Economics Question

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Auro

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If a country’s economy is growing at an unsustainably rapid rate and the central bank decreases its target inflation rate, the country’s:
A) long-term rate of economic growth will increase.
B) expected rate of inflation is likely to decline.
C) inflation rate is likely to increase
Any help pls
 
I am not 100% on this, but i would have to assume if the economy is growing rapidly and in an unsustainable manner (expansionary peak), decreasing the target inflation rate would involve a reduction of interest rates, an increased propensity to lend, and therefore an excess supply of money. This would further increase demand and cause even more inflation.
Remember, during recessionary troughs, there should be a budget deficit as the government spends to try to stimulate the economy, the inverse is true for a budget surplus. One of the tools the fed would use in the open market to slow down economic growth during an expansionary peak would be the sale of securities in the open market, thereby reducing cash, increasing interest rates, decreasing propensity to lend, and slowing demand. This example does the opposite and makes it worse.
Someone should verify my logic, I just completed this book and haven’t heavily reviewed it yet.
 
I agree with mark, inflation rate is likely to increase. The proper measure of the central bank should have been to increase its target inflation.
 
The answer should be B
The CB will raise discretionary interest rates and sell securities, removing money out of the economy and causing the yield of certain instruments to go up, and visavis the substitution effect, all other interest rates.
 
markCFAIL Wrote:
——————————————————-
> I am not 100% on this, but i would have to assume
> if the economy is growing rapidly and in an
> unsustainable manner (expansionary peak),
> decreasing the target inflation rate would involve
> a reduction of interest rates, an increased
> propensity to lend, and therefore an excess supply
> of money. This would further increase demand and
> cause even more inflation.
>
> Remember, during recessionary troughs, there
> should be a budget deficit as the government
> spends to try to stimulate the economy, the
> inverse is true for a budget surplus. One of the
> tools the fed would use in the open market to slow
> down economic growth during an expansionary peak
> would be the sale of securities in the open
> market, thereby reducing cash, increasing interest
> rates, decreasing propensity to lend, and slowing
> demand. This example does the opposite and makes
> it worse.
>
> Someone should verify my logic, I just completed
> this book and haven’t heavily reviewed it yet.
This is absolutely wrong. If economy is growing too fast, and target inflation rate is decreased, money supply will be tightened, interest rates will rise, and high inflation is directly targeted. If there is any credibility to the central banks moves and market participants perceive the tightening to be something other than a very temporary shift, expected future inflation will fall. Answer is B.
 
Page 202 of Book 2 (economics) from the schweser curriculum 2009 states the following:
To promote economic growth, central banks can, in theory, simply increase target rates when the economy is growing at an unsustainably rapid rate and decrease rates when economic growth is deemed to be too slow. In practice the management of a complex economy in a global context is quite different. Policy changes designed to promote growth may also increase inflation, and changes in interest rates also affect asset prices, income from saving and lending, investment flows between countries, foreign exchange rates, and import and export levels.
So in the third line of the paragraph, it states that if the economy is too slow they should decrease target rates. I would assume this is because the rate decrease will free up more money, increasing the money supply and inflation.
Inflation Targeting is defined as managing the money supply (FFR) as a way to keep inflation in bounds. So basically they manipulate the FFR to meet the target. If you want less inflation, you drive up rates to decrease money supply and lending, right?
If money supply increases (FFR decreases), so does lending, consumption, investment etc. This increases aggregate demand which increases inflation. This could happen from the fed buying securities in the open market. This is a fact, not a question. So the idea is that if they decrease target inflation, I believe that would be by way of decreasing the FFR. If that last sentence is not correct, I am wrong, if it is, I am right, plain and simple.
What am I missing here?
 
There’s a difference between targeting inflation rates and targeting short term lending rates. They’re generally inverse
 
