Macroeconomics: Policy and Practice, 2e (Mishkin)
Chapter 21 The Role of Expectations in Macroeconomic Policy
21.1 Rational Expectations and Policy Making
1) Adaptive expectations are formed ________.
A) from experience
B) from best guesses about the future
C) as new information becomes available
D) as a weighted average of expert forecasts
2) Assume that prices have risen in a given economy by an average of 5 percent over the last
nine years. If consumers base their expectations about future price movements on that
knowledge alone their forecasts rely on ________.
A) reverse expectations
B) adaptive expectations
C) rational expectations
D) monetary expectations
3) The notion that expectations will be identical to optimal forecasts using all available
information is known as ________.
A) adaptive expectations
B) irrational expectations
C) rational expectations
D) tertiary expectations
4) A prediction based on rational expectations ________.
A) relies solely on past experience
B) will always be superior to one based on adaptive expectations
C) is based on real, rather than nominal variables
D) will not always be accurate
5) Rational expectations are more accurate than adaptive expectations, ________.
A) on average
B) always
C) because they require less information
D) except when policies have changed
6) If households have information that monetary policy is likely to change in the future, that
information will play a role in forming ________.
A) adaptive expectations
B) rational expectations
C) tertiary expectations
D) non-adaptive expectations
7) Rational expectations theory suggests that ________.
A) consumers base their expectations about the future largely on past experience
B) economic agents will always alter their decision-making when a new piece of information
becomes available
C) economic agents will not be influenced by a piece of information if that information has
already been anticipated
D) consumers need not form expectations about the far flung future since most consumption
decisions involve satisfying an immediate impulse, e.g. hunger
8) Rational expectations theory suggests that ________.
A) policy announcements can impact behavior
B) policy announcements have no impact on behavior
C) unannounced policies have no impact on behavior
D) the optimal forecast is identical to the announced policy
9) Expectations about the future will always be accurate if formed under ________.
A) rational expectations
B) adaptive expectations
C) natural selection
D) none of the above
10) New information ought not to influence economic decision-making if ________.
A) consumers rely on rational expectations
B) monetary policy changes
C) monetary and/or fiscal policy changes
D) that information has already been anticipated
11) The “rational expectations revolution” refers to a substantial change in the thinking of
________.
A) households and businesses
B) policy makers
C) macroeconomists
D) elected officials
12) ________ rational expectations, ________.
A) Most people have always formed; but macroeconomists have only recently come to recognize
this fact
B) Macroeconomists have invented; and are trying to teach them to the general public
C) Policy makers have devised; in search of more effective policies
D) The latest information is an important input in; so most people must make do with adaptive
expectations
13) Suppose you need an estimate of future inflation (to decide, for example, whether a
particular security is a good investment). How might you formulate a rational expectation?
14) Under what circumstances might it be “rational” to rely on adaptive expectations?
15) Both adaptive expectations and rational expectations are prone to error (a discrepancy
between the expectation and the actual experience). In each case, how does error affect the
formation of new expectations?
21.2 Lucas Critique of Policy Evaluation
1) Economists use ________ to forecast economic activity and to evaluate policy options.
A) macroeconometric models
B) educated guesses
C) cost-benefit analysis
D) constrained discretion
2) Forecasts based on the extrapolation of observed trends and relationships are likely to be
accurate, if ________.
A) changes in expectations are properly considered
B) policy actions are anticipated
C) economic behavior is guided by rational expectations
D) policy changes are understood to be permanent
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3) Robert Lucas spurred the rational expectations revolution in ________.
A) the 1960s
B) the 1970s
C) the 2000s
D) the 1880s
4) The danger in using data to estimate the consequences of a proposed policy is that ________.
A) the data can reveal only the benefits of a policy, while estimating the policy’s costs is
important, also
B) policies change so often that data can never reveal which policies are the cause of which
consequences
C) the public’s expectations about the policy might influence the data, making the policy seem
more or less appropriate than is actually the case
D) the proposed policy, if implemented, might cause unforeseeable changes in the relationships
that were in operation when the data were produced
5) An economic policy has a decent chance of working as intended, if ________.
