Answers to review quizzes marcroeconomics 12e parkin chapter 14

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W H AT I S E C O N O M I C S ? 225 C h a p t e r Answers to the Review Quizzes MONETARY POLICY** Page 390 (page 798 in Economics) What are the objectives of monetary policy? As set out in law, the objectives of monetary policy are to achieve “maximum employment, stable prices, and moderate long-term interest rates.” Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run? The monetary policy goals are essentially in harmony for the long run In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable The nominal interest rate equals the real interest rate plus the (expected) inflation rate If the inflation rate is low, then the nominal interest rate will be as low as possible In the short run, however, the monetary policy goals might conflict with each other In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession The Fed’s policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate What is the core inflation rate and how does it differ from the overall CPI inflation rate? The core inflation rate is the rate of increase in the core PCE deflator The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy Accordingly, the core inflation rate is smoother, that is, less volatile than the actual inflation rate Who is responsible for U.S monetary policy? The Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) are responsible for the conduct of U.S monetary policy Page 392 (page 800 in Economics) What is the Fed’s monetary policy instrument? 225 226 While the Fed could use the quantity of money, the exchange rate, or a short-term interest rate, the Fed chooses to use a short-term interest rate, in particular, the federal funds rate The federal funds rate is the interest rate on overnight loans of reserves that commercial banks make to each other How is the federal funds rate determined in the market for reserves? The federal funds rate is determined by equilibrium in the reserve markets The federal funds rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied 226 What are the main influences on the FOMC federal funds rate decision? Though the Federal Reserve does not use an explicit formula to determine changes in its targeted federal funds rate, the Fed seems to respond to the inflation rate, the unemployment rate, and the output gap when determining its federal funds target rate Page 401 (page 809 in Economics) Describe the channels by which monetary policy ripples through the economy and explain how each channel operates When the Federal Reserve lowers the federal funds rate, other short-term interest rates also fall As a result, the exchange rate falls because investors decrease their demand for U.S dollars since the interest yield on dollars is lower When the Federal Reserve lowers the federal funds rate it does so by buying securities in the open market Bank reserves increase so that banks have excess reserves Because banks have excess reserves, they loan the excess Loans increase and a multiple expansion of the quantity of money results The supply of loanable funds increases so that the long-term real interest rate falls and consumption and investment increase Net exports increase because of the lower exchange rate All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase Do interest rates fluctuate in response to the Fed’s actions? Yes, interest rates fluctuate in response to the Fed’s actions Indeed, the first effect of a change in monetary policy is a change in the federal funds interest rate How the Fed’s actions change the exchange rate? A change in the U.S interest rate changes the U.S interest rate differential For example, a rise in the U.S interest rate, other things remaining the same, means that the U.S interest rate differential increases When the U.S interest rate differential increases people want to move funds from other countries into the United States to obtain the relatively higher returns on U.S assets To move funds into the United States, people buy dollars and sell other currencies, driving the price of the dollar up A higher dollar means that foreigners must pay more for U.S.-made goods and services and Americans pay less for foreign goods and services So the rise in the interest rate means that exports decrease and imports increase, corresponding to a fall in net exports How the Fed’s actions influence real GDP and how long does it take for real GDP to respond to the Fed’s policy changes? The Fed’s actions affect real GDP by changing expenditure plans For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports All three of these changes boost aggregate demand so that real GDP growth increases The effect on real GDP is far from immediate because there are time lags in the process Real GDP initially responds about two years after the policy is initiated How the Fed’s actions influence the inflation rate and how long does it take for inflation to respond to the Fed’s policy changes? The Fed’s actions affect the inflation rate and the price level by changing expenditure plans For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports All three of these changes boost aggregate demand so that the price level rises and the inflation rate increases The effect on the price level and inflation rate is far from immediate because there are time lags in the process The change in inflation is slower than the change in real GDP M O N E TA RY P O L I C Y Page 405 (page 813 in Economics) What are the three ingredients of a financial and banking crisis? A financial and banking crisis occurs when there is a widespread fall in assets prices, a significant currency drain, and