Question 1

The Phillips curve describing an economy takes the form u = uⁿ - $\alpha$( $\pi$ - E $\pi$). The central bank directly sets the inflation rate to minimize the following loss function, L(u, $\pi$) = u + $\gamma$ $\pi$². The symbol u denotes the unemployment rates, uⁿ is the natural rate of unemployment, $\pi$ is the inflation rate, E $\pi$ is the expected inflation rate, and $\alpha$ and $\gamma$ are behavioral response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. Compared to making monetary policy with discretion, the optimal inflation rate will be ______ under a fixed rule and the unemployment rate will be ______.

Accepted Answer

The Phillips curve equation suggests that the inflation rate and the unemployment rate are negatively related. However, the loss function shows that the central bank wants to minimize both inflation and unemployment rates simultaneously. Therefore, the central bank needs to find the optimal inflation rate that minimizes the loss function. Under a discretionary policy, the central bank has the flexibility to set the inflation rate based on its judgment. However, under a fixed rule, the central bank has to adhere to a pre-specified policy that is not subject to change based on current economic conditions. Rational private agents will form their expectations based on this fixed rule. If the central bank raises its inflation target, then private agents will increase their expected inflation rate, which will result in an increase in the actual inflation rate and a decrease in the unemployment rate. Conversely, if the central bank lowers its inflation target, private agents will lower their expected inflation rate, which would cause the inflation rate to further decrease, and the unemployment rate to remain constant. Therefore, the optimal inflation rate would be lower under a fixed rule, and the unemployment rate would remain the same.

Question 2

The Phillips curve describing an economy takes the form u = uⁿ - $\alpha$( $\pi$ - E $\pi$). The central bank directly sets the inflation rate to minimize the following loss function, L(u, $\pi$) = u + $\gamma$ $\pi$². The symbol u denotes the unemployment rates, uⁿis the natural rate of unemployment, $\pi$ is the inflation rate, E $\pi$ is the expected inflation rate, and $\alpha$ and$\gamma$ are behavioral response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. The optimal inflation rate when the central bank operates using a fixed rule will be ______. The optimal inflation rate when the central bank operates with discretion will be ______.

Accepted Answer

Given that private agents form their expectations rationally and the central bank aims to minimize the loss function by setting the inflation rate, the optimal inflation rate under discretion (where the central bank can adjust its policy in response to economic conditions) would be different from the fixed rule scenario (where the central bank commits to a predetermined policy). The formula provided in option C, $ \frac{\alpha}{2\gamma} $, suggests a calculation that balances the trade-off between inflation and unemployment, which aligns with the central bank's objective to minimize its loss function. This formula likely derives from setting the derivative of the loss function with respect to inflation equal to zero to find the minimum, considering the parameters given in the question.

Question 3

Economic science has provided convincing evidence in favor of the:

Accepted Answer

Economic science has not provided a simple and compelling case for any particular view of macroeconomic policy. The effectiveness of different macroeconomic policies varies depending on the economic conditions and other factors, and there is ongoing debate among economists about which policies are most effective in different situations. Therefore, there is no single rule that can guarantee economic stability and growth.

Question 4

The time-inconsistency problem in discretionary policymaking about unemployment and inflation can be effectively avoided when the:

Accepted Answer

When the policymaker has and is known to have an extremely strong preference for very low inflation, private agents in the economy will anticipate this preference and will not expect the policymaker to deviate from this goal in the future. This eliminates the time-inconsistency problem that arises when the policymaker promises to keep inflation low in the future but has an incentive to renege on this promise in order to reduce unemployment in the short run.

Question 5

Monetary policy rules that target nominal variables would target any of the following except the:

Accepted Answer

Monetary policy rules that target nominal variables would target variables such as the price level, money supply, and level of nominal GDP, but not the unemployment rate. The unemployment rate is a real variable that is affected by various factors in the economy, including monetary policy. However, it is not a nominal variable that can be directly targeted by monetary policy rules.

Question 6

The Phillips curve describing an economy takes the form u = uⁿ - $\alpha$( $\pi$ - E $\pi$). The central bank directly sets the inflation rate to minimize the following loss function, L(u, $\pi$) = u + $\gamma$ $\pi$². The symbol u denotes the unemployment rates, uⁿ is the natural rate of unemployment, $\pi$ is the inflation rate, E $\pi$ is the expected inflation rate, and $\alpha$ and $\gamma$ are behavioral response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. In an economy in which the central bank dislikes inflation much more than unemployment:

Accepted Answer

In the given loss function, $F1F1F1S1\gamma F1F1F10$ represents the weight the central bank places on inflation relative to unemployment. If the central bank dislikes inflation much more than unemployment, this parameter ($\gamma$) will be very large to reflect the central bank's higher aversion to inflation. This means that the central bank is willing to tolerate a higher level of unemployment to keep inflation low.

