Question

1. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy? Explain the Taylor rule and how the central bank can avoid the problem of dynamic inconsistency by following a Taylor type rule.

2. a) In some countries, the president chooses the head of the central bank. The same president can fire the head of the central bank and replace him or her with another director at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or will it engage in discretionary policy?

b) In recent years, central banks have dramatically increased the amount of communication with market participants and the public, and at the same time in many of these countries, average inflation has declined and become less volatile. Is this coincidence, or is there a connection? Explain.

3. a) “If countries fix their exchange rate, the exchange rate channel of monetary policy does not exist.” Is this statement true, false, or uncertain? Explain your answer.

b) During the 2007–2009 recession, the value of common stocks in real terms fell by more than 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of the recession? Be specific about the mechanisms through which the stock market decline affected the economy.

Answer 1

First question

Suppose the central bank expands the money supply in an attempt to stimulate demand when the economy is already in long- run equilibrium. The expansionary policy will increase the aggregate demand in the shor term. In the very short run, output will also expand without an increase in the price level. After operating at higher- than- normal production rates for a few months or quarters, companies will begin to push for price increases and input prices will begin to rise as well. The aggregate supply will steepen, and prices will increase while output will decline.
The ultimate problem for monetary authorities as they try to manipulate the supply of money in order to influence the real economy is that they cannot control the amount of money that households and corporations put in banks on deposit, nor can they easily control the willingness of banks to create money by expanding credit. Taken together, this also means that they cannot always control the money supply. And this leads to dynamic inconsistency and limits to the power of monetary policy. Also the central banks come under the pressure from the political parties , because most of them have more focus on the short term nature of the economy.

Taylor model explained that a rule-based framework if followed diligently by the central banks will help in avoiding these limitations in the long run . He argued for the response by the central bank with a plan and in a systematic way. He argued for a consistent approach to application of the monetary policy.