Chapter 5 Answers

1. How does the Feds monetary policy affect economic conditions?

ANSWER: The Feds monetary policy can affect the supply of loanable funds available in
financial markets and therefore may affect interest rates. It may also affect inflation (with a
lag) and therefore affect the demand for loanable funds by influencing inflationary
expectations.
2. Describe the economic tradeoff faced by the Fed in achieving its economic goals.
ANSWER: In general, a stimulative monetary policy can increase economic growth and
reduce unemployment, but may increase inflation. A restrictive monetary policy can keep
inflationary pressure low but may cause low economic growth and higher unemployment.
3. When does the Fed use a loose-money policy and when does it use a tight-money policy?
What is a criticism of a loose-money policy? What is the risk of using a monetary policy that
is too tight?
ANSWER: A loose monetary policy may be used to stimulate the economy, especially if
inflation is not a concern. A tight monetary policy may be used to slow economic growth in
order to reduce inflationary fears. A loose-money policy may result in higher inflation. The
risk of a tight-money policy is a potential slowdown in the economy. A tight monetary policy
may result in higher interest rates, reduced borrowing, and reduced spending to an excessive
degree.
7. Compare the recognition lag and the implementation lag.
ANSWER: The recognition lag represents the time from when a problem exists until it is
recognized by the Fed. It occurs because the economic statistics that are monitored to detect
problems are only reported periodically. The implementation lag occurs when the Fed
recognizes a problem but does not implement a policy to solve the problem until later.
11. Explain why an increase in the money supply can affect interest rates in different ways.
Include the potential impact of the money supply on the supply of and the demand for loanable
funds when answering this question.
ANSWER: An increase in money supply increases the supply for loanable funds and
therefore can place downward pressure on interest rates. Yet, it can also cause inflationary
expectations, resulting in an increased demand for loanable funds and upward pressure on
interest rates.
12. What other factors might be considered by financial market participants who are assessing
whether an increase in money supply growth will affect inflation?

ANSWER: Any factors that could offset or magnify the impact should be considered, such as
expected oil prices, the strength or weakness of the dollar, and the strength of the economy.
13. Explain what monetizing the debt means. How can this action improve economic conditions?
What is the risk involved?
ANSWER: The Fed monetizes the debt by purchasing Treasury securities in the secondary
market to offset the upward pressure on interest rates that occurs when the deficit increases
and the Treasury issues more new debt. The risk is the possibility of higher inflation.