Chapter 15: Monetary Policy

Question 1

Transmission Mechanism

Answer 1

The routes or channels, traveled by the ripple effects that the money market creates and that affect the goods and services market.
Represented by the aggregate demand and aggregate supply curves in the AD-AS framework.

Question 2

Demand for Money (Balances)

Answer 2

The inverse relationship between the quantity demanded of money balances and the price of money balances.

Question 3

Why is the Keynesian transmission mechanism considered indirect

Answer 3

Changes in the money market do not directly affect the goods and services market (Real GDP) as the investment goods market stands between the two markets.

Question 4

Liquidity Trap

Answer 4

The horizontal portion of the demand curve for money.

Keynesians believe this happens at some low interest rate

Question 5

2 Ways in which the Keynesian Mechanism may get blocked

Answer 5

• Interest-insensitive investment

- The liquidity trap

Question 6

Explain Interest-insensitive investment

Answer 6

Some Keynesian economists believe that investment is not always responsive to interest rates.
For example, when business firms are pessimistic a decrease in interest rates will do little to increase investment.

Question 7

Monetarist Transmission Mechanism

Answer 7

Monetarist theory proposes a direct link between the money market and the goods and services market.

Question 8

Expansionary Monetary Policy

Answer 8

The policy by which the Fed increases the money supply

Question 9

Contractionary Monetary Policy

Answer 9

The policy by which the Fed decreases the money supply.

Question 10

Keynesian belief on monetary policy and the problem of inflationary and recessionary gaps

Answer 10

Most Keynesians believe that the natural forces of the market economy work much faster and more assurely in eliminating an inflationary gap than in eliminating a recessionary gap.
Therefore they will rather advocate expansionary monetary policy to eliminate a stubborn recessionary gap than advocate contractionary monetary policy to eliminate a not-so-stubborn inflationary gap.

Question 11

Activists

Answer 11

Persons who argue that monetary and fiscal policies should be deliberately used to smooth out the business cycle.

Question 12

Fine-tuning

Answer 12

The (usually frequent) use of monetary and fiscal policies to counteract even small undesirable movements in economic activity.

Question 13

Nonactivists

Answer 13

Persons who argue against the deliberate use of discretionary fiscal and monetary policies. They believe in a permanent, stable, rule-oriented monetary and fiscal framework.

Question 14

The case for activist (or discretionary) monetary policy rests on 3 major claims:

Answer 14

1. The economy does not always equilibrate quickly enough at Natural Real GDP
2. Activist monetary policy work; it is effective at smoothing out the business cycle
3. Activist monetary policy is flexible, nonactivist (rules-based) monetary policy is not

Question 15

The case for nonactivist (or rule-based) monetary policy also rests on 3 major claims:

Answer 15

1. In modern economics, wages and prices are sufficiently flexible to allow the economy to equilibrate at reasonable speed at Natural Real GDP
2. Activist monetary policies may not work
3. Activist monetary policies are likely to be destabilizing rather than stabilizing, they are likely to make matters worse, not better.

Question 16

Keynesian Transmission Mechanism: 3 Markets

Answer 16

• The money market
• The investment goods market
• The goods and services market

Question 17

3 Steps in which the Keynesian Transmission mechanism operates given an increase in the money supply

Answer 17

• An increase in the money supply brings on a lower interest rate
• As a result, investment increases
• As investment increases, total expenditures rise and the aggregate demand curve shifts rightward. Real GDP rises.

Question 18

2 Steps in which the monetarist transmission mechanism operates

Answer 18

• An increase in the money supply leaves individuals with an excess supply of money.
• As a result, they increase their spending on a wide variety of goods.

Question 19

4 Nonactivist monetary proposals

Answer 19

• Constant-money-growth-rate rule
• Predetermined-money-growth-rate rule
• Taylor rule
• Inflation targeting

Question 20

Constant-money-growth-rate rule

Answer 20

The annual money supply growth rate will be constant at the average annual growth rate of Real GDP.

Question 21

Predetermined-Money-Growth-Rate rule

Answer 21

The annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity.
%∆M = %∆Q - %∆V

Question 22

Criticism of the constant-money-growth-rate rule, argue that it makes 2 assumptions:

Answer 22

• Velocity is constant

- The money supply is defined correctly.

Question 23

Taylor rule

Answer 23

Federal Funds Target = 1.5 (Inflation rate) + 0.5 (GDP gap) + 1

Question 24

GDP gap measures

Answer 24

The percentage deviation of Real GDP from its potential level.

Question 25

Inflation targeting

Answer 25

Targeting that requires the Fed to keep the inflation rate near a predetermined level.

Question 26

Criticism of Inflation targeting

Answer 26

The policy would constrain the Fed at times, such as when it might need to overlook the target to deal with a financial crisis.

Question 27

Praise of Inflation targeting

Answer 27

The policy is more in line with the Fed's objective of maintaining near price stability.