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Given the increasing role expectations play in shaping the effectiveness of economic policy, it is not surprising that a great deal of central bankers job is to manage expectations especially

  1. Given the increasing role expectations play in shaping the effectiveness of economic policy, it is not surprising that a great deal of central bankers’ job is to manage expectations, especially through careful communication strategies. In recent years, a new instrument has been increasingly used to that effect. The instrument is known as “forward guidance,” that is, the public signaling by central banks, of future policy intents in the area of monetary policy. However, this tool can be tricky as central bankers may well have to retract previous announcements.

a. Suppose that the central bank in your country just announced, at time t, that it would implement a rapid expansionary policy at a time when the output is not growing. What would happen to current output and interest rates, if markets participants were taken completely by surprise, but did not believe that the expansionary policy would last?

b. Now consider the same situation a year later: output growth is sluggish, and the central bank has, again, adopted expansionary measures. How would the markets react? Describe both the behavior of the yield curve as a result, and the IS-LM curves.

c. Suppose that, after a long period of sustained expansion, the central bank were to announce one last expansionary package, commenting that since output has resumed growing, it would be much more vigilant on inflationary pressures in the forthcoming period. What would the impact be on current output and interest rates?

Feb 06 2020 View more View Less

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