Chapter 27 — Exercises

Section A — Tools

A1. The Fed wants to lower interest rates. Should it buy or sell government bonds? Why? A2. What is the zero lower bound and why does it limit conventional monetary policy? A3. How does QE work when the federal funds rate is already at zero? A4. "Forward guidance is just talk." Why is it more powerful than this suggests?

Section B — Transmission mechanism

B1. Trace the transmission mechanism from a Fed rate cut to lower unemployment. Be specific about each step. B2. Why does monetary policy work with "long and variable lags"? B3. If the Fed raises rates today, when will the full effect on inflation be felt? B4. Housing is the most interest-rate-sensitive sector. Why? Apply the transmission mechanism.

Section C — The Taylor Rule

C1. Inflation is 4% and the output gap is −2% (economy below potential). What does the Taylor Rule recommend? C2. Inflation is 1% and the output gap is +1%. What does the Taylor Rule recommend? C3. Compare the Taylor Rule recommendation to the actual federal funds rate for the current period. Is the Fed being more hawkish or dovish than the rule?

Section D — Three episodes

D1. Compare the 2008 and COVID Fed responses. Why was the COVID response faster and larger? D2. "The Fed should have started raising rates in mid-2021 when inflation began to rise, not in March 2022." Evaluate. What information did the Fed have in mid-2021? D3. The 2022–23 rate hike cycle achieved a "soft landing." Was this skill, luck, supply-chain healing, or all three?

Section E — Data lookup

E1. Look up the federal funds rate on FRED (FEDFUNDS). Plot the last 20 years. Identify the three episodes from §27.4. E2. Look up the Fed's balance sheet (WALCL). When did it spike? What was the Fed buying? E3. Compare the 10-year Treasury yield (DGS10) to the federal funds rate. Do they always move together?

Section F — Policy debate

F1. "The Fed should follow the Taylor Rule mechanically." Argue for and against. F2. "QE inflated asset prices and made rich people richer without helping ordinary workers." Evaluate. F3. "The Fed's independence should be reduced — elected officials should have more say." Use historical evidence to evaluate.

Section G — Reflection

  • Did you know the Fed controlled your mortgage rate? Does understanding the transmission mechanism change how you think about home buying?
  • The 2022–23 soft landing was called "impossible" by most forecasters. What does this tell you about economic forecasting?

Selected answers in appendices/answers-to-selected.md.