Chapter 16
ANSWERS TO QUESTIONS
1. What are the benefits of using a nominal anchor for the conduct of monetary policy?
2. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing
overly expansionary monetary policy?
3. Why would it be problematic for a central bank to have a primary goal of maximizing
economic growth?
4. “Since financial crises can impart severe damage to the economy, a central bank’s primary
goal should be to ensure stability in financial markets.” Is this statement true, false, or
uncertain? Explain.
5. “A central bank with a dual mandate will achieve lower unemployment in the long run than a
central bank with a hierarchical mandate in which price stability takes precedence.” Is this
statement true, false, or uncertain? Explain.
False. There is no long-run trade-off between inflation and unemployment, so in the long run
6. Why is a public announcement of numerical inflation rate objectives important to the success
of an inflation-targeting central bank?
7. How does inflation targeting help reduce the time-inconsistency problem of discretionary
policy?
8. What methods have inflation-targeting central banks used to increase communication with
the public and to increase the transparency of monetary policymaking?
9. Why might inflation targeting increase support for the independence of the central bank in
conducting monetary policy?
10. “Because inflation targeting focuses on achieving the inflation target, it will lead to
excessive output fluctuations.” Is this statement true, false, or uncertain? Explain.
11. What are the key advantages and disadvantages of the monetary strategy used by the Federal
Reserve under Alan Greenspan, in which the nominal anchor was implicit rather than
explicit?
12. “The zero lower bound on short-term interest rates is not a problem, since the central bank
can just use quantitative easing to lower intermediate and longer-term interest rates
instead.” Is this statement true, false, or uncertain? Explain.
13. If higher inflation is bad, then why might it be advantageous to have a higher inflation target
rather than a lower target that is closer to zero?
14. Why aren’t most central banks more proactive in trying to use monetary policy to eliminate
asset-price bubbles?
15. Why might it be better to lean against credit-driven bubbles rather than just clean up after
other types of asset bubbles burst?
16. According to the Greenspan doctrine, under what conditions might a central bank respond to
a perceived stock market bubble?
17. Classify each of the following as either a policy instrument or an intermediate target, and
explain your choice.
a. The ten-year Treasury bond rate
b. The monetary base
c. M1
d. The fed funds rate
18. “If the demand for reserves did not fluctuate, the Fed could pursue both a reserves target
Explain.
True. In such a world, hitting a reserves target would mean that the Fed would also hit its
19. What procedures can the Fed use to control the federal funds rate? Why does control of this
interest rate imply that the Fed will lose control of nonborrowed reserves?
20. Compare the monetary base to M1 on the grounds of controllability and measurability.
Which do you prefer as an intermediate target? Why?
21. “Interest rates can be measured more accurately and quickly than reserve aggregates; hence
an interest rate is preferred to the reserve aggregates as a policy instrument.” Do you agree or
disagree? Explain your answer.
22. How can bank behavior and the Fed’s behavior cause money supply growth to be procyclical
(rising during booms and falling during recessions)?
23. What does the Taylor rule imply that policymakers should do to the fed funds rate under the
following scenarios?
a. Unemployment rises due to a recession.
b. An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%.
If inflation rises by 1%, this alone would prompt the fed funds rate to rise by 1.5
c. The economy experiences prolonged increases in productivity growth while actual output
growth is unchanged.