Chapter 16 Homework Solutions
1. “Unemployment is a bad thing, and the government should make every effort to
eliminate it.” Do you agree or disagree?
Disagree. Unemployment can be classified into three categories: frictional, structural,
and cyclical. Frictional unemployment occurs when people are moving between jobs or
entering into the workforce and taking some time to find the job that best matches their
skills. Frictional unemployment is a desirable part of a healthy and growing economy, as
it indicates that resources are being efficiently allocated. Structural unemployment
results from long-run inefficiencies in labor markets caused either by policy or by
globalization and technical change leading to a long-run mismatch in skills and job
demands. Unemployment caused by a minimum wage that is set too high or unions
exerting monopoly labor power would be classified as structural. So too would someone
who loses their job due to increased trade (a shift in production away from their
industry and toward others) and cannot acquire the necessary skills to gain employment
in other sectors of the economy. While government policy could be aimed at structural
unemployment, it is not clear that monetary policy with its relatively short-run focus can
do anything about it. Finally, we have cyclical unemployment which results from
increases and decreases in consumer (and therefore labor) demand during business
cycles. If you are cyclically unemployed, you are likely to get your job back only when
the economy recovers from a recession and moves into an expansion. As monetary
policy can hasten this process, this is the unemployment that a central bank can
effectively target.
2. Classify each of the following as either a policy instrument or an intermediate target
and explain why.
a. The ten-year Treasury bond rate
This is an intermediate target since it is not directly affected by the tools of
monetary policy (non-borrowed reserves, discount rate, and reserve
requirements.) It is however, linked to economic activitiy.
b. The monetary base.
The monetary base is an operating target because it is directly affected by open
market operations and in some cases the discount rate (depending on where the
federal funds rate is in relation to the discount rate). MB is not an intermediate
target since it does not directly link to economic activity, but rather affects the
economy through its effects on the money supply.
c. M2
M2 (and M1) is an intermediate target because it is not directly affected by the
tools of monetary policy, but rather through the monetary base. You could
make a case that M2 is directly affected by changes in the reserve requirement,
but given that this is generally not a binding constraint anymore, M1 and M2 are
better seen these days as intermediate targets.
4. “If the demand for reserves did not fluctuate, the Fed could pursue both an aggregate
target and an interest-rate target at the same time.” Is this statement true, false, or
uncertain?
This statement is false. Suppose that the Fed was targeting a higher federal funds rate.
With a fixed demand for reserves, the Fed would have to achieve this interest rate
target by selling bonds through open market operations, shifting the supply of reserves
to the left. While this would raise interest rates up to the target, it would also cause
NBR and the monetary base to fall. Any time the Fed wanted to target a different
interest rate, they would have to change their monetary aggregate target.
6. Compare the monetary base to M2 on the grounds of controllability and measurability.
Which do you prefer as an intermediate target?
MB is both more controllable and measurable than M2. MB is directly affected by the
main tool of monetary policy, open market operations. While M2 is certainly influenced
by the Fed’s purchase and sale of bonds, changes in M2 also depend on how much
currency depositors choose to hold and how much excess reserves banks choose to
hold. MB is measured more accurately since it can be estimated directly from the Fed’s
own balance sheet (MB = Fed liabilities), while M2 must be estimated from a survey of
banks that is subject to revision and has potentially long lag times in reporting. For
these reasons, MB is a better policy target than M2. However, MB may not be the best
intermediate target as its connection to a specific policy target (like inflation) is weaker
than M2’s connection. The best strategy could be to use MB as a policy instrument and
M2 as an intermediate target, using the relationship between M2 and inflation to guide
monetary policy decisions about MB.
7. “Interest rates can be measured more accurately and quickly than reserve aggregates.
Hence, an interest rate is preferred over reserve aggregates as a policy instrument.” Do
you agree or disagree?
While it is true that nominal interest rates are measured more accurately than reserve
aggregates, it is not clear that real interest rates are, since real interest rates depend on
expected inflation which is notoriously difficult to estimate. Reserve aggregates tend to
be more controllable than interest rates, but the connection between interest rates and
a desired policy outcome (low inflation for example) tends to be stronger.
9. Give an example of a time-inconsistency problem that you experience in your
everyday life?
Time-inconsistency occurs any time your long-run goals are subjugated in favor of shortrun gain. For example, you have a long run goal to lose 10 pounds by the end of the
year. But when you go out to dinner tonight and the server asks if you want dessert,
you may choose the short-run pleasure of dessert despite the long-run consequence.
12. What is the big if necessary for the success of monetary policy targeting? Does the
experience with monetary targeting suggest that the big if is a problem?
Monetary targeting only works if there is a reliable and stable relationship between the
monetary aggregate and the policy goal (inflation for example). Historical examples
suggest that this relationship is not always predictable.
16. “Because inflation targeting focuses on achieving the inflation target, it will lead to
excessive output fluctuations.” Is this statement true, false, or uncertain?
Generally, inflation targeting does not imply a sole focus on inflation. The central bank
sets limits on how much inflation fluctuates and is held accountable for any deviations
outside these limits. Within these bounds, however, the central banks often do take
steps to limit output fluctuations. Obviously the central bank will be less able to
aggressively subdue output fluctuations given their legislative limits, but oftentimes the
discipline enforced by inflation targeting will be enough to lower inflationary
expectations enough that a brief period of expansionary policy will not cause prices to
rise too rapidly.
20. How can bank behavior and the Fed’s behavior cause money supply growth to be
procyclical (rising during an expansion and falling during a recession)?
Interest rates generally rise during an expansion as bank deposits increase the demand
for reserves. With higher interest rates, banks have less of an incentive to hold excess
reserves, since the opportunity cost is higher. As a result, there will be a decline in the
excess reserve ratio and an increase in the money multiplier. Assuming no action by the
Fed, there will also be an increase in the money supply. Adding to this money supply
growth is the fact that if the federal funds rate rises above the discount rate, there will
be an increase in borrowed reserves as banks choose to borrow directly from the Fed.
With lower excess reserve ratios and an increase in the monetary base, the money
supply will surely grow. This is clearly a concern since an expansion of the money supply
during an economic boom increases the risks of inflation.