A) the policy causes no change in expectations
B) if mistaken expectations are not very costly
C) the rationale behind the policy is well-understood by the public
D) expectations are formed in the same way by both the public and the policymakers
6) According to the Lucas critique, what is the proper way to evaluate a proposal that reduces
government borrowing by raising taxes and reducing government spending?
21.3 Policy Conduct: Rules or Discretion?
1) The time-inconsistency problem involves the ________.
A) difficulties of traveling across time zones
B) tendency to deviate from good long-run plans in the short-run
C) use of adaptive expectations in building an economic model
D) time lag between the implementation of policy and its ultimate and complete results
2) The tendency to deviate from sound long-run plans in the short-run is known as ________.
A) the failure of adaptive expectations
B) the failure of rational expectations
C) the time inconsistency problem
D) the NIMBY, or not in my backyard problem
3) Which of the following is most consistent with the time-inconsistency problem?
A) while it is ten o’clock in the morning in Chicago, it will be eleven o’clock in New York City
B) a monetary policy action that is implemented in January will not begin to influence economic
variables for several months
C) a parent who acquiesces to a child’s demand just to keep them quiet in a public setting
D) an economic model with adaptive expectations
4) According to monetarists, such as Milton Friedman ________.
A) the central bank should have discretionary authority to respond to economic problems that
develop over the course of the business cycle
B) the Taylor rule should effectively address the problem of inflation
C) an increase in government spending has substantially the same effects as an unanticipated
increase in the money supply on domestic interest rates
D) the money supply should grow at a constant rate regardless of the state of the economy
5) The notion that the central bank should set its federal funds target by a formula that puts
weight on both output and inflation gaps is known as ________.
A) the Taylor rule
B) the constant growth rate rule for money
C) the equation of exchange
D) the Lucas rule
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6) According to the Taylor rule ________.
A) expectations are formed in an adaptive fashion
B) the central bank should set its federal funds rate target by a formula that puts weight on both
output and inflation gaps
C) a constant growth rate rule for money should be adopted
D) expectations should be formed consistent with the model of rational expectations
7) For monetarists, the sole source of fluctuations in aggregate demand is ________.
A) government spending and tax rates
B) the velocity of money
C) the supply of money
D) international trade variables, i.e. exports and imports
8) The constant growth rate rule for money, as initially proposed by Milton Friedman, has been
adjusted ________.
A) to take the problem of moral hazard in account
B) to account for the role played by adaptive expectations in policy formation
C) for the difference between real and nominal economic variables
D) to allow for possible short-run movements in velocity
9) According to monetarist theory, responsibility for the Great Depression lays with ________.
A) the Federal Reserve System
B) the liberal rulings of the Supreme Court
C) the President and Congress of the United States
D) unfair trade practices
10) The Swiss National Bank established the practice of targeting monetary aggregates in
________.
A) 1929
B) 1975
C) 2001
11) The political business cycle involves the ________.
A) expenditure of substantial funds by industry lobbyists to manipulate government regulation
B) movement of individuals from government employment to positions within the industry they
had previously participated in regulating
C) use of expansionary fiscal policy just prior to elections
D) election of government officials who are supportive of the government sector
12) An example of the political business cycle in action came during the ________.
A) Roosevelt administration of the 1920s
B) Nixon administration of the 1970s
C) Reagan administration of the 1980s
D) Bush administration of the 2000s
13) The use of expansionary fiscal and monetary policy just prior to elections is known as the
________.
A) electoral college
B) time-inconsistency problem
C) Watergate scandal
D) political business cycle
14) When monetary policies result in a worsening of economic performance, the least likely
explanation is ________.
