Reference no: EM13121715

Question

Provide brief but coherent responses to the following short questions.

a) Since identifying the M_D curve is difficult, the overnight interest rate is often used as the primary method of implementing monetary policy, whereas the money supply is kept fixed. Explain whether this statement is correct or incorrect, and why.

b) For a central bank that implements a credible policy of inflation targeting, this policy acts as an automatic fiscal stabilizer. Explain whether this statement is correct or incorrect, and why.

c) Assuming the Bank of Canada targets inflation of 1-3% per year, if the CPI were to rise by 5% suddenly, the Bank would surely tighten its monetary policy. Explain whether this statement is correct or incorrect, and why.

d) Because individuals base their expectations of inflation partly on its past values, even individuals with rational expectations are unable to predict large deviations in inflation. Explain whether this statement is correct or incorrect, and why.

e) Suppose rising prices of raw materials results in one region of a country experiencing a boom while another region experiences a recession. The central bank should respond by lowering the overnight rate in an attempt to stimulate the economy of the suffering region. Explain whether this policy recommendation is sensible or not, and why.

f) Suppose an economy in a severe recessionary gap is unable to lower its nominal interest rate (because it is already at the zero lower bound). In this case, a central bank should induce a higher than normal level of inflation as a method of stimulating the economy. Explain whether this policy recommendation is sensible or not, and why.