Deck 14: Monetary Policy

Question 1

Use the following news clip to work the Problems.
Sorry Ben, You Don't Control Long-Term Rates
Perhaps Ben Bernanke didn't learn in school that long-term interest rates are set by the market, but he is about to learn this lesson. Long-term interest rates cannot be manipulated lower by the central bank for a great length of time.
a. Is it the long-term nominal interest rate or the long-term real interest rate that influences spending decisionsExplain why.
b. How does the market determine the long-term nominal interest rate and why doesn't it move as much as the short-term interest rates?

Answer 1

(a) Demand and supply in the market for both loanable funds determine the long-term interest rate, which equals the long-term nominal interest rate minus the expected inflation rate. It is the long-term real interest rate, which influences the decision.
A fall in the federal funds rate that increases the supply of bank loans increases the supply of loanable funds and lowers the equilibrium real interest rate. Thus, government spending has increased. A rise in the federal funds rate that increases the supply of bank loans decreases the supply of loanable funds and raises the equilibrium real interest rate. Thus, government spending has decreased.
(b) The nominal interest rate equals the real interest rate plus the inflation rate. With stable prices, the nominal interest rate is close to the real interest rate and most of the time this rate is likely to be moderate.
The long term interest rates fluctuates less than the short term rates because it is influenced by expectation about future short term interest rates as well as current short term interest rates. The alternative to borrowing or lending long term is to borrow or lend using a sequence of short-term securities. If the long-term interest rates exceed the expected average of future short-term interest rates, people will lend long term and borrow short term. The long-term interest rates will fall.
If the long-term interest rates are below the expected average of future short term interest rates, people will borrow long term and lend short term. The long-term interest rates will rise.

Question 2

Monetary Policy Objectives and Framework
Use the following information to work the Problems.
The Fed's mandated policy goals are "maximum employment, stable prices, and moderate long-term interest rates."
Explain the conflict among these goals in the short run.

Answer 2

The conflict among these goals in the short run is, the Fed faces a trade-off between inflation and interest rates and between inflation and real GDP, employment, and unemployment. Taking an action that is designed to lower the inflation rate and achieve stable prices might mean raising interest rates, which lowers employment and real GDP and increases the unemployment rate in the short run.

Question 3

Use the following information to work the Problems.
From 2009 through 2012, the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent to 2 percent. During that same period, the federal funds rate was roughly constant at 0.25 percent a year.
What do you think happened to inflation expectations between 2009 and 2012 and why?

Answer 3

Expected rate of inflation:
The real interest rate is an inflation free interest rate. Inflation rate is deducting from nominal interest rate to measure real interest rate.
During the period 2009 to 2012, the long-term real interest rate reduced from 4 percent to 2 percent. Whereas, the federal fund rate (nominal interest rate) was constant at 0.25 percent. Since the nominal interest rate is constant and real interest has fallen, the rate of inflation might have increased.
Moreover, increase in money supply and loanable funds will increase the aggregate demand. Hence, the rate of inflation is expected to be higher.

Question 4

Use the following news clip to work the Problems.
Euro Reaches Seven-Week High vs. Dollar
The euro extended its rally against the dollar for a fourth session, rising to a seven-week high as mounting expectations for Federal Reserve easing weighed on the dollar.
How does Fed easing strengthen the euro and weaken the dollar and how does a fall in the dollar exchange rate influence monetary policy transmission?

Question 5

Monetary Policy Objectives and Framework
Use the following information to work the Problems.
The Fed's mandated policy goals are "maximum employment, stable prices, and moderate long-term interest rates."
Based on the performance of U.S. inflation and unemployment, which of the Fed's goals appears to have taken priority since 2000?

Question 6

Dollar Reaches New Low vs. Yen
Traders continued to make bets in favor of the yen, sending the dollar to a record low against the Japanese currency.
a. How do "bets in favor of the yen" influence the exchange rate?
b. How does the Fed's monetary policy influence the exchange rate?

Question 7

Use the following news clip to work the Problems.
Euro Reaches Seven-Week High vs. Dollar
The euro extended its rally against the dollar for a fourth session, rising to a seven-week high as mounting expectations for Federal Reserve easing weighed on the dollar.
Would a fall in the exchange rate mainly influence unemployment or inflation?

Question 8

What is the core inflation rate and why does the Fed regard it as a better measure on which to focus than the CPI?

