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The situation is diverse, but the overall situation has changed: deficit and debt have
increased and growth has lowered.

CHAPTER 23
Quick Check

1. a. False. Seignorage profits are typically very small and not sufficient to warrant the costs
of higher inflation.
b. False. The Fed is also charged with growing the economy and job creation.
c. False. Figure 23-1 shows several years of divergence between inflation and money
growth.
d. False. Evidence suggests that people have money illusion, when would seem to imply
that inflation would distort decision making.
e. False. The target inflation rate of most central banks is 2%.
f. True. The capital gains tax is not indexed to inflation.
g. True or uncertain. The Taylor rule uses both inflation and unemployment to help
determine the interest rate. If you limit the reference to recessions and booms as a
reference to the unemployment rate, the answer would be false.
h. False. Zero bound did not emerge as an issue until after the financial crisis of the late
2000s.
i. True
j. True
k. True

2. a. In the medium run equilibrium, the real interest rate is at rn. This is the real interest rate
where aggregate demand is equal to the natural level of output. Actual inflation will
equal expected inflation and target inflation. The target nominal interest rate will be i* =
rn + π*.

b. The right hand side of the money demand equilibrium will not change. Thus the left-hand
side must remain unchanged. The growth rate of money will equal the growth rate of
prices.

c. The right-hand side of the money market equilibrium will now grow at 3% per year. Thus
the real money stock must grow at 3%. Thus the growth rate of M must be 3 percentage
points higher than the growth rate of P. You would expect money growth to be larger
than inflation if there is growth in potential output.

d. In the part of Figure 23-1 before 1995, money growth appears to exceed inflation (price
growth) by about 2-3 percentage points. This gap would be accounted for by growth in
output. The results in parts b and c are consistent with Figure 23-1 up to 1995.

e. (i) This would reduce average cash holdings – easier to get cash when needed
(ii) This would reduce average cash holdings
(iii) This would reduce average cash holdings
(iv) This would also reduce average cash holdings

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f. Between 1980 and 2015, cash holdings rose by a factor of 10 and nominal GDP rose only
by a factor of prices only rose by a factor of 6. The ratio of currency to nominal GDP
increased. This is bit surprising given the changes in payment technology described in
part e. Non-residents of America hold a lot of American currency. Illegal transactions all
over the world are commonly carried out using American currency. This could account
for the increase.

3. a. The two version differ in that in first version the inflation rate changes between last
period and this period according to the Phillips curve. We interpreted this as saying
expected inflation was equal to last period’s inflation. In the second version, the level of
inflation this year from the anchored value (the unchanging value ) is a function of the
deviation of unemployment from the natural rate. We interpreted that as an anchored
value for the expected rate of inflation.

b. The central bank would set the nominal interest rate and thus the real interest rate so that
wherever the IS curve is, the level of output and the consequent unemployment rate
solves:
version one: ut = un + (π* - πt-1 ) / D

version two: ut = un + (π* - )/D

c. You can see if = π* then the unemployment rate is always at the natural rate. The
central bank’s task is very easy.

d. You can see if πe = πt-1 then if inflation was higher than target last period, expected
inflation is higher, and to reduce inflation unemployment must be high. The central
bank’s task is harder.

e. Credibility means people always believe that expected inflation will be target inflation.
This is the answer to part c.

f. This is not likely in practice. Shocks will drive actual inflation from target. It is unlikely
that the central bank will be able to hit its target every period. There will be surprises,
and there are lags and uncertainty in policymaking.

g. It will make it harder for central bank to set interest rates. Changes in the natural rate will
make it more difficult for the Fed to hits its target. It will be harder to distinguish
changes in the actual rate of unemployment from changes in the natural rate of
unemployment. If they do not know un exactly, then they may not adjust interest rates to
achieve the output gap to move inflation by the correct amount.

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4. a.
Cases 1 2 3 4 5
I* 2 2 2 2 2
πt 5 5 2 2 5
π* 2 2 2 2 2
Ut 8 5 8 8 5
Un 5 5 5 5 5
a 0.5 0.5 0.5 0.5 1
b 0.5 0.5 0.5 1 0.5
It (answer) 2 3.5 0.5 –1 5

b. Comments
In case 1, inflation targeting is equal to employment targeting (a and b have the same
value) and the rate of interest (It) has to be fixed at the target level, which is 2%.
In case 2, the economy has reached its natural rate of unemployment and the interest rate
has increased, slowing the rate of inflation.
In case 3, the unemployment is above its natural rate and inflation is contained.
Therefore, the interest rate has to be lowered.
Cases 4 and 5 differentiate between situations where the Bank favored either the
unemployment target (coefficient b higher than coefficient a) or the inflation target
(coefficient a higher than coefficient b).

