1. (a) Exogenous variables and parameters: t, Ta, G, NXa, C¢a, I¢p, Ms/P, s, nx, c or (1 - s), b, f, h.
(b) Endogenous variables: Y, r.
(c) Target variables: Y, r.
(d) Policy instruments: t, Ta, G, Ms/P (since P doesn¡¦t vary, setting Ms determines Ms/P).
(e) The endogenous variables are identical to the target variables.
(f) The policy instruments are a subset of the exogenous variables.
2. The monetary policy variable is Ms, or Ms/P, since P is constant. The fiscal policy variables are t, Ta, and G.
3. There are four policy instruments. There are two target variables. Yes, there are at least two policy instruments. Hence, they are sufficient in number to determine the targets.
4. In the activist paradise, policymakers could perfectly forecast changes in demand as well as the future effects of current policy changes. Also, policy instruments would have powerful effects but no serious side‑effects.
5. Rules advocates argue that the private economy is stable and that there are no significant nor lengthy demand disturbances as long as fixed, stable policies are followed. Monetarists argue that activist policy is undesirable because it is disruptive.
6. Under a rigid rule, there would be no change in the
policy instrument. For example, under the constant growth rate rule (CGRR), the
growth rate of the money supply would be fixed at some rate, say 4 percent,
regardless of what was happening in the economy. With a feedback rule, the
policy instrument would change by some specific amount in response to a change
in the target variable
(e.g., an increase in the growth rate of the money supply by 2 percent in
response to an increase in the unemployment rate of one percentage point).
7. Activists tend to be very pessimistic about the self‑correcting powers of the private economy and optimistic about the efficacy of stabilization policy. Rules advocates have opposite beliefs.
8. Like the activists, those advocating a CGRR (monetarists) believe that stable growth of nominal GDP is the most desirable target. Because the monetarists believe in the stability of the private sector (both commodity and monetary sectors), however, they believe that a stable growth rate of the money supply will mean a stable growth rate of nominal GDP. Thus, the monetarists, like the activists, care about the rate of real output and the level of employment; however, they disagree about the best approach in achieving the desired rate and level.
9. If the demand for money is stable, then the velocity of money grows at a steady and predictable rate. The monetarists argue that, in this case, a constant growth rate rule for the money supply would imply a stable growth of nominal GDP. If, however, the demand for money is unstable, rigid control of the money supply does not achieve rigid control of nominal GDP. In fact, with unstable money demand, the Fed would do better with an interest-rate target than a money-supply target.
10. The data lag refers to the time that elapses before data to measure changes in economic conditions are gathered, processed, and made available to policymakers. The recognition lag occurs because policymakers need data for more than one reporting period (and may need it for several periods) in order to detect trends in the economy. The legislative lag measures the time required to choose an appropriate policy response after an undesirable trend is detected. The transmission lag is the time needed to change the policy instruments once the policy response has been chosen. The effectiveness lag denotes the amount of time that passes before changes in the policy instruments produce changes in real output and other target variables.
11. If the lag in the policy effect is long and variable, the policymaker cannot know, beforehand, if the policy will be stabilizing or destabilizing when it finally takes effect. If the lag is long but fixed, the policymaker can predict when the policy will take effect; however, the policy will work in this case only if the policymaker is able to forecast accurately the movements of the economy.
12. Suppose policymakers knew precisely how much change in a target variable was required to produce the desired policy outcome. Suppose they also had decided which policy instrument they would use to produce the result. For example, suppose policymakers desired to increase real GDP by $10 billion by raising government expenditures. They could not produce that outcome with certainty, however, unless they knew exactly how much change in the target variable would be produced. This requires certain knowledge of multiplier effects. For example, if the government spending multiplier were known with certainty to be 2, then an increase in government spending of $5 billion would produce the desired effect.
13. There were three factors that contributed to the decline in the effectiveness of monetary policy. The first is that financial deregulation made housing expenditures less sensitive to changes in the interest rate. The second is that more consumer expenditures are financed through credit card usage and credit card interest rates vary less as interest rates change. Finally, interest rates affect exchange rates, which in turn affect net exports, but with a long lag.
14. Figure 14.3 presents two indicators of the increased stability of the economy since the mid-1980s. There has been less variation in the log output ratio since the mid-1980s, both in terms of the decline below zero in the earlier part of the 1990s and the current decade as well as the rise above zero in the late-1980s and late-1990s. Similarly, the 20 quarter moving average of the absolute value of the log output ratio shows much more stability since the mid-1980s than previously.
The increased stability since the mid-1980s has been helped by the absence of severe demand shocks caused by the wide fluctuations in government spending resulting from the Korean and Vietnam wars in the 1950s and 1960s, as well as the tax cuts of 1964¡V65. In addition, the supply shocks since the mid-1980s have been beneficial, which allows the Fed to maintain stability in output without an increase in inflation.
The Fed contributed to increased stability by raising interest rates in 1994 before inflationary pressures built up, and by lowering them rapidly in 2001, which helped make the 2001 recession so mild. The Fed also acted fairly quickly, although not preemptively, in 1988 and 1991¡V91, which again moderated the fluctuations in output in the late- 1980s and early- 1990s.
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15. This pattern resulted from the Fed¡¦s attempts to engineer a ¡§soft landing¡¨ for the economy in which the output ratio would smoothly approach 100 percent. Keeping the output ratio at or near 100 percent would prevent large swings in unemployment and also keep the inflation rate stable (in the absence of supply shocks). When the output ratio rose above 100 percent, the Fed increased the federal funds rate to stifle aggregate demand and total spending and move real GDP back toward natural real GDP. It did the opposite when the output ratio dropped below 100 percent. This practice was discontinued in 1996 and subsequent years as a result of beneficial supply shocks and reductions in the natural rate of unemployment, which led to a deceleration of inflation despite a rising output ratio and unemployment rates that fell to their lowest levels in 25 years. The economy would not have performed as well as it did during the 1996¡V99 period had the Fed stuck to its prior policy response to increases in the output ratio.
