Chapter 24

The Lucas critique has implications for the term structure of interest rates and the economy as a whole​ because:

economic decisions and behavior are strongly related to​ long-term rates.

A​ "conservative" central​ banker:

has a strong aversion to inflation.

Greater central bank independence can make the​ time-inconsistency problem worse​ because:

there is less formal accountability by central banks to pursue stable inflation policies

​"The more credible the policymakers who pursue an​ anti-inflation policy, the more successful that policy will​ be." This statement is

true

According to​ Lucas, the​ public's expectations about a policy How can use of macroeconometric models that do not assume expectations are rational be problematic for policy​ analysis?

will influence the response to that policy. They are unreliable for evaluating policy options.

What is the​ time-inconsistency problem? What role does the​ time-inconsistency problem play in the debate between advocates of discretion and rules in policy​ making?

A situation where policymakers are tempted to renege on a policy to pursue​ long-run objectives because there may be​ short-run gains from expansionary policy that produces bad​ long-run outcomes. Advocates of rules argue that rules solve the​ time-inconsistency problem because policymakers have to follow a set plan that achieves desirable​ long-run outcomes.

Which of the following is not a valid argument either for or against central bank​ independence? A. An independent central bank may create frequent policy conflicts with the fiscal​ authority, thereby signaling mixed economic strategies to the public. B. Increasing central bank independence is inconsistent with democratic principles. C. Increasing central bank credibility gives the central bank more independence from the political process and may solve the​ time-inconsistency problem. D. An independent central bank has not always used its freedom successfully.

A. An independent central bank may create frequent policy conflicts with the fiscal​ authority, thereby signaling mixed economic strategies to the public.

As part of its response to the global financial​ crisis, the Fed lowered the federal funds rate target to nearly zero by December 2008 and nearly tripled the monetary base between 2008 and​ 2011, a considerable easing of monetary policy.​ However, survey-based measures of​ five- to​ ten-year inflation expectations remained low through most of this period. Which of the following statements on the​ Fed's credibility to fight inflation is​ correct? A. The Fed has a high level of credibility. B. The fact that the market​ participants' expected real interest rate is below zero implies that the Fed has a low level of credibility. C. The fact that the market participants had low expected inflation implies that their expected aggregate demand for the future remained very low. D. The market​ participants' low expected inflation means a pessimistic forecast of the future economy—not the​ Fed's credibility to fight inflation.

A. The Fed has a high level of credibility.

Which of the following is a benefit of having a credible nominal​ anchor? A. It helps to solve the​ time-inconsistency problem. B. It enables policy makers to achieve price stability. C. It helps control inflation​ expectations, leading to smaller fluctuations in inflation and output. D. All of the above are correct.

All of the above

Which of the following statements is​ true? A. Lucas's policy critique suggests that macroeconometric models are useful for forecasting. B. Lucas's policy critique says nothing about the usefulness of macroeconometric models as forecasting tools. C. Lucas's policy critique suggests that macroeconometric models are useful for evaluating the impact of alternative policies on the economy. D. Lucas's policy critique suggests that macroeconometric models are useless for forecasting. Which of the following examples is subject to the Lucas​ Critique? A. Policymakers adjust the coefficients in their macroeconometric model to take account of changes in expectations. B. The central bank expects firm optimism to increase and so increases interest rates more in order to stabilize the economy. C. The central bank reduces interest rates more than usual because of anticipated weakness in spending and declines in consumer confidence. D. Policymakers overestimate the effectiveness of a tax cut based on the effects of prior tax changes. The ... critique indicates that because expectations are important in economic​ behavior, it may be quite difficult to predict what the outcome of a discretionary policy will be.

B. Lucas's policy critique says nothing about the usefulness of macroeconometric models as forecasting tools. D. Policymakers overestimate the effectiveness of a tax cut based on the effects of prior tax changes. Lucas

An approach to policy that has the advantage of policy flexibility but also imposes some inherent discipline on policymakers A policy framework that is believed by the public and reflects a strong commitment to a nominal anchor Making policy based on what is believed to be the right policy at the moment with no commitment to future actions Monetary policy based on binding plans that specify how monetary policy will react to particular situations Group of economists who believe that money is the sole source of fluctuations in demand​ and, therefore, believe that changing monetary policy can destabilize the economy

Constrained discretion Credibility Discretion Rules Monetarists

What does the Lucas critique say about the limitations of our current understanding of the way the economy​ works?

Econometric models that do not incorporate rational expectations ignore any effects of changing​ expectations, and thus are unreliable for evaluating policy options.

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. What is the implication of such a situation for the conduct of monetary​ policy? Do you think the central bank will follow a monetary policy​ rule, or engage in discretionary​ policy?

It is quite plausible that the conduct of monetary policy would be discretionary.

What is the significance of the Lucas critique of econometric policy​ evaluation?

It points out an econometric model based on past data may prove to be unreliable for evaluating policy options.

Central banks that engage in inflation targeting usually announce the inflation target and time period for which that target will be relevant. In​ addition, central bank officials are held accountable for their actions​ (e.g., they could be fired if the target is not​ reached), which is also public information. Why is transparency such a fundamental ingredient of inflation​ targeting?

It provides an extra incentive for central banks to attain their goals and makes their policy more credible.

If the public expects the Fed to pursue a policy that is likely to raise​ short-term interest rates permanently to​ 12%, but the Fed does not go through with this policy​ change, what will happen to​ long-term interest​ rates?