Question 9

Monetary Policy Transmission
Use the following news clip to work the Problems.
Top Economist says America Could Plunge into Recession
Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the United States would be plunged into a Japan-style slump, with house prices declining for years.
If the Fed had agreed with Robert Shiller in December 2007, what actions might it have taken differently from those it did takeHow could monetary policy prevent house prices from falling?

Question 10

Use the following news clip to work the Problems.
Business Investment Flat
Business investment in the second quarter of 2012 was $1,483 billion, $97 billion less than in 2008.
Explain the effects of the Fed's low interest rates on business investment. Draw a graph to illustrate your explanation.

Question 11

Monetary Policy Objectives and Framework
Suppose Congress decided to strip the Fed of its monetary policy independence and legislate interest rate changes. How would you expect the policy choices to changeWhich arrangement would most likely provide price stability?

Question 12

Monetary Policy Transmission
Use the following news clip to work the Problems.
Top Economist says America Could Plunge into Recession
Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the United States would be plunged into a Japan-style slump, with house prices declining for years.
Describe the time lags in the response of output and inflation to the policy actions you have prescribed.

Question 13

Use the following news clip to work the Problems.
Business Investment Flat
Business investment in the second quarter of 2012 was $1,483 billion, $97 billion less than in 2008.
Explain the effects of business investment on aggregate demand. Would you expect it to have a multiplier effectWhy or why not?

Question 14

Use the following CBO report to work the Problems.
Fiscal 2012 Deficit: Smaller, But Still Big
The budget deficit was about $1.1 trillion in fiscal year 2012, CBO estimates. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II.
How does the federal government get funds to cover its budget deficitHow does financing the budget deficit affect the Fed's monetary policy?

Question 15

Monetary Policy Transmission
Use the following news clip to work the Problems.
Greenspan Says Economy Strong
The central bank chairman said inflation was low, consumer spending had held up well through the downturn, housing-market strength was likely to continue, and businesses appeared to have unloaded their glut of inventories, setting the stage for a rebound in production.
What monetary policy actions had the Fed taken in the year before Alan Greenspan's optimistic assessment?

Question 16

Use the following news clip to work the Problems.
Business Investment Flat
Business investment in the second quarter of 2012 was $1,483 billion, $97 billion less than in 2008.
What actions might the Fed take to stimulate business investment further?

Question 17

Use the following CBO report to work the Problems.
Fiscal 2012 Deficit: Smaller, But Still Big
The budget deficit was about $1.1 trillion in fiscal year 2012, CBO estimates. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II.
How was the budget deficit of 2012 influenced by the Fed's low interest rate policy?

Question 18

Monetary Policy Transmission
Use the following news clip to work the Problems.
Greenspan Says Economy Strong
The central bank chairman said inflation was low, consumer spending had held up well through the downturn, housing-market strength was likely to continue, and businesses appeared to have unloaded their glut of inventories, setting the stage for a rebound in production.
What monetary policy actions would you expect the Fed to take in the situation described by Alan Greenspan?

Question 19

"Unemployment is a more serious economic problem than inflation and it should be the focus of the Fed's monetary policy." Evaluate this statement and explain why the Fed's primary policy goal is price stability.

Question 20

Use the following news clip to work the Problems.
IMF Warns Global Economic Slowdown Deepens, Prods U.S., Europe
The IMF said the global economic slowdown is worsening and warned U.S. and European policymakers that failure to fix their economic ills would prolong the slump.
If the IMF forecasts turn out to be correct, what would most likely happen to the output gap and unemployment in 2013?

Question 21

Use the following CBO report to work the Problems.
Fiscal 2012 Deficit: Smaller, But Still Big
The budget deficit was about $1.1 trillion in fiscal year 2012, CBO estimates. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II.
a. How would the budget deficit change in 2013 and 2014 if the Fed moved interest rates up?
b. How would the budget deficit change in 2013 and 2014 if the Fed's monetary policy led to a rapid depreciation of the dollar?

Question 22

Philly Fed's Plosser Opposes QE3
Federal Reserve Bank of Philadelphia president Charles Plosser does not think that monetary policy can "do much to speed up the slow progress" in the labor market and opposes the Fed's latest round of stimulus, known as QE3, saying he does not think it prudent to risk the Fed's hard-won credibility.
a. Describe the QE3 asset purchases that are causing Charles Plosser concern.
b. How might asset purchases damage the Fed's credibility?