5. a. The Fed was increasing the price (lowering the yield) on these securities by purchasing
them. The goal was to make mortgages less expensive and stimulate the purchase of new
houses. The other interpretation would be that the risk premium on these securities has
increased and the Fed was trying to offset part of that increase.

b. The Fed was trying to raise the price (lower the yield) on these securities. In terms of
Chapter 14, the term premium must have been higher. By taking the supply of these long-
term bonds off the market, the Fed was hoping to reduce long-term yields on government
bonds. Then they wanted to have the private sector see the lower yields and be more
willing to borrow for new investments.

c. You would expect to see long-term bond yields rise.

d. You would expect to see the interest rates on mortgage-backed securities rise

6. a. The minimum down payment is 20% of the home’s value or $60,000.

b. If the loan-to-value maximum is reduced, this increases the down payment. We would
expect this to reduce the demand for homes as households have to save a bit longer to
achieve the required down payment.

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c. Canadian home prices have continued to rise and the rate of increase was not slowing up
to 2015. By increasing the minimum down payment on very expensive homes, the
Finance Minister hoped to reduce the demand for homes and control a potential bubble.
As of the time of writing (January 2016), the policy had just been put in place. It is too
early to tell if the policy had an impact on house prices.

Dig Deeper

7. a. If inflation is zero, the value of saving after 10 years will be €32,384, which is enough to
cover the university fee of €30,000.

b. If the inflation rate is 5%, the fee will cost €48,867 after 10 years, and the rate of interest
of the saving will not be enough to cover it.

c. Under the same conditions, it will be necessary to save approximately €23,000 to cover
the fee in 10 years.

Saving (€) 15,000 23,000

Interest rate (%) 8 8
Duration (in years) 10 10
Future saving value (€) 32,384 49,655

University cost (year 1) 30,000 30,000

Inflation (%) 5 5
Period (in years) 10 10
Future cost (€) 48,867 48,867

8. a. The arguments in the paper are based on the fact that Central Banks have been designed
as fully independent from political power and the counterpart of that status is that they
must not interfere with the elected power and, consequently, with fiscal policy.

b. Applied to the letter, this position could lead to a harmful lack of coordination between
monetary policy and fiscal policy.

c. Central bankers do not want monetary policy to be the only tool to improve the economic
situation. They want to clarify the responsibilities of each authority.

d. A central bank is the key factor in financing the deficit and the debt, and it could lead to
money creation and thus inflation. Therefore, the dialogue between fiscal and monetary
authorities is crucial.

Fiscal policy has also played a large part in economic policies, but to a different extent, as has
been shown in Chapter 22.

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Explore Further

9. The ECB decided to fix a negative interest rate on the deposit facility, which is the deposit of
commercial banks on their accounts at ECB since June 11th, 2014.

In January 2016, the Central Bank of Japan decided “to apply a negative interest rate of minus 0.1
percent to current accounts that financial institutions hold at the Bank. It will cut the interest rate
further into negative territory if judged as necessary.” This differs from the ECB in that it adopts
a three-tier system in which “the outstanding balance of each financial institution's current
account at the Bank will be divided into three tiers, to each of which a positive interest rate, a
zero interest rate, or a negative interest rate will be applied”.
The aim of both central banks is the same: to induce commercial banks to issue more loans
instead of increasing their holdings at the central bank and achieve the price stability target of 2%
to sustain economic growth.

10. 1) a. The main and official concern of ECB, repeated several time, is to “return to the
objective of a rate of inflation which is close to but below 2%.” However, the
number of analysis about the weakened growth prospects shows that this
dimension is also a concern of the Bank. About the “high structural
unemployment and low potential output” the Bank firmly ask for structural
policies and “more growth-friendly composition of fiscal policy”.

b. The ECB decisions are presented based on an analysis of inflation and growth
with precise figures on quarterly and annual growth rate and monthly HIPC. So
there are all the signs of an economic model, of the same family as Taylor rule.
The Vice president of ECB confirms in one of his answers that the Bank has its
“models” – meaning that there are several models and not only one which
support the Bank decisions (see the presentation of its monetary policy by the
Bank itself which mention four category of model: “money demand models,
structural general equilibrium models with an active role for money and credit,
money-based inflation risk indicators and flow-of-funds analysis”.)

c. The rate on the deposit facility was lowered by 10 basis points to 0.40%. The
Central Bank President explains this decision by two reasons. The first one is a
matter of principle when the President said “negative rates were introduced for
one specific reason: when interest rates reached the zero lower bound, the
expectations for the future rates in the long term are only that the rates can go up.
So with negative rates we were successful in taking these expectations down.”

The other reason is the objective to incite commercial banks not to keep money
in house, but to deliver more loans to the firms – as it has been stated that “loan
growth in the euro area has been recovering now for quite a time, but it's still too
low”.

d. The term Macro prudential tools refers to structural financial aspects outside the
usual scope of monetary policy, what can be called ‘financial stability,” with
factors like housing prices, capital inflows, etc. In this very conference there are
no real of macro-prudential elements.

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2) The objective of monetary policy for the People’s Bank of China is “to maintain the
stability of the value of the currency and thereby promote economic growth.” The price
stability is not mentioned as a goal of the monetary policy, which is quite unique.

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