A) a political business cycle
B) changes in one or more key structural parameters of the economy
C) a policy-induced change in the expectations and behaviors of households and businesses
D) faulty interpretation of incomplete and ambiguous economic data
15) The argument that ________ receives strong support from the innovative policy response to
the recent financial crisis.
A) rules can be too rigid
B) discretionary policies are vulnerable to the time-inconsistency problem
C) money is the sole source of fluctuations in aggregate demand
D) changes in policies can change the coefficients in macroeconometric models
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16) Which of the following provides support for the use of discretion in economic policy-
making?
A) any policy rule that is based on a particular model will prove wrong if that model is wrong
B) the existence of a political business cycle
C) the conclusions of Friedman and Schwartz with respect to monetary and fiscal policy
D) the Watergate scandal
17) In 1975 the Swiss National Bank announced a policy of targeting ________.
A) the level of income
B) interest rates
C) rational expectations
D) monetary aggregates
18) Swiss attempts to target monetary aggregates ended in the 1990s because ________.
A) the expectations of Swiss households had evolved from being adaptive to rational
B) structural changes in the economy had rendered existing practices inflationary
C) of the resulting increase in interest rates
D) the ensuing deflation increased the real value of debt held by Swiss manufacturing firms
19) Swiss experience in the 1980s evidences the ________.
A) effectiveness of targeting monetary aggregates
B) need for discretion in the face of structural changes in the economy
C) value of fiscal policy over monetary policy
D) ascendancy of flexible exchange rate regimes over fixed exchange rate systems
20) Constrained discretion ________.
A) eliminates all discretion in policymaking
B) imposes an inherent discipline on consumers
C) imposes an inherent discipline on policymakers but does not eliminate all flexibility
D) requires policymakers follow a constant growth rate rule for money
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21) Of these policies, which is the best example of constrained discretion?
A) the annual federal budget deficit shall not exceed three percent of the GDP
B) the growth rate of the money supply shall be between two percent and five percent
C) macroeconomic policies shall promote rapid economic growth and low inflation
D) macroeconomic policies shall aim to keep inflation — on average over each five-year interval
— within a range of two percent to four percent
22) Evidence suggests that, with rare exceptions, economic policies are not manipulated in an
effort to influence electoral outcomes. Use the Lucas critique to explain why not.
23) How are rule-based policies similar to adaptive expectations?
21.4 The Role of Credibility and a Nominal Anchor
1) The tying down of the price level to a nominal variable by the central bank is known as
committing to ________.
A) a nominal anchor
B) rational expectations
C) a customs union
D) a positive aggregate demand shock
2) In the equation for the short-run aggregate supply curve, π = + γ + ρ, an
improvement in the credibility of monetary policy is represented by a change in ________.
A) expected inflation
B) the price shock
C) the sensitivity of inflation to the output gap
D) the output gap
3) One requirement for an effective nominal anchor is ________.
A) price stability
B) credibility
C) fixed exchange rates
D) rational expectations
4) The “anchor” that sustains the credibility of monetary policy is ________.
A) easily weighed during the slightest of macroeconomic storms
B) composed of some indestructible substance
C) necessary to avoid central bank independence
D) available for scrutiny to all who care to observe
5) A nominal anchor helps policy makers to avoid ________.
A) adaptive expectations
B) constrained discretion
C) negative demand shocks
D) the time-inconsistency problem
6) The immediate objective of a nominal anchor is to reduce the variability of ________.
A) monetary policy targets
B) expected inflation
C) aggregate demand
D) central bank credibility
7) For the most part, central bank credibility, or lack thereof, is reflected in the behavior of
________.
A) short-run aggregate supply
B) short-run aggregate demand
C) long-run aggregate supply
D) aggregate price shocks
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8) If the public believes the commitment to a nominal anchor to be credible, the effect of a
positive aggregate demand shock is for ________.
A) short-run aggregate supply to shift up
B) short-run aggregate supply to be unaffected
C) short-run aggregate supply to shift down
D) inflation, but not economic activity, to increase
9) If the public believes that the commitment to a nominal anchor is not credible, the effect of a
positive aggregate demand shock is for ________.
