Chapter 24
ANSWERS TO QUESTIONS
1. What does the Lucas critique state about the limitations of our current understanding of the
way in which the economy works?
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.
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.
According to the rational expectation theory, individuals might interpret this increase in the
investment in anticipation of a low inflation economic environment that encourages
investment.
b. What would be Lucas’s critique of this model?
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.
5. In what sense can greater central bank independence make the time-inconsistency problem
worse?
6. What are the arguments for and against policy rules?
Advocates of rules argue that they solve the time-inconsistency problem so that policymakers
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.
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?
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?
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
11. How does Switzerland’s monetary targeting strategy as described in this chapter
demonstrate the case against monetary policy rules?
12. How is constrained discretion different from discretion in monetary policy? How are the
outcomes of these policies likely to differ?
13. In general, how does credibility (or lack thereof) affect the aggregate supply curve?
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
Fed’s credibility in fighting inflation.
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.
True, if expectations about policy affect the wage- and price-setting process. In models in
16. Why did the oil price shocks of the 1970s affect the economy differently than the oil price shocks
of 2007?
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.
funds rate target some years ago.
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%?
maintain.
19. What are the purposes of inflation targeting, and how does this monetary policy strategy
achieve them?
poor record of inflation stabilization?