Question

Excercise 11.6

In a situation of economic or political instability, a standard reaction of citizens is to exogenously reduce their demand for money. what happens then to the interest rate, income, and the money supply under a fixed exchange rate regime? When the central bank obeys a Taylor rule? Explain also what happens to the nominal exchange rate.

Answer 1

Monetary policy is the guide that central banks use to manage money, credit, and interest rates in the economy to achieve its economic goals. A primary purpose of a central bank is to stabilize economy, promote growth and restrict inflation. The monetary tools used to achieve these objectives involve changing the size of the monetary base or changing the interest rate. However, the link between the monetary base, which is the amount of currency held by the public plus banking reserves, and the economy is weak, because the effect of the quantity of money on the economy depends not only on the size of the monetary base but also on the velocity of money — how quickly either banks lend out the money or people spend it.

Under a fixed exchange rate regime, a tax increase will: require a reduction in the money supply. cause no change in the domestic interest rate cause a reduction in income. Monetary policy ineffective under fixed exchange rates, you give up on an independent monetary policy. You cannot use monetary policy to target domestic inflation or to try to smooth out the domestic business cycle. The only hope for independent monetary policy is capital controls to prevent traders buying or selling domestic currency.

Although the actual equation used to determine Taylor's Rule can vary, depending on what central bankers considered more important and on the constant used for the long-term real interest rate, the equation has the following general format:

Target Interest Rate = Long-Term Real Interest Rate + Current Inflation + ½ Inflation Gap + ½ Output Gap.

When cetral banks obeys the Taylor rule, it is a monetary policy model that stipulates how much the central bank should change the nominal exchange rate in response to changes in inflation, output, or other economic conditions.