a run on banks When these events occur, banks and other financial institutions face incipient failure and so they drastically decrease their lending activities What are the policy actions taken by the Fed and the U.S Treasury in response to the financial crisis? The Fed and the U.S Treasury have undertaken eight policies designed to combat the financial crisis The Fed conducted massive open market operations to provide liquidity to banks To provide liquidity to money market funds, the Fed also created an asset-backed commercial paper money market mutual fund liquidity facility To provide liquidity to other financial institutions, the Fed allowed created programs that allowed term auction credit and also primary dealer and other broker credit The U.S Treasury engaged in two Troubled Asset relief Programs, TARP and TARP TARP was designed to give banks more liquidity Under it banks were to sell troubled assets to the U.S Treasury in exchange for U.S government assets This program did not work well and was replaced by TARP Under TARP the U.S Treasury directly purchased stock in financial institutions, thereby increasing their solvency and making their failure less likely Finally, accounting rules were changed to allow financial institutions to use fair value accounting rather than mark-to-market accounting to value assets This change also increased their solvency and made failure less likely Why was the recovery from the 2008–2009 recession so slow? The recovery from the recession has been slow because investment has not rebounded Investment has remained low because of uncertainty about the future How might inflation targeting improve the Fed’s monetary policy? Inflation targeting, under which the Fed would make public its inflation target and face penalties if the target was missed, would improve the Fed’s monetary policy because it would remove uncertainty The public would know what the Fed’s policy was and would not need to guess at what the inflation rate would be the future This certainty would improve people’s decision making about saving and investment and thereby improve economic performance How might using the Taylor rule improve the Fed’s monetary policy? The Taylor rules is a formula that sets the federal funds rate according to the inflation rate and the output gap This rule has worked well in computer simulations when it comes to avoiding excessive inflation or recessions Given this track record, it might improve the Fed’s monetary policy and make the Fed better able to avoid high inflation and recessions It also has the advantage of inflation targeting insofar as it removes uncertainty about what will be the Fed’s policy 183 184 CHAPTER 14 Answers to the Study Plan Problems and Applications “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 The Fed’s primary goal is price stability because price stability helps the Fed reach all three of its goals of maximum employment, stable prices, and moderate longterm interest rates Price stability directly meets the second goal of price stability And because price stability means that the inflation rate is low, it helps keep nominal long-term interest rates close to the long-term real interest rate Finally price stability helps consumers and businesses make better decisions about saving and investment and thereby keep unemployment close to the natural rate “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? The Fed has primary responsibility for the nation’s monetary policy It is the FOMC that decides upon monetary policy The Congress plays, at best, a minor role Each year the Fed must make two reports to Congress about its monetary policy and the Fed chairman testifies before Congress at these times The President’s role is limiting to appointing the members and the chairman of the Board of Governors, though Presidents have tried to influence the Fed’s decisions Fed’s Easing Has Little Impact So Far The Federal Reserve’s latest easing program may be nicknamed “QE Infinity” on Wall Street, but it’s having a limited effect on the economy so far Source: cnbc.com, October 3, 2012 a What does the Federal Reserve Act of 2000 say about the Fed’s control of the quantity of money? The Federal Reserve Act of 2000 says that the Fed “shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s longrun potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” b How can the massive increase in the monetary base resulting from “quantitative easing” or QE be reconciled with the Federal Reserve Act of 2000? The Fed is charged with setting monetary growth to “promote effectively the goal(s) of maximum employment.” The massive increase in the monetary base attempts to decrease the unemployment rate from its level at the time, near 9.5 percent, to something closer to the natural unemployment rate, thereby helping to achieve its goal of maximum employment What are the two possible monetary policy instruments, which one does the Fed use, and how has its value behaved since 2000? The Fed could use either the monetary base or the federal funds rate as its monetary policy instrument The Fed has chosen to use the federal funds rate Since 2000 the federal funds rate has been on a roller coaster Starting from about 6.5 percent in early 2000, the federal funds rate fell for the next four years until it reached percent in the second quarter of 2004 From that time the federal funds rate rose to slightly more that percent in 2006 and 2007 After 2007 the federal funds rate fell until it hit its historic low, 0.2 percent in 2008 From 2008 until 2015, the federal funds rate has stayed at or below this historic low M O N E TA RY P O L I C Y How does the Fed hit its federal funds rate