Long-term interest rates will fall.

Which of the following can provide a credible nominal​ anchor? A. expected exchange rate B. pegged exchange rate C. nominal exchange rate D. real exchange rate The benefit of having credibility is that

Pegged exchange rate the public adjust expectations in a way that reinforces the desired policy.

Which of the following statements is consistent with the Lucas​ critique?

Policy recommendations based on econometric models using data from the past may be flawed.

Which of the following is not an argument either for or against​ rules?

Rules can be flexible so policymakers will still have the same flexibility as in discretionary policy.

Which of the following is not a correct statement about the benefits and costs of sticking to a set of rules when going on a diet and raising​ children? A. In both​ cases, short-run deviations from the rules bring into question the credibility of future rules. B. The benefits of following rules when raising children are far greater than the costs. C. The benefits and costs of sticking to a set of rules when following a diet are relatively clear. D. The benefit to a set of rules when raising children may have positive effects in the long run. Sticking to a set of rules when following a diet may be compared with a ..., whereas sticking to a set of rules in raising children is similar to forcing ...

The benefits of following rules when raising children are far greater than the costs. central bank's monetary rules; governments to balance their budget every year

Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate. Assume that the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that promotes investment and economic growth. Which of the following is not an implication of the econometric​ model's predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run. What would be​ Lucas's critique of this​ model?

The increase in the federal funds rate implies an increase in real interest rates in the short run and long run.​ Therefore, the user cost of capital increases and investment decreases. ​Lucas's critique will point out the fact that the model was most probably constructed by using past data in which domestic investment decreased after interest rates increased and that individuals might revise their expectations quite quickly and decide to alter the way in which they respond to changes in the interest rate.

In​ general, how does a Central​ Bank's lack of credibility as an inflation fighter affect the aggregate supply​ curve?

The public will have higher inflation​ expectations, which will shift the aggregate supply curve up and to the​ left; thus, reducing output.

​If, in a surprise​ victory, a new administration is elected to office that the public believes will pursue inflationary​ policy, predict what might happen to the level of output and​ inflation, according to the traditional model​, even before the new administration comes into power.

There will be no predicted change in inflation or output.

Why did the oil price shocks of the 1970s affect the economy differently than the oil price shocks in​ 2007?

The​ Fed's credibility that it would keep inflation under control was stronger in 2007 than during the 1970s.

Assume a majority of governors are reluctant to increase interest rates to fight inflation for fear of causing too much unemployment in the short run. How is this situation most likely to affect the​ Fed's credibility?

This could be troublesome for the​ Fed's credibility, as it might require​ more-than-necessary increases in interest rates to show the public that the Fed still focuses on fighting inflation.

​"The more credible the policymakers who pursue an​ anti-inflation policy, the more successful that policy will​ be." Is this statement​ true, false, or​ uncertain? Explain your answer.

True. If expectations affect the​ wage- and​ price-setting process, a credible​ anti-inflation policy will reduce inflation faster and at lower costs.

​"The Lucas critique by itself casts doubt on the ability of discretionary stabilization policy to be​ beneficial." Is this statement​ true, false, or​ uncertain? Explain your answer.

True. The Lucas critique indicates that the effect of policy on inflation and output depends on​ expectations, making it harder to create a beneficial policy.

How does a credible nominal anchor help improve the economic outcomes that result from a positive aggregate demand​ shock? How does a credible nominal anchor help if a negative aggregate supply shock​ occurs?

With a credible nominal​ anchor, inflation is more stable following the demand shock. The decrease in output and the increase in inflation are less than under the absence of a credible nominal anchor.

Many economists are worried that a high level of budget deficits may lead to inflationary monetary policies in the future. Could these budget deficits have an effect on the current rate of​ inflation?

Yes, if these policies are fully​ anticipated, it could lead to a shift in​ short-run aggregate supply.

Does the case of​ Switzerland's monetary targeting strategy demonstrate the case for or against monetary policy​ rules? The Swiss strategy is a case ... monetary policy rules​ because:

against it demonstrates the difficulty in designing policy rules that can account for structural changes in the economy.

Inflation targeting can be used​ to: Which of the following is not a part of this monetary policy strategy to achieve these​ goals? A. Increased transparency of monetary policy strategy through communication with the public and the markets. B. Public announcement of the procedural details of using all​ inflation-related policy variables. C. An institutional commitment to price stability as the primary​ long-run goal of monetary policy. D. Public announcement of​ medium-term numerical targets for inflation.

keep inflation under control and increase the credibility of monetary​ policymakers' commitment to price stability. Public announcement of the procedural details of using all​ inflation-related policy variables.

Lucas argued that when policies change or new policies are​ implemented, public expectations are likely to change. The implication of this argument is​ that:

relationships established using econometric models also change.

More credibility helps ... both output and inflation when faced with an aggregate supply shock. A credible reduction in aggregate demand designed to reduce inflation Large government budget deficits

stabilize is costly in terms of lost​ output, but the cost is less than if the central bank had no credibility. may reduce the credibility of the central bank as an inflation fighter.

What does it mean to appoint a​ "conservative" central​ banker? A conservative central banker is viewed as having a particular aversion to higher One possible drawback to appointing a conservative central banker is that

the central banker is an​ anti-inflation hawk inflation the​ public's desire for a conservative central banker may change over​ time, but not be reflected in the actions of the conservative central banker.