Questions -- Monetary Policy

Monetary Policy

1.	What is M1?
2.	What is M2?
3.	What is the monetary base, or high-powered money?
4.	What is the money multiplier?
5.	What determines how large the money multiplier is?
6.	How does the Federal Reserve control the money supply?	Answers
7.	Why might changes in the money supply have real effects on the economy?
8.	If prices are not perfectly flexible, how does a one-time unanticipated increase in the money supply affect nominal interest rates? Real interest rates? Real output?
9.	How does a sustained increase in the growth rate of the money supply affect nominal interest rates? Real interest rates? Real output?
10.	What is the short-run Phillips curve?
11.	What is the long-run Phillips curve?
12.	What accounts for the difference between the two?

Old Exam Questions

a.	What is the Phillips curve?
b.	From 1956 through 1969, the inflation rate averaged 2.46 percent per year and the unemployment rate averaged 4.89 percent. The corresponding figures were 8.14 percent and 7.46 percent for 1974-83. Are these numbers consistent with the traditional view of the Phillips curve as it was originally described in the 1950s? If so, why? If not, what might account for the discrepancy?
c.	Does the Phillips curve represent a stable set of policy choices for an economy? Why or why not?

Answer:

The Phillips curve depicts a negative relation between the unemployment rate and the inflation rate.

The numbers above are inconsistent with the traditional Phillips curve because both unemployment and inflation were higher during 1974-83 than during 1956-69. This pattern can be explained by a model with the following features: (i) there is no long-run relation between inflation and unemployment (i.e., the long-run Phillips curve is vertical at the "natural" rate of unemployment), (ii) given people's expectations of inflation, actual inflation and unemployment are negatively related in the short run (i.e., the short-run Phillips curve slopes downward), and (iii) the short-run Phillips curve shifts upward whenever the expected rate of inflation increases. According to this expectational Phillips curve, there is a negative relation only between unemployment and unexpected inflation. Several models can explain why unexpectedly high inflation temporarily raises aggregate supply. First, nominal wages or prices may be sticky in the short run. Alternatively, workers may not have good information about output prices, may mistakenly interpret an increase in nominal wages as an increase in real wages, and thus may supply more labor. Finally, firms may not have good information about output prices (other than their own), may mistakenly interpret an increase in the nominal price of their product as an increase in the relative price, and thus may supply more output. Unless people are very stupid or very unobservant, inflation cannot remain unexpectedly high forever. When they realize that prices in general have increased, aggregate supply returns to its natural rate.

Because the short-run Phillips curve shifts with changing inflation expectations, and because the long-run Phillips curve is vertical, there is no stable tradeoff between inflation and unemployment.

One of the most dramatic economic phenomena of the 1980s was a substantial reduction in the average rate of inflation. Inflation averaged 8.8% per year during the nine years from 1973 through 1981 (including an average of 10.3% per year from 1978 through 1981) and only 3.5% per year during the four years from 1982 through 1985. The inflation rate fell to 1.0% in 1986 and has not exceeded 4.5% in any year since then.

a.	What was responsible for this reduction in inflation?
b.	What effects would you expect such a long-lasting reduction in inflation to have in the short run? In the long run? Did these effects materialize? Be sure to address the effects on both real and nominal variables.

Answer:

The primary cause of the reduction in inflation was a reduction in money growth.

In the short run, money is not neutral because prices do not instantaneously adjust to clear the money market. A reduction in the rate of money growth (below what had been expected) causes an excess demand for real money balances. Because prices do not instantaneously adjust, this excess demand can be eliminated only through an increase in the nominal interest rate. Lower money growth almost certainly does not increase expected inflation, and probably reduces inflationary expectations. A higher nominal interest rate combined with unchanged or lower expected inflation implies a higher real interest rate. The higher real interest rate reduces consumption and investment spending, leading to lower GDP and higher unemployment than would otherwise occur.

These predicted short-run effects did materialize. After the Federal Reserve slowed the rate of money growth at the end of 1979, short-term nominal interest rates increased, reaching 20% for part of 1980. The economy experienced a brief recession in 1980, followed by a more severe downturn in 1981-82.

In the long run, money is neutral and does not affect real variables. In particular, it does not affect the real interest rate. A lower rate of money growth ultimately means a lower inflation rate and a lower nominal interest rate.

These long-run effects also materialized. The low inflation rate since the early 1980s has not depressed the economy, which experienced a prolonged period of growth until mid-1990 and then, after a milder recession, has experienced more than seven years of uninterrupted growth. Nominal interest rates ultimately came down in the mid-1980s as inflation remained low.