markCFAIL Wrote:
——————————————————-
> Page 202 of Book 2 (economics) from the schweser
> curriculum 2009 states the following:
>
> To promote economic growth, central banks can, in
> theory, simply increase target rates when the
> economy is growing at an unsustainably rapid rate
> and decrease rates when economic growth is deemed
> to be too slow. In practice the management of a
> complex economy in a global context is quite
> different. Policy changes designed to promote
> growth may also increase inflation, and changes in
> interest rates also affect asset prices, income
> from saving and lending, investment flows between
> countries, foreign exchange rates, and import and
> export levels.
>
> So in the third line of the paragraph, it states
> that if the economy is too slow they should
> decrease target rates. I would assume this is
> because the rate decrease will free up more money,
> increasing the money supply and inflation.
They would not decrease rates, they would adjust the growth of money such that equilibrium levels in money markets drive rates toward a targeted level.
>
> Inflation Targeting is defined as managing the
> money supply (FFR) as a way to keep inflation in
> bounds. So basically they manipulate the FFR to
> meet the target. If you want less inflation, you
> drive up rates to decrease money supply and
> lending, right?
>
Again, if you want to less inflation, decreasing money supply would lead to higher rates, lower levels of investment, slowing economic growth, and price levels rising at a slower pace. It should be noted that the actual transmission mechanism is not quite as clear cut as this, but generally speaking in the absense of supply or demand shocks, this is close to the actual mechanics.
> If money supply increases (FFR decreases), so does
> lending, consumption, investment etc. This
> increases aggregate demand which increases
> inflation. This could happen from the fed buying
> securities in the open market. This is a fact,
> not a question. So the idea is that if they
> decrease target inflation, I believe that would be
> by way of decreasing the FFR. If that last
> sentence is not correct, I am wrong, if it is, I
> am right, plain and simple.
>
> What am I missing here?
Please read what you have just written. You say that decreasing rates leads to increasing inflation. Correct. You then state in the very next line that decreasing target inflation would be done by decreasing short term rates. This is in direct contradiction. The answer is that you are wrong. There is a fundamental difference between interest rate and inflation targeting, one that I think you are not understanding. As I said before, a shift in monetary policy towards a lower inflation target would send a signal to market participants that inflationary pressures would be directly battled, assuming of course that the central bank has any credibility in its public policy. The answer to this question is really quite simple, and there is no need to work through all this mess. THINK!!! CENTRAL BANK SAYS “WE WANT LOWER INFLATION”. Can you really come up with a logical reason why that would make me think that inflation would INCREASE????? No. My expectation is that inflation will fall in the future as the central bank enacts its policy of making inflation lower.
 
Dear all,
Thanks for your help :-)
Here is the answer:
C) inflation rate is likely to increase.
The central bank should increase target inflation rates when the economy is growing at an unsustainable (above-full-employment) level. Decreasing the target rate is likely to further increase aggregate demand and cause inflation, which will be detrimental to the long-term growth rate of the economy.
 
this is not correct. decreasing the interest rate will increase aggregate demand. which is different from decreasing inflation which is done by raising the interest rates.
in addition it’s a stupid question because even while raising interest rates and slowing the economy, the economy was in an inflationary gap and after the rate hike it still might not be enough to slow inflation. so b and c can both be correct but b is the better answer.
 
Definitely not correct. Not sure where you are getting the answer from, but I would seriously consider the legitimacy of your source.
 
I think Auro is correct.
If you review the role of central bank, C is probably the answer. Of course, this is for the exam. Economics is never deterministic and there are always many possible answers (and that’s the real life). But for the exam, I think C is what we are expected to choose.
Here summarized the role of central bank and as Auro mentioned, inflation will be worst:
source:
http://minute-class.com/finance/the-role-of-central-banks/
”
To control price level, the central banks will set appropriate price level. If it realized that the growth is too high (unsustainable), it will, e.g. in US, increase the discount rate FFR and reserve requirements.
In some countries, they have inflation target. Therefore, the central bank will lower the inflation target in order to cool down the economy. And to achieve that target, they have to lower the interest rate as in US. “
 
wyantjs,
When I read the question, I did choose Option B. However I was surprised to see the answer as Option c.
The source is from Schwerser’s Q-Bank, if you have a chance pls review Question ID#: 100859 in Q-Bank.
Most of the candidates certify Q-Bank as one of the best source for exam preparation.
If Option B is our understanding, then for the exam sake we have to correct our understanding.
 
I have never used Q-bank, so I cannot check it or certify its accuracy. I have however heard of outside study sources making mistakes, and this is one of them. The cite linked above is flat out wrong. Is anybody here actually thinking for themselves on this one? Let me repeat the question: “WHAT DO YOU THINK WILL HAPPEN IN THE FUTURE IF BERNANKE AND CO. PUBLICALLY ANNOUNCE THAT THEY HAVE THE INTENTION OF TARGETING A LOWER INFLATION RATE?” Answer: WE EXPECT INFLATION TO BE LOWER. I have studied numerous models for monetary policy and the transmission mechanism (IS-LM, IS-MP (Romer 2000), Walsh (2000), Carlin and Soskice (2004), Taylor(1993), etc…..), and not one of them even comes close to suggesting that a lower inflation target would result in higher inflation expectations, nor would it be achieved by lowering interest rates. The most likely method would be to tighten money supply, introduce a recessionary gap, and observe a shifting of an expectations-augmented Phillips curve toward a new equilibrium at a lower inflation target. You have the correct understanding now. “Correcting” your understanding for the sake of taking an exam would be a huge mistake.
 
