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CHAPTER 21
Monetary Policy Strategies
1. A nominal anchor helps promote price stability by tying inflation expectations to low levels
directly through its constraint on the value of money. It can also limit the timeinconsistency problem by providing an expected constraint on monetary policy.
3. Central bankers might think they can boost output or lower unemployment by pursuing
overly expansionary monetary policy even though in the long run this just leads to higher
inflation and no gains on the output or unemployment front. Alternatively, politicians may
pressure the central bank to pursue overly expansionary policies.
5. German reunification produced tight monetary policy in Germany which raised interest rates
for the other ERM countries because their currencies were pegged to the German mark. The
high interest rates then slowed economic growth and increased unemployment in the other
countries.
7. Emerging market countries may not lose much by giving up the ability to pursue an
independent monetary policy because they are unable to do monetary policy well as a result
of weak political or monetary institutions.
9. Exchange rate targeting is likely to be a sensible strategy for industrialized countries when
domestic monetary and political institutions are not conducive to good monetary
policymaking, and when there are other important benefits of an exchange rate target that
have nothing to do with monetary policy. Exchange rate targeting is likely to be sensible for
emerging market countries whose political and monetary institutions are weak so that it is
the only way to break inflationary psychology and stabilize the economy.
11. Dollarization has the advantage that there is no possibility of a speculative attack.
Dollarization has the disadvantage that it results in the loss of seignorage, the revenue to the
government from having its own currency.
13. Monetary targeting it only works well if there is a reliable relationship between the monetary
aggregate and inflation, a relationship that has often not held in different countries.
15. Sustained success in the conduct of monetary policy as measured against a pre-announced
and well-defined inflation target can be instrumental in building public support for a central
bank’s independence and for its policies. Also inflation targeting is consistent with
democratic principles because the central bank is more accountable.
17. False. Inflation targeting does not imply a sole focus on inflation. In practice, central banks
do worry about output fluctuations and inflation targeting may even be able to reduce output
fluctuations because it allows monetary policymakers to respond more aggressively to
declines in demand because they don’t have to worry that the resulting expansionary
monetary policy will lead to a sharp rise in inflation expectations.
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19. This strategy has the following advantages: (1) it enables monetary policy to focus on
domestic considerations, (2) it does not rely on a stable money-inflation relationship, and (3)
it has had a demonstrated success, producing low inflation with the longest business cycle
expansion since World War II. However, it has the following disadvantages: (1) it has a
lack of transparency, (2) it is strongly dependent on the preferences, skills, and
trustworthiness of individuals in the central bank and the government; and (3) it has some
inconsistencies with democratic principles because the central bank is not highly
accountable.