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An open economy is currently producing at an output level that exceeds its long-run production capacity. To bring output back to the full-employment level, the central bank adjusts the target for the overnight rate to close the output gap. What should the central bank do? Also, describe how the monetary transmission mechanism works for the proposed change in monetary policy (i.e., describe how does the change in the target for the overnight rate affect the economy through different channels).

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Retselisitsoe Pokothoane
Retselisitsoe PokothoaneLv10
28 Sep 2019

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Canada is a small open economy with a flexible exchange rate. Recent statistics show that there is a slowdown in the Canadian economy. What would happen to the target for the overnight rate if the Bank of Canada wants to maintain output at full-employment? Describe how the monetary transmission mechanism affects output after the change in monetary policy.

An economy is operating with output $400 billion below its natural rate, and fiscal policy-makers want to close this recessionary gap. The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. The marginal propensity to consume is 4/5, and the price level is completely fixed in the short run. In what direction and by how much would government spending need to change to close the recessionary gap? Explain.

As we observed in this chapter, central banks, rather than purposefully setting the level of the money supply, usually set a target level for a short-term interest rate by standing ready to lend or borrow whatever money people wish to hold at that interest rate. (When people need more money for a reason other than a change in the interest rate, the money supply therefore expands, and it contracts when they wish to hold less.)

A. Describe the problems that might arise if a central bank sets monetary policy by holding the market interest rate constant. (First, consider the flexible-price case, and ask yourself if you can find a unique equilibrium price level when the central bank simply gives people all the money they wish to hold at the pegged interest rate. Then consider the sticky-price case.)

B. Does the situation change if the central bank raises the interest rate when prices are high, according to a formula such as R - R0= a(P - P0), where a is a positive constant and P0a target price level?

C.Suppose the central bank’s policy rule is R - R0= a(P - P0) + u, where u is a random movement in the policy interest rate. In the overshooting model shown in Figure 15-12, describe how the economy would adjust to a permanent one-time unexpected fall in the random factor u, and say why. You can interpret the fall in u as an interest rate cut by the central bank, and therefore as an expansionary monetary action.

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