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ii) The likely effects are the following: commercial banks will pass on to customers the decrease in the official rate through similar decisions affecting the level of commercial interest rates. New investments will be more likely to be implemented (due to the lower cost of borrowing money) and this will lead to a multiplier-accelerator effect (see also Chapter 16). Expectations will improve because operators see in the Fed's decision the end of the 'bad times' and this will reinforce positive expectations. Eventually, the growth rate and the level of employment will increase and the economy will move towards the positive side of the cycle. As the White House economist says, this process will not be instantaneous. The first positive effects on the growth rate will take around 3-6 months from the Fed's decision.

iii) The first sectors to benefit from the decision will be the sectors producing investment goods and durable consumption goods, the ones that are more sensitive to changes in the interest rate.  Public goods are naturally the less sensitive to economic fluctuations (demand for health or education is quite stable throughout the cycle).

Q2 'The bond market lost its momentum as higher than expected inflation lowered expectations of another German rate cut'. Interest rate analysis stresses the role of market expectations. Explain the logical sequence behind this statement.

The sequence starts with the decision of the Deutschbank to lower the interest rate. We do not know the reasons behind this decision: probably the actual growth rate of the economy was not close to the estimated potential growth rate and this move was aimed to sustain investment and aggregate demand.  The policy has been effective to the point where inflation has now reached acceptable levels.  Hence the prospect of further interest rate deductions has disappeared, and with it the likelihood of a further rise in bond prices.  Hence the bond market "lost its momentum".

Q3 'Monetary policy must be defined in terms of its final goal. For us, this final goal is, without any shadow of doubt, price stability'. (Dr. H. Tietmeyer, President of the Bundesbank, address to the Zurich Economic Society, November 1993).

(a) What does price stability mean?

(b) Comment on the usefulness of money supply targets as a guide for monetary policy.

(c) In the speech from which the above quotation is taken, Dr. Tietmeyer noted that 'the German money demand function has turned out to be stable'. Explain the significance of this remark.

(d) Suppose money supply exceeds its target in a particular period. What action could or should a central bank take in a response?

a) Price stability does not mean exactly zero inflation. As question 1 of Chapter 12 reminds, a little bit of inflation is beneficial for the markets and for the economy. Zero inflation might easily hide, due to bias in the estimate, a situation of actual deflation which might be as dangerous as rising prices. A goal of 0% - 2% of inflation is nowadays considered as 'price stability'.

b) The central bank has the ultimate objective of price stability and disposes of the monetary policy tools to influence prices. Because monetary policy works with a delayed reaction of 1-2 years, the actual goal is not current inflation but future inflation.


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