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Quiz 16 :

Monetary Policy: Goals and Tradeoffs

Quiz 16 :

Monetary Policy: Goals and Tradeoffs

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What is the main goal of stabilization policy? If successful, what does stabilization policy do?
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The main goal of stabilization policy is to smooth out the business cycle, reducing output during economic expansions and increasing output during recessions.
If the Fed were able to use stabilization policy to perfectly smooth out the business cycle, then output would line-up with its trend and the business cycle would be eliminated. However, most likely the cycle can be smoothed only imperfectly.
With stabilizing policy, recessions would not be as deep, output would not decline as much, and the unemployment rate would not rise as high as it would with neutral policy. With stabilizing policy expansions would not be as strong, output would not rise as much, and inflation would not increase as high as it would with neutral policy.
This result is achievable if the private sector has difficulty adjusting to changes in the growth rate of output. In that case, in the face of some shock to the economy, the Fed may be able to use monetary policy to offset the shock because the private sector is not very adaptable.

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Why might stabilization policy lead to an outcome that is worse than if the Fed used neutral monetary policy?
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The Fed uses the monetary policy as a tool to correct any imbalances that arises in the economy. This is sometimes called the stabilization policy. The main objective is to keep the GDP growth close to its trend line. This will eliminate the business cycle and thus the recession. However, it is only theoretically possible.
If the Fed can achieve the right monetary policy it can eliminate the business cycle. However, the monetary policy can be destabilizing in marginal cases. This can occur due to the various lags that associated with the monetary policy. Due to the policy lags the monetary policy can be implemented at the wrong time. That is, it might happen that the Fed takes a tighter policy in the time of recession. This leads to a situation called destabilization policy. In this situation, the fall of output is greater in the recession than it would have been under neutral policy.

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Describe the major goals of the Fed and how well they have been achieved in the past 20 years.
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The Fed uses monetary policy to achieve three major goals: maximize output, decreasing unemployment, and stabilizing inflation rate. In case of affecting the output, the Fed can influence it in the short run but it depends on many other factors such as total factor productivity and growth in labor force. The output growth was stable during 60s, 70s, and 80s. The biggest fall in output is marked by the 2008 recession.
The next goal of the Fed is to keep unemployment rate low. The unemployment rate is correlated with the output growth, higher the output growth, lower the unemployment rate. However, even if the economy produces the potential output the unemployment rate remains low but never eliminated. The unemployment rate that exists when the economy performs at potential output is called the natural rate of employment. The Fed policy target is to keep unemployment as close to natural rate as possible. Over the last 20 years, the largest increase in unemployment rate was during 2008 recession and it went below 4% (lowest in past 30 years) in 1980s.
The third and trickiest was targeting inflation rate. However, as output and unemployment rate, the Fed cannot solely affect the inflation rate. The inflation can be measured in many different ways, among which the CPI index excluding food and energy prices is a useful indicator of the inflation. In past 20 years, the inflation rate was steady at 2%. The Fed took special care about inflation because it redistribute wealth between borrower and lender, it affect many economic decision including wage negotiation and investment.

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What is the output gap? Is it measured precisely?
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What is the unemployment gap? How is it related to the output gap?
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What is the infl ation gap? What is the ideal infl ation rate? Is there widespread agreement about the value of the ideal infl ation rate?
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Describe the Fed's objective function and how it can be used with an economic model to evaluate alternative monetary policies.
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Why didn't policy based on the Phillips curve work to help the Fed reduce the unemployment rate to a lower level than before? What happened in the 1970s as the Fed tried to take advantage of the tradeoff between infl ation and unemployment?
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What caused the increase in infl ation in the 1960s and 1970s?
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Where is the Phillips curve now compared with its location in the 1970s and 1980s?
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Consider three alternative policies, each with a different set of outcomes in terms of output and infl ation, as shown in the following table: img Potential output is 500 in period 1 and rises 3 percent per year. The Fed's objective function is img where w = 1, and the infl ation target is 2.0 percent. a Calculate the value of the objective function over the fi ve-year period for each of the three policies. b Which policy is best? Why? c Would your answer to part b change if w = 5? Explain.
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The relationship between infl ation and unemployment is given by img a Graph the long-run Phillips curve and three different short-run Phillips curves. b What is the value of the natural rate of unemployment? c If actual infl ation is 2 percent and expected infl ation is 5 percent, what is the unemployment rate? d If actual infl ation is 8 percent and expected infl ation is 5 percent, what is the unemployment rate?
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Policymaking is much easier when the state of the economy is easily observable than when there is uncertainty about how the economy is doing, as this problem illustrates. Suppose that the economy is either in an expansion or a recession. Suppose that in an expansion, monetary policy ideally sets the interest rate on federal funds (loans between banks) at 6 percent, whereas if the economy is in a recession, the federal funds rate is ideally set at 2 percent. If monetary policymakers know the state of the economy when they set policy, then policymaking is easy-set the fed funds rate at 6 percent when in expansion and at 2 percent when in recession. Suppose, however, that policymakers cannot easily observe the current state of the economy. They know only what the state of the economy was three months ago. Suppose that if the economy was in an expansion three months ago, there is a 90 percent chance the economy is still in an expansion (and thus a 10 percent chance that it is now in a recession). And suppose that if the economy was in a recession three months ago, there is a 75 percent chance that it is still in a recession (and a 25 percent chance that it is now in an expansion). Given these probabilities, what would you guess is the right setting for the federal funds rate if the economy was in a recession three months ago? What is the right setting for the federal funds rate if the economy was in an expansion three months ago? ( Note: To answer these questions, you must make an assumption about the ideal federal funds rate when you do not know what the state of the economy is-you may make any reasonable assumption you want, but you must justify it.)
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Why doesn't the Fed simply keep increasing the growth rate of the money supply at faster and faster rates to drive the unemployment rate lower and lower? Wouldn't the gains in terms of faster output growth far exceed the losses from infl ation?
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A new Fed governor argues during FOMC meetings that the Fed has not suffi ciently achieved the goal of helping the economy reach its potential level of output. She asks the committee to be more aggressive, using expansionary monetary policy to increase the growth rate of output. What are the likely consequences of such a policy? Illustrate your answer using the expectationsaugmented Phillips curve.
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Suppose that the members of the FOMC agree about the state of the economy at any time but have widely different views about the weight that should be placed on infl ation in the Fed's objective function. How is monetary policy likely to be determined?
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