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Quiz 17 :

Rules for Monetary Policy

Quiz 17 :

Rules for Monetary Policy

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What is an expectations trap? If people thought that the central bank was likely to raise the infl ation rate to 3 percent from 2 percent, how might that lead to an expectations trap?
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img The expectation trap refers to the high inflationary stage of economy as a result of people's expectations about monetary policy. If people think that Fed will cut its fund rate then there will be possibility of higher inflation rate as a result of it. And due to this high inflation rate people will expect a long term tight monetary policy with higher interest rate. And it will lead to a slow growing economy in the long run. Hence in order to cope with this expectation related issues at present Fed will cut its fund rate and this will lead a higher level of inflation rate. This phenomenon is precisely termed as expectation trap.
If people thought that Fed was going to raise inflation rate from 2 % to 3% then they will expect in future Fed will follow a tight monetary policy with a higher interest rate. And hence correspondingly the economy will enter into a slow growth path in future. Hence to combat this gloomy expectation situations Fed has to react and then Fed would cut its fund rate and inflation will rise.

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Describe the idea of time inconsistency in general terms. How can the problem be prevented?
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img Time inconsistency refers to the issue of changing policy over time by the Fed. Usually one policy apparently seems to be an optimal policy for the Fed in one time afterward Fed usually deviate from that policy. For example suppose if Fed announces that it would like to maintain a constant price level. Hence worker and owners may believe Fed and would agree to maintain a negotiated wage level. But in that case if Fed conduct monetary easing then it the monetary value of the output would rise and real wage would fall. And more workers can be hired and output growth may increase. So this is time inconsistency.
The problem of this can be solved if Fed remains its stance intact about monetary policy. It implies that if Fed announces a constant level of price and it follows it over time then price level would not be affected by monetary policy and the problem of time inconsistency can be addressed.

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How can the central bank establish credibility for keeping inflation low?
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img There are largely two ways to ensure credibility of Fed's policy such that it does not become time inconsistent. One way to make it is that if Fed put higher importance about maintaining low inflation rather than focusing on output growth. Largely Fed under politician's influence before election usually ease monetary policy to boost output growth. Hence one way to maintain Fed's credibility is to maintain its independence from politician's influence. Empirically it has been found that the countries where Fed enjoys more independence use to experience lesser time inconsistency problem. And those countries experience a lower inflation level.
Also another way to maintain credibility of Fed is to choose very conservative people as governors of Fed such that it does not follow too much discretion in formulating monetary policy.

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Why have rules for monetary policy based on money growth been unsuccessful in recent years?
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Describe how activist rules differ from nonactivist rules. Give an example of each
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On average, would inflation over the last 45 years have been higher or lower if the Fed had followed the Taylor rule? In what periods would monetary policy have been tighter? When would it have been easier?
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Does an inflation-targeting country follow a particular rule for monetary policy, such as the Taylor rule?
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Describe New Zealand's approach to inflation targeting. What are the advantages and disadvantages of that system?
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Why is the inflation report such an important part of an inflation-targeting system?
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Why don't policymakers want to adopt rules for monetary policy?
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Suppose that the Fed's inflation target is 2 percent, potential output growth is 3.5 percent, and velocity is a function of how much the interest rate differs from 5 percent: img Suppose that a model of the economy suggests that the real interest rate is determined by the equation img where Y is the level of output, so %? Y is the growth rate of output. Suppose that people expect the Fed to hit its inflation target. a Calculate the optimal money growth rate needed for the Fed to hit its inflation target in the long run. b In the short run, if output growth is just 2 percent for two years and the equation determining the real interest rate changes to r = 4.5 - %? Y , what money growth rate should the Fed aim for to hit its inflation target in that period? c If the Fed instead maintained the money growth rate from part a, what is likely to happen to inflation? d Which policy do you think is better in the short run? Which is better in the long run?
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Suppose that the economy is thought to be 3 percent below potential when potential output grows 3.5 percent per year. Suppose that the Fed is following the Taylor rule (with the equilibrium real federal funds rate assumed to be 2 percent and the weights on the inflation gap and output gap both equal to ½). The inflation rate was 3 percent over the past year. The federal funds rate is currently 4 percent. a What is the Fed's target for the inflation rate? b Suppose that a year has gone by, output is now just 1 percent below potential, and the inflation rate was 2.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)?
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Suppose that the economy is thought to be 2 percent above potential (that is, the output gap is 2 percent) when potential output grows 4 percent per year. Suppose also that the Fed is following the Taylor rule, with an inflation rate of 2 percent over the past year. The federal funds rate is currently 3 percent. The equilibrium real federal funds rate is 3 percent, and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 1 percent. a Is the federal funds rate currently too high or too low? By how much? Show your work. b Suppose that a year has gone by, output is now just 1 percent above potential, and the inflation rate was 1.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)?
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What would have happened to the money supply in the United States in the 1990s if the Federal Reserve had adhered to a policy of targeting monetary base growth of 3 percent each year regardless of the demand for currency? Note that currency growth averaged 5 percent each year in that period largely owing to the demand from abroad.
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Looking at the historical record for the Taylor rule, were there any periods when the rule gave bad advice? That is, are there periods when the rule would have tightened policy in the face of weak economic growth or periods when the rule would have eased policy even though inflation was rising?
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In some macroeconomic models, the equilibrium real federal funds rate changes percentage point for percentage point with the growth rate of output. If the Fed believed such models and was following the Taylor rule, how would the Fed need to adjust its rule in the "new economy" of the second half of the 1990s as productivity growth increased?
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Would it make sense for a central bank to try inflation targeting by using the Taylor rule? What problems might the central bank encounter in trying to do so?
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