Goal of monetary policy
To achieve price stability
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| Term | Definition |
|---|---|
| Goal of monetary policy | To achieve price stability |
| Why is high employment a key goal? | Because it avoids human misery caused by unemployment and prevents output loss due to idle workers and resources |
| Why isn’t full employment equal to zero unemployment? | Because frictional and structural unemployment always exist |
| What is frictional unemployment? | Temporary unemployment during job searching and transitions that helps match workers to suitable jobs |
| What is structural unemployment? | Mismatch between workers' skills and job requirements that cannot easily be fixed by monetary policy |
| What is the natural rate of unemployment? | The unemployment rate when labor demand equals labor supply |
| How does the natural rate of unemployment change over time? | It varies; estimated at 6% in the past |
| How can government policies affect the natural rate of unemployment? | Through job training and better job information to improve labor matching |
| What does stabilizing output around the natural rate mean? | Achieving high employment by keeping output close to potential output |
| How do central banks achieve high employment? | By stabilizing output at its natural level |
| Why is economic growth related to employment? | Because low unemployment encourages business investment in capital equipment |
| Why does high unemployment slow growth? | It discourages investment since factories and resources remain idle |
| How can policies promote economic growth? | By encouraging investment or saving |
| What is supply-side economics? | Policies that promote growth via tax incentives for business investment and saving |
| What is the role of monetary policy in economic growth? | It’s debated; some say it helps indirectly through stable conditions |
| Why is stability in financial markets important? | Because crises disrupt the ability of markets to channel funds to productive investments |
| What is financial stability? | Avoiding crises that can cause economic contractions |
| Why is interest-rate stability important? | It reduces uncertainty and helps individuals and firms make long-term decisions |
| What are the dangers of fluctuating interest rates? | They create uncertainty |
| How does interest-rate stability support financial markets? | It reduces bond losses and the risk of financial institution failures |
| Why is exchange-rate stability important? | It helps firms and individuals engaged in international trade plan effectively |
| What happens if the dollar rises in value? | U.S. exports become less competitive abroad |
| What happens if the dollar falls in value? | Inflationary pressure increases |
| Why is FX stability more critical in trade-dependent countries? | Because currency fluctuations can severely impact their economies |
| What is the pivotal importance of price stability? | It supports economic growth |
| What is a hierarchical mandate? | A framework (ECB |
| What is a dual mandate? | The Fed’s goal of promoting maximum employment |
| Why can dual mandates cause problems? | They may create time-inconsistency — pursuing short-term output gains at the cost of higher inflation later |
| Why do some prefer hierarchical mandates? | To prevent overly expansionary policies and keep inflation control as the top priority |
| What is an “inflation nutter”? | A central bank too focused on inflation |
| What is inflation targeting? | A strategy recognizing price stability as the main long-term goal and using a nominal anchor to achieve it |
| What are the five features of inflation targeting? | Public inflation goal |
| How does inflation targeting reduce time-inconsistency? | By holding central banks accountable and discouraging short-term expansionary policies |
| How does inflation targeting improve transparency? | Through clear communication |
| Why does inflation targeting support democracy? | It ensures accountability to elected officials while keeping central bank independence |
| What is a main disadvantage of inflation targeting? | Delayed signaling and potential overemphasis on inflation |
| Why isn’t inflation targeting too rigid? | Because it’s flexible enough to adjust for short-term economic conditions |
| How can inflation targeting affect output? | If too strict |
| Does inflation targeting reduce growth? | No — evidence shows economies return to or exceed previous output and employment levels |
| What is monetary targeting? | Using a nominal anchor (like money supply) to tie down the price level and stabilize inflation expectations |
| What is the time-inconsistency problem? | When policymakers abandon a good long-term plan for short-term gains |
| What was the Fed’s “Just Do It” strategy? | A pre-2012 approach of implicit inflation control without a formal anchor or target |
| What were the problems with “Just Do It”? | Lack of transparency and accountability increased uncertainty and time-inconsistency risk |
| When did the Fed officially adopt inflation targeting? | January 25 |
| What was Alan Greenspan’s stance on inflation targeting? | He opposed it |
| What did Bernanke change about Fed communication? | He increased transparency and promoted explicit inflation targeting |
| What did the global financial crisis reveal about monetary policy? | That financial sector stability is crucial for overall economic stability |
| What is the effective lower bound problem? | Interest rates cannot go much below zero |
| Why is financial crisis recovery costly? | It leads to slow recovery |
| Did price stability guarantee financial stability? | No — stable inflation led to complacency and excessive risk-taking |
| What were the implications for inflation targeting after the crisis? | It remains valid but needs flexibility and consideration of financial stability |
| Why not raise the inflation target to 4%? | Because controlling high inflation is historically difficult and distorting |
| What are asset-price bubbles? | Periods of rapidly rising asset prices disconnected from fundamentals |
| What are the two types of bubbles? | Credit booms and irrational exuberance |
| What does “lean vs clean” mean? | Whether to lean against bubbles early or clean up after they burst |
| What are macroprudential policies? | Regulations to limit excessive risk-taking and prevent credit-driven bubbles |
| Should monetary policy target bubbles? | It’s debated; most prefer focusing on price and output stability |
| Why are macroprudential tools imperfect? | Political pressure and regulatory loopholes limit their effectiveness |
| What are the criteria for choosing a policy instrument? | Observability |
| Why are short-term interest rates preferred as instruments? | They’re observable |
| What is the Taylor Rule? | A formula for setting the federal funds rate based on inflation |