target? Illustrate your answer with an appropriate graph To hit its federal funds rate target, the Fed uses open market operations to change the quantity of reserves Figure 14.1 illustrates this process Initially the federal funds rate target is 5.25 percent The quantity of reserves is $100 billion, as indicated by RS0 If the Fed wants to lower the federal funds rate to percent, the Fed will use open market purchases of government securities to increase reserves to $200 billion These open market operations will shift the supply of reserves curve to RS1 and thereby lower the equilibrium federal funds rate to the targeted value, 2.00 percent What does the Fed to determine whether the federal funds rate should be raised, lowered, or left unchanged? The Fed changes in the federal funds rate based on its forecasts of the three economic variables: the inflation rate, the unemployment rate, and the output gap If the inflation rate is forecasted to rise, the unemployment rate is forecasted to fall, or the output gap is forecasted to fall and perhaps become an inflationary gap, the Fed might be concerned about inflation and push the federal funds rate up If the inflation rate is forecasted to fall, the unemployment rate is forecasted to rise, or the output gap is forecasted to rise, the Fed might be concerned about unemployment and push the federal funds rate down Use the following news clip to work Problems and Fed Sees Unemployment and Inflation Rising It is May 2008 and the Fed is confronted with a rising unemployment rate and rising inflation Source: CNN, May 21, 2008 Explain the dilemma faced by the Fed in May 2008 Rising unemployment calls for expansionary monetary policy, that is, a cut in the interest rate to lower the unemployment rate This policy, however, raises the inflation rate Rising inflation calls for a contractionary monetary policy, that is, a hike in the interest rate to lower the inflation rate This policy, however, raises the unemployment rate So if the Fed combats unemployment, it worsens the inflation problem But if the Fed combats inflation, it worsens the unemployment problem a Why might the Fed decide to cut the interest rate in the months after May 2008? The Fed might have decided to cut the interest rate after May 2008 if unemployment worsened and became a more severe problem than inflation 185 186 CHAPTER 14 b Why might the Fed have decided to raise the interest rate in the months after May 2008? The Fed might have decided to raise the interest rate after May 2008 if inflation worsened and became a more severe problem than unemployment M O N E TA RY P O L I C Y Use the following data to work Problems to 11 The Bureau of Economic Analysis reported that 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 and use a graph to illustrate your explanation The low interest rates are achieved by increasing banks’ reserves, which leads to an increase in the supply of loanable funds Then, as illustrated in Figure 14.2, the increase in the supply of loanable funds lowers the real interest rate, in the figure from percent per year to percent per year The fall in the real interest rate increases firms’ purchase of investment items, such as factories, plants, machine tools, and so forth, because it makes their purchase less expensive 10 Explain the effects of business investment on aggregate demand Would you expect it to have a multiplier effect? Why or why not? The increase in investment increases aggregate demand as illustrated in Figure 14.3 It is likely that the increase in investment has a multiplier effect The initial increase in investment increases real GDP and consumers’ disposable income In turn the increase in disposable income induces additional consumption expenditure, which serves to further increase aggregate demand and real GDP 11 What actions might the Fed take to stimulate business investment further? The Fed might commit to keeping the inflation rate low by stating that it will raise the interest rate at some specified point in the future if inflation starts to pick up This commitment would help dispel fears of inflation It would also make clear that buying investment goods will be cheaper at the present time, when the interest rate is low, then in the future, when the interest rate rises This belief would lead firms to increase their investment at the present time 187 188 CHAPTER 14 Use the following news clip to work Problems 12 to 14 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 Source: Reuters, October 9, 2012 12 If the IMF forecasts turn out to be correct, what would most likely happen to the output gap and unemployment in 2013? The “global economic slowdown” means that the output gap will probably increase and the unemployment rate will either rise or not change 13.a What actions taken by the Fed in 2011 and 2012 would you expect to have influenced real GDP growth in 2013? Explain how those policy actions would transmit to real GDP The Fed has undertaken monetary stimulus of almost historic proportions The Fed has driven the federal funds rate to its lowest level ever, virtually percent The Fed has engaged in bouts of quantitative easing These expansionary policies are designed to increase consumption expenditure, net exports, and particularly investment and thereby increase aggregate demand The Fed’s goal is to increase aggregate demand and by so doing increase real GDP and employment, which would lower the stubbornly high unemployment rate b Draw a graph of aggregate demand and aggregate supply to illustrate your answer to part (a) Figurer 14.4 shows the outcome described in part (b) In the absence of the Fed’s policy, the aggregate demand curve would be AD0 and