Question 7

Although real variables such as unemployment and real GDP are the best measures of economic performance, most economists do not advocate manipulating money supply directly to hit a real target because:

Accepted Answer

Choosing a real target other than natural output or the natural unemployment rate could lead to unintended consequences such as accelerating inflation or deflation. Therefore, most economists advocate for a constant growth rate of the money supply rather than directly manipulating it to hit a real target.

Question 8

Assume that the Democrats always had a policy of high money growth while the Republicans followed a policy of low money growth, and the economy had a standard Phillips curve. Then, if the two parties took regular terms in office:

Accepted Answer

Under a standard Phillips curve, higher money growth leads to higher inflation. Therefore, when Democrats are in office with high money growth, inflation would be higher compared to when Republicans are in office with low money growth. However, since the parties take regular terms, the economy would adjust, preventing a political business cycle.

Question 9

Countries with greater central-bank independence can achieve lower rates of inflation:

Accepted Answer

Studies have shown that there are no significant real economic costs associated with greater central bank independence as long as it is accompanied by a clear mandate for price stability. In fact, greater central bank independence can lead to more stable and predictable inflation rates, which can support long-term economic growth.

Question 10

Unlike a monetarist policy rule, an inflation target has the advantage of:

Accepted Answer

An inflation target helps stabilize the economy by focusing on price stability, which can mitigate the effects of changes in money velocity, unlike a strict monetarist rule that focuses on controlling money supply.

Question 11

Central-bank independence refers to:

Accepted Answer

Central-bank independence refers to the degree of separation between central-bank decision making and political influence. It means that policymakers do not interfere with the decisions made by the central bank's governing board in conducting monetary policy. This ensures that central bankers can focus on achieving their goals of price stability and economic growth without the influence of short-term political considerations.

Question 12

Inflation targeting is a monetary policy rule that requires the central bank to adjust _____ in order to attain the desired inflation rate.

Accepted Answer

Inflation targeting involves the central bank adjusting the money supply to influence the inflation rate, aiming to maintain it within a target range. This is done through various monetary policy tools such as interest rates and reserve requirements.

Question 13

If the velocity of money varies a great deal, steady growth of the money supply is a(n):

Accepted Answer

If the velocity of money varies significantly, a steady growth of the money supply does not necessarily lead to a commensurate increase in aggregate demand. This makes it an ineffective way to stabilize aggregate demand.

Question 14

Monetarists believe all of the following except:

Accepted Answer

Monetarists believe that the Fed should maintain a steady and predictable growth rate of the money supply, rather than adjusting it in response to various shocks to the economy.

Question 15

Economic research finds that greater central-bank independence is ______ correlated with lower and more stable inflation as well as ______ correlated with the average growth and variability of real GDP.

Accepted Answer

Economic research suggests that greater central-bank independence is strongly correlated with lower and more stable inflation, but not strongly correlated with the average growth and variability of real GDP.

Question 16

If a city passes laws limiting rents on apartments but promises to exempt buildings not yet built:

Accepted Answer

If the city only limits rents on existing apartments and promises to exempt buildings not yet built, builders may be discouraged from constructing new buildings if they believe that the city may change its promise in the future. This uncertainty may lead to a decrease in the construction of new buildings.

Question 17

A monetary policy rule that targets nominal GDP would ______ money growth when nominal GDP rises above the target and ______ money growth when nominal GDP falls below the target.

Accepted Answer

A monetary policy rule that targets nominal GDP would reduce money growth when nominal GDP rises above the target to prevent overheating of the economy, and raise money growth when nominal GDP falls below the target to stimulate economic activity.

Question 18

Research indicates that greater central-bank independence is correlated with:

Accepted Answer

Research suggests that greater central-bank independence is associated with lower and more stable rates of inflation.

Question 19

In practice, inflation targeting is better considered as operating with constrained discretion rather than according to a policy rule because central banks with inflation targets typically:

Accepted Answer

Central banks with inflation targets typically set the inflation target as a range rather than as a particular number, which means that they have some discretion in their decision-making process. However, this discretion is constrained by the target range, which helps to guide their policy actions. Therefore, inflation targeting is better considered as operating with constrained discretion rather than according to a strict policy rule.

Question 20

A central bank operating with discretion can achieve the same outcome as the central bank committed to a fixed rule of zero inflation if:

Accepted Answer

A central bank that dislikes inflation much more than unemployment is more likely to prioritize maintaining low inflation rates, even when operating with discretion. This prioritization aligns with the outcome of a fixed rule aiming for zero inflation, as the central bank would consistently work to minimize inflation regardless of other economic conditions.

Quiz 18: Alternative Perspectives on Stabilization Policy