Auro is right here. The central bank should increase target inflation rates when the economy is growing at an unsustainable (above-full-employment) level. Wyantjs, I see your logic as well and agreed when I first read the question. However, you have to examine the effect of increasing targeted inflation on the FFR.
Increasing target inflation rates will increase the targeted FFR. See the Taylor rule calculation for FFR in reading #27 - Monetary Policy. An increase in the target inflation rate necessarily results in an increase in the targeted FFR because: FFR = 2% + actual inflation + 0.5 (actual inflation - 2%) + 0.5 (output gap). If you increase that 2% (the target inflation), there will be a resulting increase in the FFR. As many have already explained above, an increase in the FFR will slow down economic activity and the growth of the economy. An increase in the FFR results in fewer bank reserves, which means that banks are less willing to lend to each other, which increases short- and long-term interest rates, which discourages investment by businesses and consumers and thus decreases aggregate demand, putting downward pressure on the price level (decreasing inflation) and employment and real GDP.
Decreasing the target rate will also decrease the FFR, which is likely to further increase aggregate demand and cause inflation, which will be detrimental to the long-term growth rate of the economy. I hope that helps, and welcome any feedback.
 
Didn’t have any doubt it was C.
The economy was overheating, yet the Fed cut interest rates, what do you expect to happen?
 
lcampbell Wrote:
——————————————————-
> Auro is right here. The central bank should
> increase target inflation rates when the economy
> is growing at an unsustainable
> (above-full-employment) level. Wyantjs, I see
> your logic as well and agreed when I first read
> the question. However, you have to examine the
> effect of increasing targeted inflation on the
> FFR.
>
> Increasing target inflation rates will increase
> the targeted FFR. See the Taylor rule calculation
> for FFR in reading #27 - Monetary Policy. An
> increase in the target inflation rate necessarily
> results in an increase in the targeted FFR
> because: FFR = 2% + actual inflation + 0.5 (actual
> inflation - 2%) + 0.5 (output gap). If you
> increase that 2% (the target inflation), there
> will be a resulting increase in the FFR. As many
> have already explained above, an increase in the
> FFR will slow down economic activity and the
> growth of the economy. An increase in the FFR
> results in fewer bank reserves, which means that
> banks are less willing to lend to each other,
> which increases short- and long-term interest
> rates, which discourages investment by businesses
> and consumers and thus decreases aggregate demand,
> putting downward pressure on the price level
> (decreasing inflation) and employment and real
> GDP.
>
> Decreasing the target rate will also decrease the
> FFR, which is likely to further increase aggregate
> demand and cause inflation, which will be
> detrimental to the long-term growth rate of the
> economy. I hope that helps, and welcome any
> feedback.
READ THE FUCKING QUESTION!!!!!! It says “If a country’s economy is growing at an unsustainably rapid rate and the central bank decreases its target inflation rate, the country’s: ”
NOTICE that it says the central bank DECREASES its target INFLATION RATE as defined in the question. Your logic is completely wrong in all aspects, as well as your elementary ability to read a simple question. THE ANSWER IS B.
 
wyantjs, are you sure you are not confusing inflation and interest rate in this question?
 
What? I am starting to wonder if you people are fucking with me at this point. No, I am not confusing anything. For the 5th time…..the original question says
“If a country’s economy is growing at an unsustainably rapid rate and the central bank decreases its target INFLATION rate, the country’s:”
B) expected rate of INFLATION is likely to decline.
Where is the confusion? Even better……where does an interest rate even play into the question? There is no need to even bring interest rates into the analysis. All you need is a little common sense! Listen to what you are saying. Using your logic, next time I here the FED state that they will begin tightening monetary policy in order to permanently lower inflation, you suggest that I should take their word as a complete lie, and assume that they will in fact do just the opposite, and take measures to increase inflation in the future. Come on people!!! I understand Level 1 material may be large in quantity, but it really is not that difficult.
 
wyantjs, I know you are a smart guy, I’ve seen your other posts.
Here is one final try for you to consider:
1) Lets say the Fed had estimated inflation rate to be %5.
2) Today they changed their estimate from 5% to 4%, i.e., they don’t think inflation is a problem for the next few months, that’s why they lowered their target inflation rate - yes, the Fed has a target inflation rate.
3) A day later in the Fed’s meeting, they conclude that there is no problem with making interest rates even lower, because inflation is *under control*. They wouldn’t dare lower interest rates if inflation was a threat.
4) They cut interest rates (more specifically, they set the FFR to a lower target).
5) Next few weeks as a result of the Fed buying securities, more money flows into the system, interest rates start to go down, more inflation is on the way.
 
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