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chap19

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									Answers to in-text Questions in Chapter 19


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549  (Box 19.1) Give some every-day examples of Goodhart’s Law.
          •   Using waist measurements as an indicator of a person’s fatness. By wearing a corset, this will pull in
              the waist, but it will not make the person any lighter! Controlling the waist through a corset makes the
              waist measurement a poor indicator of the person’s true fatness. [This was the problem with the form
              of monetary control used in the 1970s known as `the corset’: see page 553 of the text.]
          •   Using exam marks alone as an indicator of a student’s overall academic ability. The student will swot
              up for exams, which will then be a poor indicator of overall ability, and instead will be an indicator of
              (a) the person’s ability to do exams in that subject and (b) the amount of revision done.

      How could long-term monetary growth come about if the government persistently ran a public-sector
       surplus (public-sector debt repayment, PSDR)?
         See the flow-of-funds equation on page 534 of the text for the sources of monetary growth. If the PSBR is
         negative (i.e. a PSDR), then this will have a downward effect on money supply, but this may be offset by a
         growth from the other sources: the government buying back debt; banks creating more credit; a total
         currency flow surplus.

550  If banks operated a rigid 12½ per cent cash ratio and the government reduced the supply of cash by £1
      million, how much must credit contract? What is the money multiplier?
         Assuming that this resulted in £1 million less cash being held in the banking system (i.e. that the
         proportion of cash in circulation did not fall), then credit must contract by £7 million, giving an overall
         reduction in money supply of £8 million (of which the £1 million cash is 12½ per cent). The money
         multiplier is therefore 8 (i.e. 1/12½%)

551  Why would it be difficult for a central bank to predict the precise effect on money supply of open-market
      operations?
         (a) Banks may vary their liquidity ratio.
         (b) It is difficult to predict how much the holding of Treasury bills by the banks will vary, and how much
             the banks will take this into account when deciding how much credit to grant.

      If the Bank of England issues £1 million of extra bonds and buys back £1 million of Treasury bills, will
       there automatically be a reduction in credit by a set multiple of £1 million?
         No. It depends on the proportion of the £1 million of bills that were held by the banks (since only by
         reducing these will there be a reduction in banks’ liquidity). It also depends on banks’ willingness to vary
         their liquidity ratio. Finally, it depends on banks’ use of repo and rediscounting facilities available through
         the Bank of England (if these are used by the banks as a means of maintaining short-run liquidity, there is
         less pressure on them to reduce credit). (See pages 559-60.)

552  (Box 19.2) Assume that the Bank of England wants to reduce interest rates. Trace through the process
      during the day by which it achieves this.
         The Monetary Policy Committee will announce a reduction in the rate of interest. The Bank of England
         will then conduct open market operations to back this up. This will entail making more liquidity available
         to banks through gilt repos. Assuming that the reduction in the rate of interest was announced the
         previous day, then early in the morning the Bank of England will forecast the day’s shortage of liquidity in
         the banking system (at the new lower interest rate) and will offer assistance to banks through repos and
         rediscounting in order to meet the shortfall. By making additional assistance available at further points
         during the day, the Bank can adjust liquidity as necessary to maintain the rate of interest at the new level.
Answers to questions in Economics (4th edition) by John Sloman

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553  (Box 19.3) In what ways is the Fed’s operation of monetary policy (a) similar to and (b) different from the
      Bank of England’s?
          (a) The Fed, like the Bank of England, uses open market operations to influence the money supply and
              thereby to make the announced discount rate the equilibrium rate. If the discount rate is raised (just as
              when the Monetary Policy Committee of the bank of England raises the rate of interest) then open
              market sales of bands and Treasury bills are used to back this up.
          (b) Unlike the Bank of England, however, the Fed also from time to time alters the minimum reserve ratio
              as a means of influencing bank lending (see last paragraph of the box).


555  (Box 19.4) What are the arguments for and against publishing the minutes of the meetings of the ECB’s
      Governing Council and Executive Board?
          For: The greater transparency and publicity would help to show how focused the ECB was on keeping the
          rate of inflation down to the target. It could help to reduce inflationary expectations. It could help to
          inform public debate on the direction and efficacy of monetary policy.
          Against: Any disagreements could be seen as a weakness and could undermine public and international
          confidence in monetary policy and the strength of the euro. It might limit frank debate by the members of
          the Council and make the Council more cautious. Secrecy goes against the principles of democratic
          accountability.


