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Homework 3_solution

Homework 3_solution - Homework 3 E305 Money and Banking...

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Homework 3 E305: Money and Banking Spring 2010 1. Problem 15.2 The power of a central bank is based on its monopoly over the issuance of currency. Economics teaches us that monopolies are bad and competition is good. Would competition among more several central banks be better? Provide arguments both for and against. Answer: Competition could force central banks to become more efficient and would increase accountability. However, the central bank’s monopoly over the issuance of currency is what allows it to control money growth and inflation. 2. Problem 15.6 Explain why even the most independent central banks are still dependent on the support of the government to meet their policy objectives effectively? Answer: Fiscal policy decisions can be inflationary, making the pursuit of price stability more difficult for central banks. Even if central bank independence prohibits the government from forcing the central bank to buy its bonds to finance its spending through the printing of money, in extreme circumstances the government may shut down the banking system and issue its own currency, making the independence of the central bank irrelevant. 3. Problem 15.11 Which do you think would be more harmful to the economy – an inflation rate that averages 5% a year that has a high standard deviation or an inflation rate of 7% that has a standard deviation close to zero? Answer: Inflation of 5% with a high standard deviation is likely to be more harmful to the economy. The less predictable inflation is, the more it distorts economic decisions and the more systematic risk it creates. 4. Problem 15.16 Suppose in an election year, the economy started to slow down. At the same time, clear signs of inflationary pressures were apparent. How might the central bank with a primary goal of price stability react? How might members of the incumbent political party who are up for reelection react? Answer: In this case, the appropriate monetary policy is to tighten monetary policy, increasing interest rates to curb the emerging inflationary pressures in pursuit of the long-run goal of price stability. In contrast, it is likely that the politicians due for reelection would be more concerned with
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the slowdown in the economy and be in favor of a cut in interest rates. In the absence of influence
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