Transcript Chapter 32 Checkpoint - Georgia Regents University

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Monetary Policy
33
CHECKPOINTS
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Checkpoint 33.1
Checkpoint 33.2
Checkpoint 33.3
Problem 1
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Problem 1
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Problem 2
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Problem 2
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Problem 3
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Problem 3
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Problem 4
Problem 4
Problem 4
In the news
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CHECKPOINT 33.1
Practice Problem 1
What are the objectives of U.S. monetary policy?
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CHECKPOINT 33.1
Solution
The objectives of U.S. monetary policy are to achieve
stable prices (interpreted at a core inflation rate of 2 percent
a year) and maximum employment (interpreted as full
employment).
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CHECKPOINT 33.1
Study Plan Problem
The objectives of U.S. monetary policy are to achieve ___.
A. maximum employment, stable prices, and moderate
long-term interest rates
B. zero unemployment, predictable prices, and long-term
interest rates that are lower than short-term interest
rates
C. zero unemployment, stable prices, and moderate
long-term interest rates
D. maximum employment, predictable prices, and shortterm interest rates that are lower than long-term
interest rates.
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CHECKPOINT 33.1
Practice Problem 2
What is core inflation and how does it differ from total
PCE inflation?
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CHECKPOINT 33.1
Solution
Core inflation excludes the changes in the prices of food
and fuel.
The total PCE inflation rate includes the changes in all
consumer prices.
The core inflation rate fluctuates less than the total PCE
inflation rate.
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CHECKPOINT 33.1
Study Plan Problem
The core inflation rate is the annual percentage change
in the _____. The core inflation rate fluctuates _____
than the total PCE inflation rate.
A. Personal Consumption Expenditure deflator excluding
the prices of food and fuel; more
B. Personal Consumption Expenditure deflator excluding
the prices of food and fuel; less
C. Personal Consumption Expenditure deflator excluding
the prices of food, fuel, and housing; less
D. GDP deflator; more
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CHECKPOINT 33.1
Practice Problem 3
What is the Fed’s monetary policy instrument and what
influences the level at which the Fed sets it?
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CHECKPOINT 33.1
Solution
The federal funds rate is the Fed’s monetary policy
instrument .
The inflation rate and output gap are two variables that Fed
tries to influence when it sets the federal funds rate.
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CHECKPOINT 33.1
Study Plan Problem
What is the Fed’s monetary policy instrument, and what
influence the level at which the Fed sets it?
A.
B.
C.
D.
monetary base; nominal GDP and real GDP
quantity of money; the output gap and the inflation rate
federal funds rate; the output gap and the inflation rate
core inflation rate; the unemployment rate and the
long-term interest rate
E. federal funds rate; the quantity of money and the
monetary base
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CHECKPOINT 33.1
Practice Problem 4
The current quantity of reserves
supplied is $20 billion.
The Fed wants to set the federal
funds rate at 4 percent a year.
Illustrate the target on the graph and
show the supply of reserves that will
achieve the target.
Does the Fed conduct an open
market operation and if so, does it
buy or sell securities?
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The demand for bank
reserves, RD.
CHECKPOINT 33.1
Solution
If the initial quantity of reserves
supplied was $20 billion, the federal
funds rate must have been 5 percent
a year at point A.
To set the federal funds rate at 4
percent a year, the Fed must conduct
an open market purchase to increase
the supply of reserves to RS.
The equilibrium federal funds rate
equals the target of 4 percent a year.
CHECKPOINT 33.1
In the news
Can Fed target jobless rate? Bernanke hints at
new policy
With little notice, Bernanke seemed to buck
conventional wisdom and suggest that the Fed can,
and should, try to influence long-term
unemployment.
Source: CNCB, October 10, 2011
Explain whether trying to influence the long-term
unemployment rate is consistent with the Fed’s
monetary policy objectives.
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CHECKPOINT 33.1
Solution
The objectives of monetary policy are maximum
employment and stable prices.
The maximum-employment goal means keeping the
economy as close as possible to potential GDP.
The stable-prices goal means keeping the inflation rate
low.
In 2011, the inflation rate was low but the unemployment
rate and the output gap were high.
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CHECKPOINT 33.1
By focusing on the output gap, the Fed was seeking to reestablish “maximum employment.”
The Fed believed that inflation would remain low, so its
focus was consistent with its monetary policy objectives.
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CHECKPOINT 33.2
Practice Problem 1
List the sequence of events in the transmission from
a rise in the federal funds rate to a change in the
inflation rate.
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CHECKPOINT 33.2
Solution
When the Fed raises the federal funds rate, other shortterm interest rates rise and the exchange rate rises.
The quantity of money and supply of loanable funds
decrease and the long-term real interest rate rises.
Consumption expenditure, investment, and net exports
decrease.
