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chapter
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Monetary Institutions
and Strategies
1. Suppose a parent paid your college tuition this year. He or she wants you to get a
summer job so you can contribute next year. You would prefer to spend your time
with friends at the beach. Your parent says, “There’s no way I’ll pay for everything next
year. If you don’t get a job, you’ll have to take a semester off.”
Are you likely to take this threat seriously and get a job? Explain why or why not. An-
swer this question under two different assumptions:
a. You are an only child.
ANSWER: Whether you will take the threat seriously depends on the track record of
your parents and on how much you care about going back to college. If your parents
are complete pushovers who can be easily manipulated and have a comfortable in-
b. You are the oldest of 10 children.
ANSWER: Other things being equal, the time-consistency problem is much less se-
vere if you are one of 10 children. You’d better believe that your parents will not pay
2. Suppose the Phillips curve becomes steeper: a given change in output has a larger
effect on inflation. How does this affect the time-consistency problem facing the cen-
tral bank and the likelihood of high inflation? (Hint: Think about the surprise-inflation
decision in Figure 16.2.)
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ANSWER: The surprise-inflation decision hinges on the fact that once inflationary
expectations are anchored, that is,
π
eis fixed, the central bank can increase output
ealong the
3. In the Kydland-Prescott theory, it is desirable for central bank officials to hate in-
flation passionately. Is it also desirable for them to hate unemployment passionately?
Explain why or why not.
ANSWER: By definition, conservative central bankers care more about keeping in-
flation low than about stimulating output. If central bankers hate unemployment
4. Governors of the Federal Reserve serve overlapping terms in office. When one
governor is appointed, the others are at various points in their terms. Suppose a
new law mandates that all governors are appointed at the same time for concur-
rent terms. Would this increase or decrease the risks of discretionary monetary
policy? Explain.
ANSWER: Appointing all governors at the same time will increase the risks of dis-
cretionary monetary policy. In this case of joint appointments, monetary policy will be
associated with a particular group of people who can put their own stamp on policy.
5. Consider the relationship between inflation targeting and Taylor rules (Section
15.3).
a. The adjustment of interest rates under inflation targeting is similar to a Taylor
rule. Explain why.
ANSWER: The Taylor rule advocates changes in the real interest rate in response to
an output gap and to deviations from an inflation target. With inflation targeting, the
b. If a central bank shifts from flexible inflation targeting to strict targeting, does
the equivalent Taylor rule become more or less aggressive? (A more aggressive
rule responds more strongly to movements in output and inflation.)
CHAPTER 16 Monetary Institutions and Strategies A-107
ANSWER: In the context of the Taylor rule from Chapter 15, r= rn+ ayY
~+ a
π
(
π
–
π
T),
a more aggressive policy can be interpreted as an increase in the parameters ayand
6. In 2005, when President Bush announced Ben Bernanke’s appointment as Fed
chair, the Dow Jones stock index jumped by more than 1 percent in a few minutes.
a. Why do you think that happened?
ANSWER: Recall the classical theory of asset prices from Chapter 3. This theory
states that stock prices are the present value of the sum of expected future earnings.
With Ben Bernanke, President Bush appointed a highly accomplished economist with
b. If the United States adopted inflation targeting, how might that affect the reac-
tion of the stock market to Fed appointments? Explain.
ANSWER: With an explicit inflation target, the stock market is expected to react much
7. Figure 12.23 on p. 377 shows the effects of an adverse supply shock in the AE/PC
model. The figure assumes adaptive inflation expectations:
π
e=
π
(–1) and shows
how the economy evolves if the central bank accommodates the supply shock and if
it doesn’t. Now suppose the central bank adopts an explicit inflation target,
π
T. Infla-
tion expectations become anchored at the target:
π
=
π
T.
a. For these expectations, show how the economy responds to a supply shock
under accommodative and nonaccommodative policy.
ANSWER: Assume that the economy starts out at potential output and the actual in-
e=
T. The ad-
Under an accommodative monetary policy, the central bank will hold the real interest
rate constant. Output will stay at potential, but inflation will increase above its target
With a nonaccommodative monetary policy, the central bank responds to the supply
shock by increasing the real interest rate, which leads to a reduction in spending and
b. Does the anchoring of expectations make it more or less desirable to accom-
modate the shock? Explain.
ANSWER: The successful anchoring of inflation expectations makes it more desir-
8. Consider a policy of “output and inflation targeting”: the central bank announces nu-
merical targets for both inflation and real GDP. What are the pros and cons of such
a policy? No central bank has seriously considered this approach; why not?
ANSWER: Numerical output targeting requires that the central bank can correctly
measure potential output. Since potential output is hard to measure, the central bank
can easily pursue the wrong target with respect to output. Also if the central bank an-
From a more theoretical perspective based on the AE/PC model it is clear that out-
put and inflation are simultaneously determined. Especially in the case of an adverse
9. Suppose the growth rate of Europe’s money supply exceeds the ECB’s reference
value, leading the ECB to raise its interest-rate target. Will this action push money
growth toward the reference value? Explain. (Hint: Review money and interest-rate
targeting in Section 11.6.)
ANSWER: Based on the liquidity preference framework, money supply and the
money demand curve determine the nominal interest rate. If the money demand curve
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10. In 2006, Ben Bernanke said the goals of strong output growth and low inflation
“are almost always consistent with each other.” Alan Greenspan once called the trade-
off between output and inflation “ephemeral.”
a. Are these statements accurate? Explain.
ANSWER: The Encarta dictionary explains the meaning of the word ephemeral as
short-lived, lasting for only a short period of time and leaving no permanent trace.
b. Why do you think the chairmen made these statements?
ANSWER: In both cases, the chairmen made those comments to address the prob-
lem of time-consistency. By emphasizing the short-lived nature of the trade-off be-
ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
11. The text Web site has data from the Ball-Sheridan study on inflation targeting.
One variable is the standard deviation of output growth, which measures the insta-
bility of output.
a. In theory, how might inflation targeting affect output stability? (Hint: One could
argue for either positive or negative effects.)
ANSWER: The Phillips curve relationship shows a theoretical connection between in-
flation and output stability with
π
=
π
e+ aY
~. Output variability can be measured by the
size of the output gap Y
~; the larger Y
~on average (in absolute terms since Y
~can be
e, large out-
b. What do the Ball-Sheridan data say about this issue? Compare the standard
deviation of output growth before and after the early 1990s in countries that
adopted inflation targets and countries that didn’t.
CHAPTER 16 Monetary Institutions and Strategies A-109
ANSWER: Comparing both groups of countries, those that adopted inflation target-
ing and those that didn’t, shows that both groups were characterized by lower output
12. The text Web site links to “Inflation Targeting for the United States?,” a 2005 ar-
ticle by economist Marvin Goodfriend, and to a comment on the article by Donald
Kohn, then the vice-chair of the Fed. Goodfriend supports inflation targeting and Kohn
opposes it. Write a brief essay saying which side you agree with and why. Have
events since 2005 bolstered Goodfriend’s or Kohn’s arguments?
ANSWER: The major arguments for inflation targeting stress that targeting one ulti-
mate goal of policymaking provides a constraint to policymakers, increasing the like-
lihood of locking in good policy. Also, inflation targeting is thought to help anchor
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