer 26

Future returns r1 and r2 fall --> gradient of budget constraint declines in portfolio choice diagram Investors substitute away from risky towards safe assets (SE dominating IE) Smaller reward for bearing risk --> safe asset share rises

Question 27

Draw the impact of lower expected risky assets

Answer 27

Question 28

Draw the portfolio balance effect

Answer 28

CB purchase of risky assets --> reduced supply of risky assets --> higher risky asset price --> declined risk premium --> QE transfers risk from private investors' portfolio to CB payment with reserves --> more risk free assets

Question 29

Critique of portfolio balance effect

Answer 29

Risk of CB ultimately borne by taxpayers --> Ricardian Equivalence

Question 30

Benefit of a higher inflation target?

Answer 30

Lower bound on nominal IR reduces power of MP Higher π * implies higher nominal i on average as π ' e = π * : i = r * + π * more room to lower i, real interest rate can be reduced to -π *

Question 31

Benefits of average inflation targetting instead of standard

Answer 31

Target based on rates averaged over a number of years - expected average of π and π' to be stable - if π falls because of a negative demand shock, expect higher π' value in future - higher π'e reduces real IR and boosts demand now

Question 32

Alternatve targets instead of inflation

Answer 32

* Price level targeting --> if credible lower inflation now causes expectation of future inflation to rise * Target for level of nominal GDP --> if credible, low inflation and recession now means an increase in expectations of future inflation or future real GDP