The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

Chapter 25

The Role of Expectations in Monetary Policy - all with Video Answers

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Chapter Questions

Problem 1

What does the Lucas critique state about the limitations of our current understanding of the way in which the economy works?

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Problem 2

"The Lucas critique by itself casts doubt on the ability of discretionary stabilization policy to be beneficial." Is this statement true, false, or uncertain? Explain your answer.

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Kaylee Mcclellan

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Problem 3

Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate. Assume the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that will encourage investment and economic growth.
a. Discuss the implications of the econometric model's predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.
b. What would be Lucas's critique of this model?

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Problem 4

If the public expects the Fed to pursue a policy that is likely to raise short-term interest rates permanently to $5 \%,$ but the Fed does not go through with this policy change, what will happen to long-term interest rates? Explain your answer

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Problem 5

In what sense can greater central bank independence make the time-inconsistency problem worse?

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Problem 6

What are the arguments for and against policy rules?

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Kaylee Mcclellan

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Problem 7

If, in a surprise victory, a new administration that the public believes will pursue inflationary policy is elected to office, predict what might happen to the level of output and inflation even before the new administration comes into power.

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Problem 8

Many economists are worried that a high level of budget deficits may lead to inflationary monetary policies in the future. Could these budget deficits have an effect on the current rate of inflation?

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Problem 9

In some countries, the president chooses the head of the central bank. The same president can fire the head of the central bank and replace him or her with another director at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or will it engage in discretionary policy?

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Problem 10

Outline the benefits and costs of sticking to a set of rules in each of the following cases. How does each of these situations relate to the conduct of economic
policy?
a. Going on a diet
b. Raising children

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Problem 11

How does Switzerland's monetary targeting strategy as described in this chapter demonstrate the case against monetary policy rules?

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Problem 12

How is constrained discretion different from discretion in monetary policy? How are the outcomes of these policies likely to differ?

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Problem 13

In general, how does credibility (or lack thereof) affect the aggregate supply curve?

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Problem 14

As part of its response to the global financial crisis, the Fed lowered the federal funds rate target to nearly zero by December 2008 and quadrupled the monetary base between 2008 and $2014,$ a considerable easing of monetary policy. However, survey-based measures of five- to ten-year inflation expectations remained low throughout most of this period. Comment on the Fed's credibility in fighting inflation.

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Problem 15

"The more credible the policymakers who pursue an anti-inflation policy, the more successful that policy will be." Is this statement true, false, or uncertain? Explain your answer.

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Problem 16

Why did the oil price shocks of the 1970 s affect the economy differently than the oil price shocks of $2007 ?$

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Problem 17

Central banks that engage in inflation targeting usually announce the inflation target and time period for which that target will be relevant. In addition, central bank officials are held accountable for their actions (e.g., they could be fired if the target is not reached), and their success or lack thereof is also public information. Explain why transparency is such a fundamental ingredient of inflation targeting.

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Problem 18

Suppose the statistical office of a country does a poor job in measuring inflation and reports an annualized inflation rate of $4 \%$ for a few months, while the true inflation rate has been around $2.5 \%$. What will happen to the central bank's credibility if it is engaged in inflation targeting and its target is $2 \%$, plus or minus $0.5 \% ?$

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Problem 19

What are the purposes of inflation targeting, and how does this monetary policy strategy achieve them?

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Problem 20

How can the establishment of an exchange-rate target bring credibility to a country with a poor record of inflation stabilization?

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Problem 21

What traits characterize a "conservative" central banker?

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Problem 22

Suppose the central bank is following a constant money-growth-rate rule and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show the possible effects on the economy. How does this situation reflect on the credibility of the central bank if it maintains the money growth rule? How does it reflect on the central bank's credibility if it abandons the money growth rule to respond to the downturn?

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Problem 23

Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country's central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

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Problem 24

Suppose two countries have identical aggregate demand curves and potential levels of output, and $\gamma$ is the same in both countries. Assume that in 2016 both countries are hit with the same negative supply shock. Given the table of values below for inflation in
each country, what can you say, if anything, about the credibility of each country's central bank? Explain your answer.$$\begin{array}{lcc}
& \text { Country A } & \text { Country B } \\
\hline 2015 & 3.0 \% & 3.0 \% \\
2016 & 3.8 \% & 5.5 \% \\
2017 & 3.5 \% & 5.0 \% \\
2018 & 3.2 \% & 4.3 \% \\
2019 & 3.0 \% & 3.8 \%
\end{array}$$

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Problem 25

How does a credible nominal anchor help improve the economic outcomes that result from a positive aggregate demand shock? How does a credible nominal anchor help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.

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