Question 23

"Because the core inflation rate excludes the prices of food and fuel, the Fed should pay no attention to it and should instead be concerned about the CPI inflation rate." Explain why the Fed regards the core inflation rate as a good measure on which to focus.

Question 24

Use the following news clip to work the Problems.
IMF Warns Global Economic Slowdown Deepens, Prods U.S., Europe
The IMF said the global economic slowdown is worsening and warned U.S. and European policymakers that failure to fix their economic ills would prolong the slump.
a. What actions that the Fed had taken in 2011 and 2012 would you expect to influence U.S. real GDP growth in 2013Explain how those policy actions would transmit to real GDP.
b. Draw a graph of aggregate demand and aggregate supply to illustrate your answer to part (a).

Question 25

Monetary Policy Objectives and Framework
The Federal Reserve Act of 2000 instructs the Fed to pursue its goals by "maintain[ing] long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production."
a. Has the Fed followed this instruction?
b. Why might the Fed increase money by more than the potential to increase production?

Question 26

Suppose that the Reserve Bank of New Zealand is following the Taylor rule. In 2012, it sets the official cash rate (its equivalent of the federal funds rate) at 4 percent a year. If the inflation rate in New Zealand is 2 percent a year, what is its output gap?

Question 27

"Monetary policy is too important to be left to the Fed. The President should be responsible for it." How is responsibility for monetary policy allocated among the Fed, the Congress, and the President?

Question 28

Use the following news clip to work the Problems.
IMF Warns Global Economic Slowdown Deepens, Prods U.S., Europe
The IMF said the global economic slowdown is worsening and warned U.S. and European policymakers that failure to fix their economic ills would prolong the slump.
What further actions might the Fed take in 2013 to influence the real GDP growth rate in 2013(Remember the time lags in the operation of monetary policy.)

Question 29

The Conduct of Monetary Policy
Looking at the federal funds rate since 2000, identify periods during which, with the benefit of hindsight, the rate might have been kept too low. Identify periods during which it might have been too high.

Question 30

After you have studied Reading Between the Lines on pp. 366-367, answer the following questions.
a. What was the state of the U.S. economy in the fall of 2011 when the Fed made the decision to undertake operation twist?
b. What was the Fed's expectation about future employment, real GDP growth, and inflation at the time of the news article
c. How would operation twist influence the markets for short-term and long-term loanable funds, and aggregate demand
d. Would you expect the effects on real GDP and the price level to be immediate or spread over a number of months and even yearsWhy

Question 31

Bernanke Warns of High Budget Deficits
The government must rein in budget deficits in the years ahead, Federal Reserve Chairman Ben S. Bernanke told Congress.
a. Does the Fed Chairman have either authority or responsibility for federal budget deficits?
b. How might a federal budget deficit complicate the Fed's monetary policy(Hint: Think about the effects of a deficit on interest rates.)
c. How might the Fed's monetary policy complicate Congress's deficit cutting(Hint: Think about the effects of monetary policy on interest rates.)

Question 32

Use the following news clip to work the Problems.
Dollar Under Pressure Amid QE2 Speculation
Persistent speculation that the Federal Reserve would soon embark on a fresh program of long-term asset purchases-a second round of quantitative easing or QE2-kept the dollar under pressure in the foreign exchange market ahead of crucial U.S. employment data.
What is the connection between actions that the Fed might take and U.S. employment data?

Question 33

Now that the Fed has created $3 trillion of bank reserves, how would you expect a further open market purchase of securities to influence the federal funds rateWhyIllustrate your answer with an appropriate graph.

Question 34

Fed's Evans: Offers Full Support for New Stimulus
Federal Reserve Bank of Chicago President Charles Evans expressed strong support for the new stimulus provided by the central bank saying, "This was the time to act" and adding, "I am optimistic that we can achieve better outcomes through more monetary policy accommodation."
a. Why, in the economic conditions of September 2012, was Charles Evans happy to see the Fed stimulating the economy?
b. What would be the effects of the Fed's QE3 and other stimulative actionsExplain the immediate effects and the ripple effects.
c. What are the risks arising from greater monetary stimulus

Question 35

What are the two possible monetary policy instruments, which one does the Fed use, and how has its value behaved since 2000?