the aggregate supply curve would be SAS The Fed’s expansionary policies increased aggregate demand so the aggregate demand curve shifts to AD1 In the absence of the Fed’s policies, real GDP would be $12.7 trillion and the price level would be 119 The Fed’s expansionary policies have raised the price level to 121 and increased real GDP to $12.9 trillion 14 What further actions might the Fed take in 2013 to influence the real GDP growth rate in 2014? (Remember the time lags in the operation of monetary policy.) The time lags in the operation of monetary policy suggest that any further expansionary policy the Fed takes in 2013 likely will have a small effect in 2014 If, early in 2013 the Fed conducts a further quantitative easing, by buying a significant quantity of assets, there might be a positive impact on real GDP and employment in late 2014 M O N E TA RY P O L I C Y 15 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.” Source: ft.com, October 1, 2010 What monetary policy strategy is Mr Dudley raising? How does inflation targeting work and why might it “help anchor inflation expectations at the desired rate”? Mr Dudley is suggesting that the Fed move toward inflation rate targeting If the Fed followed a policy of inflation rate targeting, it would make a public commitment about its inflation rate target and would explain how its policy actions will achieve its goal Inflation rate targeting gives the public guidance about what the central bank expects the inflation rate will be This will help “anchor inflation expectations” and, as long as the announced inflation rate target is the desired rate, it will help anchor the expectations “at the desired rate.” 189 190 CHAPTER 14 Answers to Additional Problems and Applications Use the following information to work Problems 16 to 18 The Bank of Korea’s monetary policy is to reduce the vulnerability of South Korean won and achieve price stabilization through increasing money supply and lowering interest rates 16 How does the Bank of Korea attempt to minimize the output gap through money supply and interest rates? To minimize the output gap (recessionary gap), as the Bank of Korea increases money supply by buying securities in an open-market operation, the Bank of Korea base rate falls A lower interest rate boosts investment expenditure As the interest rates fall in comparison to other countries, say, the U.S., keeping other factors unchanging, the South Korean won depreciates against the U.S dollar, which increases net exports The combined effect is that aggregate demand increases, implying a rightward shift in the aggregate demand curve A multiplier process begins too The increase in aggregate demand increases income, which in turn induces an increase in consumption expenditure Aggregate demand further shifts to the right and the new equilibrium GDP will be higher Money supply keeps increasing until the equilibrium GDP reaches the potential GDP 17 How does the policy affect the price level in the short run and the long run? Given the short-run aggregate supply, when aggregate demand keeps increasing due to continuous increase in money supply, the price level continues to increase until the potential GDP is reached At full-employment equilibrium, the price level remains stable 18 Can the Bank of Korea achieve price stability and economic growth simultaneously? The Bank of Korea cannot have both price stability and economic growth simultaneously in the short term Lowering inflation rate to achieve price stability might entail increasing interest rate which would lower employment and real GDP, thereby discouraging economic growth The central bank has to prioritize In the years of 2014 and 2015, the Bank of Korea has been found inclined to have economic growth as its first priority while accepting a small increase in price in the short run 19 What is the core inflation rate and why does the Fed regard it as a better measure on which to focus than the CPI? The core inflation rate is the rate of increase in the core personal consumption expenditure (PCE) deflator The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy Accordingly, the core inflation rate is the inflation rate over which the Fed believes it has the greatest control 20 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 change? Which arrangement would most likely provide price stability? If interest rates are determined by Congress, there would be a bias toward persistently increasing monetary growth to keep the interest rate low and help the re-election prospects of legislators While this policy is successful in the short run, in the long run the higher monetary growth leads to higher inflation In turn, the M O N E TA RY P O L I C Y higher inflation rate leads to a higher nominal interest rate Keeping the Fed independent of Congress is most likely to provide price stability Use the following CBO report to work Problems 21 to 23 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 Source: Congressional Budget Office 21 How does the federal government get funds to cover its budget deficit? How does financing the budget deficit affect the Fed’s monetary policy? The federal government borrows the funds Borrowing, by selling government securities, is how the federal government funds its budget deficit When the government borrows to fund its deficit, the increased demand for loanable funds raises the real interest rate The budget deficit has no direct impact on the Federal Reserve’s monetary policy But the budget deficit might exert an indirect effect For its monetary policy, the Federal Reserve targets the federal funds rate and uses open market operations to meet the target When government borrowing