Aggregate demand decreases.
Eventually the real GDP growth rate and the inflation rate
decrease.
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CHECKPOINT 33.2
Practice Problem 2
The economy has slipped into recession and the Fed takes
actions to lessen its severity.
What action does the Fed take?
Illustrate the effects of the Fed’s actions in the money
market and the loanable funds market.
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CHECKPOINT 33.2
Solution
The Fed lowers the federal
funds rate.
When the Fed lowers the
Federal funds rate, other shortterm interest rates fall and the
supply of money increases.
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CHECKPOINT 33.2
The lower federal funds rate
increases the supply of bank
loans, which increases the
supply of loanable funds.
The real interest rate falls.
CHECKPOINT 33.2
Practice Problem 3
The Fed thinks that the economy is about to slip into
recession and takes actions to lessen its severity.
Explain how the Fed’s actions change aggregate demand
and real GDP.
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CHECKPOINT 33.2
Solution
A lower real interest rate (and lower
exchange rate) and a greater
quantity of money and loans
increase aggregate expenditure.
Aggregate demand increases and
the AD curve shifts to AD0 + ∆E.
A multiplier effect increases
aggregate demand and the AD
curve shifts rightward to AD1.
Real GDP increases and recession
is avoided.
CHECKPOINT 33.2
In the news
The Fed’s tricky balancing act
The FOMC was a bit more optimistic about the economy
recovering, but said that policy tightening was not going
to happen any time soon.
Source: Business Week, June 6, 2009
What are the ripple effects and time lags that the Fed
must consider in deciding when to start raising the
federal funds rate?
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CHECKPOINT 33.2
Solution
The figure describes the ripple
effects and the time lags.
The Fed can influence interest
rates quickly, but several
months pass before the quantity
of money and loans respond,
up to a year before expenditure
plans respond, and up to two
years before the inflation rate
responds to the Fed’s interest
rate actions.
CHECKPOINT 33.3
Practice Problem 1
What are the three alternative monetary policy strategies
that the Fed could have adopted?
Why is discretionary monetary policy not one of them?
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CHECKPOINT 33.3
Solution
The Fed could have adopted three alternative monetary
policy strategies:
1 Inflation targeting rule
2 A k-percent monetary targeting rule
3 A nominal GDP targeting rule
A rule-based monetary policy beats discretionary
monetary policy because it provides a more secure
anchor for inflation expectations, which in turn makes
long-term contracting in labor and capital markets more
efficient.
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CHECKPOINT 33.3
Practice Problem 2
Why does the Fed not target the quantity of money?
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CHECKPOINT 33.3
Solution
The Fed does not target the quantity of money
because it believes that the demand for money is too
unstable.
Fluctuations in the demand for money would bring
unwanted fluctuations in interest rates, aggregate
demand, and real GDP and the inflation rate.
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CHECKPOINT 33.3
Study Plan Problem
The Fed does not target the quantity of money
because the Fed believes that _______.
A. it does not have enough control over the quantity of money
because it is the banks that determine the quantity of loans
and deposits.
B. changes in the demand for money would occur, which would
increase the interest rate and slow the growth of aggregate
demand.
C. The quantity of money should be fixed.
D. Technological change in the banking system leads to large
and unpredictable shifts in the demand for money curve,
which makes the use of money targeting unreliable.
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CHECKPOINT 33.3
Practice Problem 3
Which countries practice inflation targeting?
How does inflation targeting work?
Does inflation targeting achieve lower inflation
rates?
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CHECKPOINT 33.3
Solution
The countries that practice inflation targeting are the
United Kingdom, Canada, Australia, New Zealand,
Sweden and the Eurozone (the European countries that
use the euro).
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CHECKPOINT 33.3
Inflation targeting works by
• Announcing a target inflation rate
• Setting the overnight interest rate (equivalent to the
federal funds rate) to achieve the target
• Publishing reports that explain how and why the central
bank believes that its current policy actions will achieve
its ultimate policy goals.
Only Eurozone and New Zealand have missed their inflation
targets, but the others targeters have achieved their targets.
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CHECKPOINT 33.3
In the news
One tool, one goal
The one-tool, one-goal rule by which central banks
operated has gone. Monetary policy is now a
messier business.
Source: The Economist, April 25, 2009
What is the tool and the goal that the news clip
says is gone?
What is the problem with “messy” monetary policy?
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CHECKPOINT 33.3
Solution
The tool is the overnight interest rate (the federal funds
rate in the United States). There never has been one
goal for U.S. monetary policy.
The Fed’s “dual mandate” is low inflation and maximum
employment.
Even the central banks that have a formal inflation target
pay attention to the output gap and unemployment rate.
The problem with “messy” monetary policy is that it might
fail to anchor inflation expectations and lead to a
worsening of the short-run policy tradeoff.
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