A) short-run aggregate supply to shift down
B) short-run aggregate supply to remain unchanged
C) short-run aggregate supply to shift up
D) inflation, but not economic activity, to increase
10) If the public believes the commitment to a nominal anchor to be credible, the effect of a
negative aggregate demand shock is for ________.
A) short-run aggregate supply to shift up
B) short-run aggregate supply to be unaffected
C) short-run aggregate supply to shift down
D) inflation, but not economic activity, to decrease
11) If the public believes that the commitment to a nominal anchor is not credible, the effect of a
negative aggregate demand shock is for ________.
A) short-run aggregate supply to shift down
B) short-run aggregate supply to remain unchanged
C) short-run aggregate supply to shift up
D) inflation, but not economic activity, to decrease
12) Monetary policy credibility has the benefit of ________.
A) stabilizing inflation in the short run when faced with positive demand shocks
B) stabilizing economic activity in the short run when faced with positive demand shocks
C) transmitting the effect of aggregate demand shocks onto short-run aggregate supply
D) enhancing the job opportunities of Federal Reserve officials after they leave the central bank
13) The strength of the movement in the short-run aggregate supply schedule, in response to an
aggregate demand shock is determined by ________.
A) the price elasticity of demand
B) the credibility of the monetary authorities
C) the underlying state of the economy
D) the choice of nominal anchors
14) Consider two similar economies hit by the same temporary negative supply shock. In the
economy with the more credible monetary policy, there will be ________.
A) smaller increases in both inflation and the real interest rate
B) a smaller increase in inflation and larger increase in the real interest rate
C) a smaller increase in inflation and larger decrease in output
D) a smaller increase in output and larger increase in the real interest rate
15) In 1973, 1979 and 2007, the U.S. economy was hit by ________.
A) the collapse of the financial sector
B) the assassination of a Federal Reserve Board member
C) three major aggregate supply shocks
D) the after-effects of the process of creative destruction
16) The effects of the negative supply shocks of 1973, 1979 and 2007 were different due to the
________.
A) role played by rational expectations in the 1979 event
B) different sources of the supply shocks
C) credibility of the monetary authorities
D) different individuals who led the Federal Reserve System
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17) The effects of the negative supply shocks of 1973, 1979 and 2007 were different due to the
________.
A) willingness of policy makers, in the earlier episodes, to cause a sharp increase in
unemployment, in order to keep inflation low
B) coincidence, in 2007, of politically-motivated expansionary policies to lower unemployment
C) collapse of savings banks and real estate markets in the 1970s
D) need, in the earlier episodes, to resort to severely contractionary monetary policy
18) The negative supply shock of 2007, compared to the shocks in 1973 & 1979, involved
________.
A) a larger decrease in aggregate demand
B) larger decreases in the real interest rate
C) smaller decreases in aggregate supply
D) larger increases in the real interest rate
19) Comment on the ability of a credible nominal anchor to allow policy makers to exploit a
short-run trade-off between unemployment and inflation.
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21.5 Approaches to Establishing Central Bank Credibility
1) The adoption of inflation targeting in the United States ________.
A) brought an end to the “dual mandate” regime
B) resulted from legislation enacted in 1914
C) occurred after its adoption in more than a dozen other countries
D) was blocked by its staunch opponent, Ben Bernanke
2) Inflation targeting makes more sense than unemployment targeting, because ________.
A) monetary policies affect inflation, not unemployment
B) expected unemployment is not a key determinant of the unemployment rate
C) a commitment to avoid high inflation is inherently more credible than a commitment to avoid
high unemployment
D) most voters and most elected officials are more concerned about inflation
3) Which of the following is not, in general, an aspect of inflation targeting?
A) institutional commitment to a dual mandate
B) the public announcement of medium-term numerical inflation targets
C) increased accountability of the central bank
D) increased transparency of monetary policy
4) In the United States, the long-run inflation target is ________.