raises the real interest rate, the federal funds rate rises The rise in the federal funds rate might affect the Fed’s assessment of the level at which to target the federal funds rate 22 How was the budget deficit of 2012 influenced by the Fed’s low interest rate policy? The Fed’s low interest rate policy lowered the interest payments the federal government had to make on its debt Therefore the low interest rate policy decreased the amount of government spending and hence decreased the size of the government budget deficit 23.a How would the budget deficit change in 2013 and 2014 if the Fed moved interest rates up? If the Fed boosts interest rates, the government payments on its debt will increase The higher payments increase the amount of government spending and therefore increase the size of the budget deficit 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? A rapid depreciation of the dollar can have two effects on the budget deficit First it can increase the U.S inflation rate With the increase in the inflation rate, inflation expectations would increase, thereby increasing interest rates The increase in the interest rate increases the budget deficit because the government must increase the interest payments it makes on its debt Second, a rapid depreciation of the dollar can also increase U.S net exports which decreases the U.S unemployment rate A decrease in unemployment decreases the needs-based expenditure the government must make and thereby lowers the budget deficit 24 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? The Fed would argue that it has tried to follow this instruction The Fed would point to the relatively low inflation rate as evidence that it did not let the growth rate of 191 192 CHAPTER 14 the quantity of money get out of hand And the Fed would argue that the financial crisis and ensuing recession is not the fault of its monetary policy b Why might the Fed increase money by more than the potential to increase production? During a recession the Fed increases the quantity of money by more than the “long-run potential” in an effort to conduct a monetary policy that moves real GDP back to its “long-run potential.” 25 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 Some analysts assert that the federal funds rate was too low during the period from 2001 to 2005 During this period house prices skyrocketed It was the following rapid fall in house prices, starting in 2006, that helped lead to the financial crisis These analysts say that if the Fed had raised interest rates earlier, then demand for housing would have not been as strong, thereby limiting the rise in house prices Some observers believe that the Fed kept interest rates too high at the start of in 2000 and in 2006-2007 In both periods the economy was poised to enter a recession These observers say that if the Fed had lowered the interest rate before the economy entered the recession, the following recession would have been milder and might have been avoided all together M O N E TA RY P O L I C Y 26 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 rate? Why? Illustrate your answer with an appropriate graph The Fed’s immense creation of $3 trillion of bank reserves might mean that further open market operations would have no effect on the federal funds rate The $3 trillion of reserves has sent the federal funds to virtually percent, so there is little room for it to fall further At this exceedingly low federal funds rate, banks might be willing to hold any quantity of additional reserves In this situation, as Figure 14.5 illustrates, the demand curve for reserves is horizontal If the demand curve for reserves is flat, then increasing the quantity of reserves has no effect on the federal funds rate because banks merely hold the additional reserves Banks hold the reserves because the opportunity cost of holding them rather than loaning them in the federal funds market is so low 27 What is the Beige Book and what role does it play in the Fed’s monetary policy decision-making process? The Beige Book is a key element in the Fed’s monetary policy decision-making process The Beige Book summarizes economic conditions within each of the Federal Reserve districts It provides the FOMC important information about the current state of the economy that, together with forecasts of the future evolution of the economy, determines the nation’s monetary policy To work Problems 28 to 30, use the information that during 2012 the inflation rate increased but remained in the “comfort zone” and the unemployment rate remained high 28 Explain the dilemma that rising inflation and high unemployment poses for the Fed Raising inflation and high unemployment pose a dilemma for the Fed because the policy necessary to decrease one of these factors increases the other On one hand, to control inflation, the Fed must raise the interest rate and decrease growth in the quantity of money But this policy raises the unemployment rate However, on the other hand to control high unemployment the Fed needs to lower the interest rate and increase the growth rate of the quantity of money But this expansionary policy raises the inflation rate 29 Why might the Fed decide to try to lower interest rates (or stimulate in other ways) in this situation? The Fed might lower the interest rate because it perceives high unemployment as a larger problem than inflation because inflation, while increasing, was in the “comfort zone.” 193 194 30 CHAPTER 14 Why might the Fed decide to raise interest rates in this situation? The Fed might raise the interest rate if it perceives that inflation will rise outside of its comfort zone and if it perceives the rising