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16. (a) Because the public believes the policy
announcement, it expects the inflation rate to be lower and the SP curve shifts
downward. The slowdown of nominal GDP growth can then reduce the inflation rate
with no decline in the output ratio or unemployment rate. (Note that if
long-term wage and price agreements prevent actual inflation from responding
immediately to policy changes, the expected inflation rate will not fall
immediately and there will therefore be a temporary decline in the output ratio
and increase in the unemployment rate.)
(b) As in part (a), the SP curve shifts downward (although, as before,
this may not happen immediately). With an unchanged rate of nominal GDP growth,
the output ratio rises, the unemployment rate falls, and the inflation rate
falls, although not as much as the expected inflation rate does.
(c) The public does not believe the announcement, so the SP curve does not
shift downward. Because policymakers actually reduce nominal GDP growth, the
output ratio declines, the unemployment rate rises, and the inflation rate
falls, although not as much as if the policy had credibility.
(d) As in part (c), the SP curve does not shift and, with no change in
nominal GDP growth, there is no change in the economy's position on the SP
curve. Therefore, neither inflation, the output ratio, nor the unemployment rate
change.
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17. If the Fed¡¦s response to a supply shock is neutral, then as shown in Chapter 8, a supply shock results in equal changes in the inflation rate and the output ratio, although in opposite directions. This indicates that the Fed¡¦s response is putting equal weight on inflation and output. If the Fed¡¦s response to the supply shock is accommodating, then it maintains the level of output, while allowing a change in the rate of inflation. This indicates that the Fed is putting no weight on inflation and all of its weight on output. Finally, if the Fed¡¦s response to the supply shock is extinguishing, then it maintains the rate of inflation, while allowing a change in the output ratio. This indicates that the Fed is putting all its weight on inflation and no weight on output.
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18. Reducing inflation from 5
percent to zero will cause temporary reductions in the output ratio and
increases in unemployment. These costs occur before the economy receives the
benefits of zero inflation; thus their present value likely will outweigh that
of the benefits of reduced inflation for policymakers whose time horizon is
short and who discount future benefits at a high discount rate. The longer
a policymaker¡¦s time horizon and the lower the discount rate, the more weight he
or she assigns the benefits of reduced inflation in the policy decision.
19. A nominal anchor is a rule that sets a limit on the growth rate of a nominal variable such as high-powered money, or the price level, or nominal GDP. The advantage of a nominal anchor is that by targeting a nominal value, an upper limit is placed on the rate inflation. That upper bound provides a guide for consumers and business in forming expectations about future inflation. Economists and policymakers sometimes refer to this effect as saying that inflationary expectations are well anchored.
A nominal GDP growth rate rule is the same as a Taylor rule which places equal weight on inflation and output growth in that the nominal GDP growth rate equals the rate of inflation plus the real GDP growth rate. Therefore both target the growth of a nominal variable, in this case nominal GDP, and therefore place a limit on how high inflation can be.
The difference between a Taylor rule which places equal weight on inflation and output growth with one that places equal weight on inflation and the output ratio is that when the output ratio is quite low, as in the early 1980s, or quite high, as in the late 1960s, the Fed has more flexibility in adjusting interest rates than if it is limited by how fast real GDP can grow.
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20. If effectiveness lags are long and variable, then policymakers should base their actions on what they expect the state of the economy to be when their policies have an effect on the economy. Therefore policymakers need to use their best forecasts of target variables in determining the actions that they take to influence those variables.
In raising interest rates in 1994, the Fed appears to have taken action anticipating that the economy would be operating near natural real GDP by the time the higher interest rates had the desired affect of slowing the growth of the economy. Similarly, the Fed acted quickly in early 2001 to sharply lower interest rates in anticipation of the recession that started in March of that year. Finally, while some economists may think that it was ill-advised of the Fed to lower interest rates in 1998 while the log output ratio was positive, the Fed may well have been expecting that the collapse of the Asian currencies would have had an adverse affect on net exports.
21. The arguments for
exchange-rate targeting are that it can signal a central bank¡¦s commitment to
follow
a rule for money supply growth, lending credibility to policymakers¡¦ pronounced
desires to lower inflation and helping them overcome the time inconsistency
problem. The arguments against a fixed exchange-rate policy include the fact
that the central bank relinquishes its ability to use monetary policy in pursuit
of domestic policy objectives and the possibility that the commitment to a fixed
exchange rate itself may lack credibility in the absence of additional
constraints on policymakers.
22. There are three arguments to support the euro. First, a common currency for members of the Economic and Monetary Union eliminates the risks of exchange rate fluctuations and the costs of exchanging currencies in commerce between countries within the union. Second, the use of a common currency is a way to force on all members of the union the monetary policies of Germany which resulted in low inflation. Third, the criteria for inclusion in the euro forces fiscal discipline on members wishing to use the euro as a currency.
The main argument against the euro is essentially that members of the union give up independent monetary policy to the European Central Bank. This is important if shocks do not impact all countries equally. A second argument against the euro is that the fiscal criteria for membership could restrict the ability of individual members of the union to use fiscal policy to stimulate their economies.
The evidence during the period 1999¡V2004 tends to support the case against the euro. Germany has suffered through low growth, in part due to it having high labor costs when compared to its neighbors, while Ireland has suffered from accelerating inflation due to its rapid growth. Yet neither country has the ability to use the appropriate monetary policy to correct its economic problem. Furthermore, if the European Central Bank chose to take actions to correct the problem of one country, it would exacerbate the difficulties of the other.
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