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Chapter 28: Problem 9

(Related to the Apply the Concept on page 1015 ) In an opinion column in the Wall Street Journal, economist Sebastian Mallaby argued that when investors believe that financial markets will remain calm, they may be more willing to make risky investments. The result can be a financial crisis such as occurred during \(2007-2009,\) when the prices of risky mortgage-backed securities declined. Mallaby argued: The central-banking fashion now is to target inflation and to communicate prodigiously about coming interest-rate adjustments.... But stable finance often matters more than stable prices. And transparency about future interest- rate moves can induce disruptive speculation. a. What does the Fed call attempts to shape expectations of future policy decisions? b. Why did targeting inflation and communicating about future changes in interest rates become "central bank fashion"? c. Why might investors be more likely to buy risky securities if they feel confident that they know what interest rates will be in the future as a result of Fed announcements?

Short Answer

Expert verified
a. The Fed calls attempts to shape expectations of future policy decisions as 'forward guidance'. b. Inflation targeting and communicating future changes in interest rates became central-banking trend as they help stabilize the economy and provide market transparency. c. Investors are likely to buy risky securities if they know future interest rates because it provides them with a degree of certainty related to their expected returns.

Step by step solution

01

Understanding Policy Expectations

The Federal Reserve's attempts to shape expectations of future policy decisions are called 'forward guidance'. Forward guidance helps the market anticipate the direction of monetary policy decisions like interest rates adjustments.
02

Inflation Targeting as Central Bank Fashion

Targeting inflation and communicating about future changes in interest rates became a 'central-banking fashion' primarily due to two reasons. First, inflation targeting helps to stabilize the economy by managing inflation rate within a target range. Second, communicating future changes provides transparency, enabling markets and investors to anticipate shifts in policy and accordingly adjust their investment strategies.
03

Investors' Behavior and Interest Rate Predictions

Investors might be more likely to buy risky securities if they feel confident about future interest rates because it reduces the uncertainty attached to their return on investment. If they know that interest rates will be low, they may invest more in risky assets like stocks to achieve higher returns, as the potential loss (cost of borrowing to invest) is low. Conversely, if future interest rates are expected to be high, investors may shy away from risky assets due to potential higher borrowing costs and invest in safer bonds or money market instruments.

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Most popular questions from this chapter

What actions should the Fed take if it wants to move from a point on the short-run Phillips curve representing high unemployment and low inflation to a point representing lower unemployment and higher inflation?

(Related to the Apply the Concept on page 1000) When Robert Shiller asked a sample of the general public what they thought caused inflation, the most frequent answer he received was "corporate greed." Do you agree that greed causes inflation? Briefly explain.

(Related to the Chapter Opener on page 994) In its 2016 Annual Report, Toll Brothers noted, "If mortgage interest rates increase significantly ... our revenues, gross margins, and net income could be adversely affected." a. Why might an increase in mortgage interest rates reduce revenue and profit for Toll Brothers? b. During this period, was Fed policy attempting to reach a point on the short-run Phillips curve representing higher unemployment and lower inflation or a point representing higher inflation and lower unemployment? Briefly explain. c. What connection is there between Fed policy and Toll Brothers' concern about the effect of rising mortgage interest rates on its profit?

A column in the New York Times in 2017 was titled "The Low-Inflation World May Be Sticking Around Longer Than Expected." Are the low inflation rates of recent years entirely the result of Federal Reserve policy? Could they have occurred without the Fed having a mandate to achieve price stability? Briefly explain.

In a blog post, former Fed Chairman Ben Bernanke argued that the Fed should not conduct monetary policy according to a rule, such as the Taylor rule, that it announces in advance. Among other objections, Bernanke noted that "the Taylor rule assumes that policymakers know, and can agree on, the size of the output gap. In fact ... measuring the output gap is very difficult and FOMC members typically have different judgments." (Note: In answering this problem, you may want to review the discussion of the Taylor rule in Chapter 26, Section 26.5.) a. Why is agreeing on the size of the output gap difficult? b. Why might disagreements over the size of the output gap make it difficult for the Fed to use a preannounced rule in conducting monetary policy?
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