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CHAPTER 17: OPTIMAL MONETARY POLICY
Additional Questions
Essay Questions and/or Problems:
1. “The independence of the Fed leaves it unaccountable for its actions.” Do you agree or
disagree with this statement?
2. Does targeting the money supply become more or less effective if money demand is highly
interest rate elastic? Use a graph to explain your intuition.
3. Briefly discuss an argument for Central Bank Independence. When looking across
countries, has Central Bank independence been successful? Explain.
4. According to the theory of time inconsistency, why are rules preferable to discretion? Does
it make a difference if you are talking about this in a model with rational expectations or
not?
5. Under what conditions is a money-stock target considered superior to an interest-rate
target? Under what conditions is an interest-rate target preferred to a money-stock target?
6. After two decades with inflationary rates that exceeded the Organization for Economic Co-
operation and Development average and with output growth rates that fell short of that
average, the New Zealand government adopted a very strict form of inflation targeting in
1990. Explain the New Zealand experiment and its strict form of inflation targeting.
7. Discuss the merits of a money growth rule versus an inflation target rule. Which was
preferred by Monetarists? Which is the most widely used today, and why?
8. According to the Taylor rule, how should monetary policy and interest rates change in
response to a situation in which actual output exceeds the natural rate of output? In what
sense is the Taylor rule consistent with Keynesian stabilization policy? Explain.
9. What is the FOMC? Who votes on the FOMC? How often does it meet? What is the
outcome of their meetings?
188 CHAPTER 17
Additional Essay Questions and/or Problems:
10. There is a long-standing controversy in the macroeconomic policy literature concerning the
relative merits of rules versus discretion in policy design. Summarize the arguments for and
against rules to govern policy formation. Examples of such rules are the constant money
growth rate rule proposed by Milton Friedman and suggested amendments to mandate a
balanced federal budget. In your answer, discuss the degree to which the positions
economists take in this debate depend on their theoretical macroeconomic views
(monetarist, Keynesian, etc.).
11. Evaluate the relative merits of interest rates versus monetary aggregates as intermediate
targets for monetary policy.
12. Describe the Federal Reserve’s current monetary policy strategy. Compare and contrast it
with general movements in policy in other central banks discussed in this chapter.
13. It was said in the text that use of a monetary aggregate as an intermediate target limited
possible monetary accommodation of inflation. Does an interest rate target have the same
advantage? Why or why not?
14. Describe the Taylor rule. Is the Taylor rule a rule as envisioned by monetarists? Why has it
become more popular among monetary policymakers? What are its implications for
monetary policy if used exclusively by policymakers in the future?
15. Consider an economy with a high rate of inflation. Would you advocate targeting interest
rates or the money supply under such considerations? Analyze the effects of each policy,
making sure to consider the long run effects of alternative.
16. Define “inflation targeting” and discuss at least two benefits of inflation targets? What is its
primary cost?
17. Define the Taylor rule. According to the Taylor rule, if inflation increases by 1%, how
much does the target federal funds rate have to change?
18. According to the Taylor rule with a targeted federal funds rate of 3 percent and targeted
inflation of 2 percent, what is the recommended federal funds rate if:
a. inflation is 4 percent and output is 2 percent below its target?
b. inflation is 2 percent and output is 1 percent below its target?
Multiple-Choice Questions:
1. Intermediate targeting the money supply is preferable if there is a(n)
2. The FOMC meets approximately eight times per year and at these meetings they
3. If the central bank targets the interest rate, it
4. Over the Fed’s history, it has targeted
5. The best case for intermediate targeting on monetary aggregates is where the
6. Assuming an decrease in money demand, then to keep interest rates constant the Fed must
7. If the great majority of shocks to our system arise from unpredictable shocks to money
demand, the preferred tactic of monetary policy is targeting
8. If the financial innovations such as ATM machines make money demand less elastic than it
was before, then
9. According to the Taylor rule, if actual output is greater than the natural rate of output, then
the Fed should
10. If velocity is highly unstable, then targeting the money supply
11. According the principle of time inconsistency, the most important element of policy
making is
12. Which of the following statements is (are) correct? Regardless of whether the LM curve is
vertical or upward sloping,
13. Assuming the central bank follows a money supply target, then an increase in the demand
for money
14. Which of the following statements is (are) correct? Over the past 20 years, the Federal
Reserve
15. In today’s Fed, its primary strategy is to
16. On October 6, 1979, the Federal Reserve abandoned the strategy of targeting the Federal
funds rate and focused on target ranges for growth in the monetary aggregates. Since that
time, the Federal Reserve
17. An argument against inflation targeting is that
18. Time inconsistency is a problem when policymakers
19. Assuming the Federal Reserve is targeting the interest rate, a decrease in money demand
will
20. If money demand does not depend upon income, then
21. Monetary policy decisions, such as the target growth rate in the money supply or the target
level for interest rates, are set by the
22. In the United States, the strategy of monetary policy
23. A variable that the Federal Reserve focuses on because it has a direct link to the variables
the Fed is ultimately concerned about is known as a(n)
24. Relative to fiscal policy, monetary policy
25. The Federal funds rate
26. An index constructed by Alberto Alesina and Lawrence Summers measuring central bank
independence for a sample of industrialized countries during the late 1980s notes that the
27. Assuming that the central bank is following a money stock targeted, an exogenous rise in
investment demand
28. Assume that the Fed is targeting interest rates. If a desirable new type of bank deposit
increases the demand for money at a given level of income and the rate of interest, then
29. The voting members of the Open Market Committee are
30. A change in monetary policy has a larger effect on aggregate demand the
31. If money demand does not depend on the interest rate then
32. The money-stock target is preferable when uncertainty is the result of unpredictable shifts
in which of the following?
33. Inflation targeting alleviates the problem of
34. Which of the following is not considered an ultimate target that the monetary authority
attempts to control?
35. The primary tool utilized by the Federal Reserve today in conducting monetary policy is
36. The Taylor rule relates
37. If the Federal Reserve “pegs” the interest rate, then in the IS-LM framework, the LM
schedule
38. Throughout the 1980s, the Federal Reserve
39. The Federal Reserve System
40. Which of the following statements is (are) correct?
41. Policy is conducted via a rule if policymakers
42. Assume that the money stock is the intermediate target and money demand is totally
interest- inelastic. Then, the
43. Monetarists are in favor of
44. If the central bank targets the money stock, then a negative shock to money demand will
45. Policy is conducted via discretion if policymakers
46. One way to overcome the problem of time inconsistency is to
47. If the Fed has the discretion to choose its policy and announces a low inflation policy, then
48. Assume that the Federal Reserve replaces the money stock with the interest rate as an
intermediate target. Then,
49. Unlike a money supply target, an inflation rate target
50. The Taylor rule specifies
51. Which of the following statements is false?
52. Assume that targeted inflation is 1 percent. According to the Taylor rule, the federal funds
rate is:
53. According to the Taylor rule, when inflation and/or output is above its target, then:
54. Inflation targeting is one policy that attempts to deal with the problem of:
55. If velocity is more stable than the IS curve, then targeting the money supply