A) undisclosed
B) currently set at 7%
C) currently set at 2%
D) currently set at minus 1%
5) Inflation targeting involves public disclosure of each of the following, except ________.
A) policy makers’ plans and objectives
B) explanation of discrepancies between target inflation and actual inflation
C) the federal government debt ceiling
D) projections of macroeconomic conditions
6) Nominal GDP targeting ________.
A) is consistent with a dual mandate
B) has been adopted in more countries than have adopted inflation targeting
C) is, compared to inflation targeting, easier both to implement and to explain
D) is preferred strongly by “conservative” central bankers
7) The country with the highest degree of central bank independence in the period 1973-88 was
________.
A) the United States
B) New Zealand
C) Spain
D) Germany
8) The country with the lowest degree of central bank independence in the period 1973-88 was
________.
A) Germany
B) Japan
C) The United States
D) Spain
9) The academic work of Ben Bernanke, recent Chairman of the Board of Governors of the
Federal Reserve System, suggests that he is a firm advocate of ________.
A) fixed exchange rates
B) inflation targeting
C) decreased central bank transparency
D) nominal GDP targeting
10) Which of the following has served most recently as Chairman of the Board of Governors of
the Federal Reserve System?
A) Nancy Pelosi
B) Alan Greenspan
C) Ben Bernanke
D) Paul Volcker
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11) The dual mandate of the Federal Reserve System is to maintain ________.
A) exchange rate and price stability
B) price stability and maximum sustainable employment
C) maximum sustainable employment and GDP growth
D) GDP growth and exchange rate stability
12) Central bank credibility may be established by ________.
A) the appointment of individuals to the Fed with a strong aversion to inflation
B) quicker responses to negative aggregate supply shocks
C) greater coordination between monetary and fiscal policy
D) the appointment of central bankers who are hawkish on defense
13) Which of the following is least likely to enhance central bank credibility?
A) “town meetings” on the topic of monetary policy
B) policy makers’ expertise
C) independence from short-run political influences
D) accurate measurement of macroeconomic variables
14) Paul Volcker was appointed to head the Federal Reserve System by ________.
A) Richard Nixon in 1969
B) Jimmy Carter in 1979
C) Ronald Reagan in 1992
D) Barack Obama in 2009
15) During his tenure at the helm of the Federal Reserve System, Paul Volcker reestablished
________.
A) a system of fixed exchange rates
B) the role of open market operations in the monetary policy actions of the Fed
C) the credibility of the Federal Reserve as an inflation fighting institution
D) the targeting of monetary aggregates, like the fed funds rate
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16) Greater central bank independence is positively related to ________.
A) a low rate of unemployment
B) the length of terms of Governors on the Board of Governors
C) a higher level of GDP
D) the ability to fight inflation
17) Central bank independence ________.
A) is receding as democratic movements gain influence around the world
B) is correlated with relatively high unemployment
C) remains an obstacle to policy transparency
D) is the norm in a growing number of countries
18) The expected benefits of central bank independence include avoidance of ________.
A) Ben Bernanke
B) public scrutiny of central bank policies
C) the time-inconsistency problem
D) serious policy errors
19) Policy independence for the Federal Reserve is logically similar to allowing the ________.
A) National Oceanographic and Atmospheric Administration to select the nation’s weather
B) Congressional Budget Office to estimate the government’s expenditures
C) individual states to set highway speed limits
D) Social Security Administration to determine benefit levels and eligibility requirements
20) The non-democratic character of the Board of Governors of the Federal Reserve System
helps support ________.
A) the political business cycle
B) the time-inconsistency problem
C) its independence
D) rational expectations of Federal Reserve behavior
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21) How is inflation targeting consistent with the “dual mandate” of price stability and maximum
employment?
22) How does central bank independence cause lower inflation?
23) What might an “anti-inflation hawk” do so that good macroeconomic performance is likely
to continue under his or her successors as head of the central bank?