Reference no: EM131833210

Question: Assume that the central bank can really control money growth and velocity growth within a reasonable period of time. Instead, let's work with the more realistic assumption that it takes about a year for a change in monetary policy to actually influence money growth: Even though the central bank can increase bank reserves literally within minutes through open market operations or the term auction facility, it takes months for banks to determine whom they should lend to. And as you know, most money is created through bank loans. In this question, the central bank tries to follow nominal GDP targeting so that AD grows at 7% per year. In other words, the central banks tries to set the money growth rate so that velocity growth plus money growth equals 7%. Each year, it responds to that year's velocity growth, but the response won't actually kick in until next year. (Think of this as driving a car with loose steering: You steer to the right, but the car only starts moving to the right about 2 seconds later.)

a. Fill in the following table. Notice that in each year, Actual AD = Velocity growth + Money growth. In the first year, the central bank observes velocity growth of 3% and thus targets money growth of 4%. The next year money grows at 4% as targeted, but velocity growth in that year is 1% so actual AD grows at 5%. In Year 2, the central bank observes velocity growth of 1% and thus targets money growth of 6%. Keep going.

b. Every year, the central bank tries to keep AD = 7%, yet it never accomplishes its goal. How do "long lags" explain this failure?

c. How would this table look if you had followed Friedman's 3% money growth rule instead? Don't calculate any numbers, just answer verbally: Would the swings tend to be bigger than in the table or smaller?