inflation as a larger problem than the high unemployment M O N E TA RY P O L I C Y Use the following information to work Problems 31 to 33 From 2009 through 2012, the long-term real interest rate paid by the safest U.S corporations fell from percent to percent During that same period, the federal funds rate was roughly constant at 0.25 percent a year 31 What role does the long-term real interest rate play in the monetary policy transmission process? The long-term real interest rate plays an important part in the monetary transmission process Both consumption expenditure and investment respond to the long-term real interest rate When the long-term real interest rate falls, consumption expenditure and investment both increase The increase in consumption expenditure and investment increase aggregate demand and thereby increase real GDP and the price level 32 How does the federal funds rate influence the long-term real interest rate? The long-term interest rate is an expected average of short-term interest rates People can either borrow or save by making a long-term commitment or by making successive short-term commitments Adjusted for risk, the average of the interest rates on the short-term commitments must equal the long-term interest rate If they were not equal one method of borrowing would be more or less expensive than the other People would stream to borrow using the less expensive method, pushing that interest rate higher, back toward equality Simultaneously other people would stream to save using the method with the higher return, pushing that interest rate lower, back toward equality When the Fed lowers the federal funds rate, other short-term interest rates also fall This fall makes borrowing by using a series of short-term loans less expensive and saving using a series of short-term commitments less profitable The demand for long-term loans falls, which lowers the long-term interest rate and the supply of long-term saving commitments rises, which also lowers the long-term interest rate So a fall in the federal funds rate lowers the long-term real interest rate 33 What you think happened to inflation expectations between 2009 and 2012 and why? Inflation expectations probably increased The expected inflation rate equals the nominal interest rate minus the real interest rate Over this time period, the federal funds rate did not change, so the nominal interest rate did not change But the real interest rate fell Therefore inflation expectations increased 34 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 Source: The Wall Street Journal, August 20, 2011 a How “bets in favor of the yen” influence the exchange rate? “Bets in favor of the yen” are “bets” that the yen will rise in the future To place this “bet,” traders need to buy yen The demand for yen increases, which raises the value of the yen and lowers the dollar exchange rate b How does the Fed’s monetary policy influence the exchange rate? The Fed’s monetary policy affects U.S interest rates, which affect the exchange rate For example, if people expect the Fed to either lower U.S interest rates or else keep U.S interest rates lower for a longer period of time, the fall in expected interest rates lowers the exchange rate U.S savers become more likely to sell dollars to acquire foreign exchange to save abroad, so the supply of dollars increases Foreign savers become less likely to buy dollars to save in the United States, so the demand for dollars decreases On both counts the U.S exchange rate falls 195 196 CHAPTER 14 Use the following news clip to work Problems 35 and 36 As US Growth Lags, Some Press the Fed to Do Still More The Fed’s campaign to increase growth is not working Economists blame the prudent, slow-acting monetary policy of the Fed, especially with regard to the pace of inflation, for the growth lags Source: The New York Times, Feb 1, 2013 35 The short-term interest rates have been held near zero since December 2008 The Fed is being urged to push inflation to accelerate growth How does the monetary policy of managing inflation expectations help? Long-term real interest rate equals long-term nominal interest rate minus expected inflation rate Given the nominal interest rate is near zero, if the Fed pushes inflation, inflation expectations will rise, the real interest rate will fall Other things remaining the same, the lower the real interest rate, the greater the investment and consumption expenditure Aggregate demand increases, which increases real GDP 36 Describe how the slow response of the real economy to the monetary policy of the Fed can explain the growth lag The lags between the Fed’s actions and their effect on the real economy are substantial It takes time before the policy affects output Even if the interest rate drops, firms are unlikely to change their investment plans immediately Consumers may not increase their consumption, if they are not sure that their incomes are going to increase in the long run In addition, lower interest rates lead to a depreciation of home currency, but exports may not increase and imports may not decrease immediately as the amount of exports and import are bound by contracts, schedules and production plans for a period of time 37 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 Source: Philadelphia Inquirer, September 25, 2012 a Describe the QE3 asset purchases that are causing Charles Plosser concern Mr Plosser is concerned about the Fed’s large purchases of mortgage-backed securities b How might asset purchases damage the Fed’s credibility? The asset purchases might cause people to doubt the Fed’s commitment to price level stability The asset purchases increase banks’ reserves and if banks