Chapter 23
Modern Monetary Policy and the Challenges Facing Central
Bankers
Conceptual and Analytical Problems
1. Explain in detail how monetary policy influences banks’ lending behavior. Show
how an open market purchase affects the banking system’s balance sheet, and dis-
cuss the impact on the supply of bank loans. (You may wish to refer to Chapter 17
in answering this question.) (LO1)
Answer: The traditional tool of monetary policy in the U.S. is the federal funds
rate. To achieve the target rate, the Fed buys or sells Treasury securities. When the
2. Explain why you might expect the recovery from the 2007–2009 recession to be
weaker than normal. (LO1)
Answer: Recoveries from recessions precipitated from financial crises tend gener-
ally to be weaker. Banks tend to tighten credit standards in the wake of financial
disruptions which makes it harder for firms—particularly small firms who are
3. *Explain why the traditional interest-rate channel of monetary policy transmission
from monetary policy actions to changes in investment and consumption deci-
sions may be relatively weak. (LO1)
Answer: External financing by firms is made difficult by problems associated
with asymmetric information, weakening the impact of changes in the cost of
external funds on investment. Interest-sensitive consumption decisions depend on
4. Explain why monetary policymakers’ actions in cutting the target range for the
federal funds rate to 0 to ¼ percent were not sufficient to boost economic activity
during the recession of 2007–2009. (LO2)
Answer: The financial system is the key link between monetary policy and eco-
nomic activity. When the financial system is disrupted, so too is the mechanism
that transmits monetary policy actions to the real economy. The financial crisis
5. When monetary policymakers hit the effective lower bound with their policy rate,
they have the option to turn to unconventional tools of monetary policy. How do
these unconventional tools work, and why might policymakers be reluctant to use
them except in very difficult circumstances? (LO2)
Answer: Forward guidance, quantitative easing and targeted asset purchases are
examples of unconventional tools. Forward guidance, where the central bank ex-
presses the intent to keep interest rates low in the future; influencing long-term in-
terest rates if it is credible. A policy of targeted asset purchases involves buying
different assets than usual, such as longer-term Treasury bonds and mort-
Policymakers usually are reluctant to use these tools as they have limited experi-
ence with them, making the impact of their use less predictable. In addition, exit-
6. The government decides to place limits on the interest rates banks can pay their
depositors. Seeing that alternative investments pay higher interest rates, deposi-
tors withdraw their funds from banks and place them in bonds. Will their action
have an impact on the economy? If so, how? (LO1)
Answer: If depositors withdraw their funds, banks will be forced to shrink the size
of their balance sheets so the supply of loans will fall, with a special effect on
small firms and households that cannot issue debt in the securities markets (the
7. New developments in information technology have simplified the assessment of
individual borrowers’ creditworthiness. What are the likely consequences for the
structure of the financial system? For monetary policy? (LO2)
Answer: Individuals can now obtain loans and mortgages from many different
8. * Describe the theory of the exchange-rate channel of the monetary transmission
mechanism. How, through the exchange rate, does an interest rate increase influ-
ence output? Why is this link difficult to find in practice? (LO1)
Answer: A rise in nominal interest rates will lead to a rise in real interest rates in
the face of price stickiness. This makes domestic investments more attractive to
In practice, there are many factors that affect the demand and supply for domestic
9. Why might the effective lower bound on nominal interest rates lead policymakers
to raise their inflation objective? (LO2)
Answer: Nominal interest rates cannot fall significantly below zero. If an
economy experiences a deflationary shock when the nominal interest rate is zero,
10. Considering the role of the U.S. house price bubble in the financial crisis of
2007–2009, how do you think monetary policymakers should respond to bubbles
in asset markets? (LO2)
Answer: Sharp changes in asset prices can be very damaging to the economy, cre-
ating large swings in consumption through wealth effects, facilitating booms and
While monetary policymakers may wish to act to avoid or contain such bubbles,
there is disagreement as to what they should (and indeed can) do. A major prob-
lem is that it is difficult to identify bubbles as they are emerging and so policy-
11. For each of the following, explain whether the response is theoretically consistent
with a tightening of monetary policy and identify which traditional channel of
monetary policy is at work: (LO1)
a. Firms become more likely to undertake investment projects.
b. Households become less likely to purchase refrigerators and washing ma-
chines.
c. Net exports fall.
Answer:
a. This is not consistent with a tightening of monetary policy, which would
b. This is consistent with a tightening of monetary policy. In the face of high-
er interest rates, households become less likely to borrow to purchase con-
c. This is consistent with a tightening of monetary policy. When interest rates
rise, there is an increase in investor demand for U.S. assets, leading to an
12. In Country A suppose that changes in short-term interest rates translate quickly
into changes in long-term interest rates, while in Country B long-term interest
rates do not respond much to changes in short-term rates. In which country would
you expect the interest-rate channel of monetary policy to be stronger? Explain
your answer. (LO1)
Answer: Households’ decisions to buy cars and houses and firms’ decisions to
13. Consider a situation where central bank officials repeatedly express concern that
output exceeds potential output, implying that the economy is overheating. Al-
though they haven’t implemented any policy moves as yet, the data show that
consumption of luxury goods has begun to slow. Explain how this behavior could
reflect the asset-price channel of monetary policy at work. (LO1)
Answer: Policymakers expressing concern about the economy overheating may
14. Do you think the balance-sheet channel of monetary policy would be stronger or
weaker if: (LO1)
a. Firms’ balance sheets in general are very healthy?
b. Firms have a lot of existing variable-rate debt?
Answer:
a. The balance-sheet channel is likely to be weaker if firms generally have
b. The balance-sheet channel is likely to be stronger if firms have high levels
15. In the wake of the financial crisis of 2007–2009, would you anticipate the
bank-lending channel becoming more or less important in the United States? Ex-
plain your answer. (LO2)
Answer: The financial crisis interrupted the trend toward securities market fi-
nance, which could increase the importance of bank lending and strengthen the