Question 36

Use the following news clip to work the Problems.
Dollar Under Pressure Amid QE2 Speculation
Persistent speculation that the Federal Reserve would soon embark on a fresh program of long-term asset purchases-a second round of quantitative easing or QE2-kept the dollar under pressure in the foreign exchange market ahead of crucial U.S. employment data.
What does the news clip mean by "the dollar under pressure"?

Question 37

The Conduct of Monetary Policy
What is the Beige Book and what role does it play in the Fed's monetary policy decision-making process?

Question 38

How does the Fed hit its federal funds rate targetIllustrate your answer with an appropriate graph.

Question 39

Use the following news clip to work the Problems.
Dollar Under Pressure Amid QE2 Speculation
Persistent speculation that the Federal Reserve would soon embark on a fresh program of long-term asset purchases-a second round of quantitative easing or QE2-kept the dollar under pressure in the foreign exchange market ahead of crucial U.S. employment data.
Why was the Fed contemplating QE2What were the arguments for and against further quantitative easing in the fall of 2010?

Question 40

To work the Problems, use the information that during 2012 the inflation rate increased but remained in the "comfort zone" and the unemployment rate remained high.
Explain the dilemma that rising inflation and high unemployment poses for the Fed.

Question 41

What does the Fed do to determine whether the federal funds rate should be raised, lowered, or left unchanged?

Question 42

Prospects Rise for Fed Easing Policy
William Dudley, president of the New York Fed, raised the prospect of the Fed becoming more explicit about its inflation goal to "help anchor inflation expectations at the desired rate."
a. What monetary policy strategy is Mr Dudley raising?
b. How does inflation rate targeting work and why might it "help anchor inflation expectations at the desired rate"?

Question 43

To work the Problems, use the information that during 2012 the inflation rate increased but remained in the "comfort zone" and the unemployment rate remained high.
Why might the Fed decide to try to lower inter-est rates (or stimulate in other ways) in this situation?

Question 44

Use the following news clip to work the Problems.
Fed Sees Unemployment and Inflation Rising
It is May 2008 and the Fed is confronted with a rising unemployment rate and rising inflation.
Explain the dilemma faced by the Fed in May 2008.

Question 45

Suppose that the Fed had followed the Taylor rule before the financial crisis of 2008. In the first quarter of 2007, the inflation rate was 2.5 percent a year and the output gap was zero. At what level would the Fed have set the federal funds rate targetThe actual federal funds rate target was 5.25 percent a year. Was the Fed restraining aggregate demand by too much or too little?

Question 46

To work the Problems, use the information that during 2012 the inflation rate increased but remained in the "comfort zone" and the unemployment rate remained high.
Why might the Fed decide to raise interest rates in this situation?

Question 47

Use the following news clip to work the Problems.
Fed Sees Unemployment and Inflation Rising
It is May 2008 and the Fed is confronted with a rising unemployment rate and rising inflation.
a. Why might the Fed decide to cut the interest rate in the months after May 2008?
b. Why might the Fed have decided to raise the interest rate in the months after May 2008?

Question 48

Suppose that the FOMC had followed the Taylor rule starting in 2000.
a. How would the federal funds rate have differed from its actual path?
b. How would real GDP and the inflation rate have been different

Question 49

Use the following information to work the Problems.
From 2009 through 2012, the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent to 2 percent. During that same period, the federal funds rate was roughly constant at 0.25 percent a year.
What role does the long-term real interest rate play in the monetary policy transmission process?

Question 50

Use the following news clip to work the Problems.
Sorry Ben, You Don't Control Long-Term Rates
Perhaps Ben Bernanke didn't learn in school that long-term interest rates are set by the market, but he is about to learn this lesson. Long-term interest rates cannot be manipulated lower by the central bank for a great length of time.
What is the role of the long-term interest rate in the monetary policy transmission process?

Question 51

Monetary Policy Objectives and Framework
Use the following information to work the Problems.
The Fed's mandated policy goals are "maximum employment, stable prices, and moderate long-term interest rates."
Explain the harmony among these goals in the long run.

Question 52

Use the following information to work the Problems.
From 2009 through 2012, the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent to 2 percent. During that same period, the federal funds rate was roughly constant at 0.25 percent a year.
How does the federal funds rate influence the long-term real interest rate?