loan these reserves, the money supply could expand significantly and with it the price level and inflation rate might jump higher 38 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 percent a year If the inflation rate in New Zealand is percent a year, what is its output gap? The Taylor rule sets the official cash rate according to CASH = + INF + 0.5(INF − 2) + 0.5GAP So the with a cash rate of percent and an inflation rate of percent, the Taylor rule is that = 2+ + 0.5(2 – 2) + 0.5GAP, or = + 0.5GAP The last equation shows that the output gap is percent M O N E TA RY P O L I C Y Use the following news clip to work Problems 39 and 40 Bernanke on Inflation Targeting Inflation targeting promotes well-anchored inflation expectations, which facilitate more effective stabilization of output and employment Thus inflation targeting can deliver good results with respect to output and employment as well as inflation Source: Federal Reserve Board, remarks by Ben Bernanke to the National Association of Business Economists, March 25, 2003 39 What is inflation targeting and how “well anchored inflation expectations” help to achieve more stable output as well as low inflation? Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve a specific inflation rate goal Inflation rate targeting helps “anchor expectations” because the public has a good idea of hat the inflation rate will be There are fewer gyrations in inflation expectations which lead to fewer changes in the real interest rate and, accordingly fewer changes in investment and consumption expenditure Because aggregate demand is more stable, so, too, is output 40 Explain how inflation targeting as described by Ben Bernanke is consistent with the Fed’s dual mandate The Fed’s dual mandate is to maintain stable prices and maximum employment By setting a low inflation rate target, the Fed directly helps achieve its goal of stable prices , which is the best environment for households and firms to make the saving and investment decisions By limiting fluctuations in aggregate demand, the Fed can keep real GDP growing at a rate that more closely approximates its long-term trend Economics in the News 41 After you have studied Economics in the News on pp 406–407 (814–815 in Economics) answer the following questions a What was the state of the U.S economy in the fall of 2014 when the Fed made the decision to commit to keeping interest rates low for a “considerable time”? The economy was mired in a very slow recovery from a very deep recession The unemployment rate was high by historical standards and a recessionary gap existed The Fed was concerned by the slow recovery from the recession b What was the FOMC majority expectation about future employment, real GDP, and inflation in September 2014? The majority view was that the economy still had a large recessionary gap The majority expected that fed policy would lead to further increases in employment and real GDP while the inflation rate would remain low c How would an earlier and faster rise in interest rates influence aggregate demand? An earlier and faster rise in interest rates would lead to an earlier and stronger restraint on the growth of consumption expenditure and investment and, thereby, an earlier and stronger restraint on the growth of aggregate demand d If the San Francisco Fed view of the output gap is correct, where will interest rates be in 2016 and 2017? Why? If the San Francisco Fed view of the output gap is correct, the Fed’s policy will lead to an inflationary gap Real GDP will exceed potential GDP and the inflation rate 197 198 CHAPTER 14 will start to rise The rise in the inflation rate will raise interest rates And the Fed’s policy of raising the interest rate to lower the inflation rate will lead to a further rise in interest rates M O N E TA RY P O L I C Y 42 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.” Source: The Wall Street Journal, September 18, 2012 a Why, in the economic conditions of September 2012, was Charles Evans happy to see the Fed stimulating the economy? Mr Evans was concerned that the economy still had a large recessionary gap and that the economy might even move into another recession b What would be the effects of the Fed’s QE3 and other stimulative actions? Explain the immediate effects and the ripple effects If the Fed buys securities, banks’ reserves increase The federal funds rate falls and along with it other short-term interest rates fall The exchange rate also falls The supply of money and the supply of loanable funds increase The increase in the supply of loanable funds lowers the real interest rate Consumption expenditure, investment, and net exports increase, which increases aggregate demand Real GDP increases and the price level rises c What are the risks arising from greater monetary stimulus? The risk from greater monetary stimulus is significantly higher inflation If the monetary stimulus is too great, it could propel the United States into a situation in which inflation and inflation expectations soar 199 ... desired rate.” 189 190 CHAPTER 14 Answers to Additional Problems and Applications Use the following information to work Problems 16 to 18 The Bank of Korea’s monetary policy is to reduce the vulnerability... rate rises This belief would lead firms to increase their investment at the present time 187 188 CHAPTER 14 Use the following news clip to work Problems 12 to 14 IMF Warns Global Economic Slowdown... able to avoid high inflation and recessions It also has the advantage of inflation targeting insofar as it removes uncertainty about what will be the Fed’s policy 183 184 CHAPTER 14 Answers to
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