558  (Box 19.5) How does the easy availability of credit affect the problem of inequality?
          People on low incomes may be encouraged to take out loans beyond what they can afford. They may then
          find it difficult to get out of debt. This will reduce their income available for spending, given that they will
          be having to make interest payments. If easy credit (i.e. less stringent checks on creditworthiness) leads to
          a faster growth in credit for the poor than the rich (who are generally more `creditworthy’ than the poor)
          then it will aggravate the problem of inequality.


559  1. Trace through the effects of a squeeze on the monetary base from an initial reduction in cash, to banks’
      liquidity being restored by the rediscounting of bills. Will this restoration of liquidity by the Bank of
      England totally nullify the initial effect of reducing the supply of cash? (Clue: what is likely to happen to
      the rate of interest?)
          Banks, short of cash, will, in the last resort, acquire money from the Bank of England through gilt repos or
          the rediscounting of bills. But the Bank of England will only do this at a penal rate, thereby driving up
          interest rates (to its announced level, assuming that it has raised the rate of interest) and thereby reducing
          the demand for money, and hence the quantity of credit supplied.


       2. Given the difficulties of monetary base control, would you expect M0 and broader measures of the
        money supply, such as M4, to rise and fall by the same percentage as each other? Explain.
          No. Even if M0 is controlled, if the demand for credit is still high, banks may be prepared to reduce their
          cash ratio and allow credit to expand, and with it M4. To reduce their risks of a lower cash ratio, they may
          try to encourage customers to switch to time accounts (by increasing the interest rate differential).


561  Is credit rationing easier to implement if banks operate as a cartel or if they are highly competitive?
          It is easier if they operate as a cartel. See the last part of Box 19.7 (on page 562)




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                                                                                                           Chapter 19

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561  (Box 19.6) 1. Give some other examples of the impossibility of using one policy instrument to achieve two
      policy objectives simultaneously.
          Two examples are:
          • Using changes in personal allowances (on income tax) to boost aggregate demand and to increase
             incentives to work. To boost aggregate demand the allowances would have to be raised (thereby
             reducing the amount of tax paid). But this will reduce incentives (except for those actually on the
             threshold), since there will be an income effect but no substitution effect.
          • Using the exchange rate both to reduce inflation and to improve the balance of trade. An
             improvement in the balance of trade would require a depreciation of the exchange rate, whereas a
             reduction in inflation would require an appreciation of the exchange rate (to reduce import prices and
             thereby compete down the prices of import substitutes, and to reduce the domestic currency price of
             exports and thus put downward pressure on costs in export industries).


      (Box 19.6) 2. If the government wanted to achieve a lower rate of inflation and also a higher exchange
       rate, could it under these circumstances rely simply on the one policy instrument of interest rates?
          A higher interest rate would help both to reduce inflation and push up the exchange rate. The problem is
          that the desired magnitude of these effects may require a different sized increase in interest rates. If this
          were the case, then again relying on one instrument alone would not be sufficient.


562  (Box 19.7) Does increased bank competition necessarily make it harder for a central bank to force
      through changes in interest rates (a) by decree; (b) by dealings in the money market?
          (a) Yes. If all banks abide by a simple rule relating their base rate to the central bank’s minimum lending
              rate, then a simple change in minimum lending rate will bring the desired effect on banks’ interest
              rates. The more competition there is, however, the more difficult will it be for the Bank of England to
              enforce its decrees (even if they are statutory), partly as a result of competition from institutions not
              affected by the decrees, especially foreign banks, and partly as a result of banks seeking to circumvent
              the decrees.
          (b) No. There will be a knock on effect through the various markets. Nevertheless, it is possible that any
              interest rate changes may have to be larger, if by increased competition is meant the lifting of any
              statutory reserve requirements.


563  (Box 19.8) Is there any case for an independent body to determine fiscal policy? If so, what would its role
      be?
          Yes. A case could be made on economic grounds for a body to determine the size of the budget deficit or
          surplus. This could then provide a more stable fiscal environment, where manipulation of aggregate
          demand for short-term political ends would be ruled out.
               The government would still decide the levels of government expenditure and taxation (i.e. whether to
          have higher government expenditure and higher taxes, or lower government expenditure and lower taxes
          for any given size of the budget deficit), and of course it would still decide the individual amounts
          allocated to each item of government expenditure and the rates of each specific tax.
               Despite this limited role for the independent body, governments would be very unlikely to create such
          a body, since they would see the control of their own expenditure and taxation as entirely the concern of
          government.


564  Why does an unstable demand for money make it difficult to control the supply of money?
          Because the supply of money depends in part on the demand for money.




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