EC3115 - Chapter 12 Quiz 2: Monetary Policy Uncertainties

1. In the Poole model, how does a steeper IS curve affect the choice of monetary policy instrument?

It makes interest rate targeting more attractive regardless of the shock source. It makes money supply targeting more attractive regardless of the shock source. It makes money supply targeting more attractive relative to interest rate targeting, especially when IS shocks are large. It has no impact on the optimal choice of instrument.

Correct Answer: C.

A steeper IS curve means that aggregate demand is less sensitive to changes in the interest rate. When a money supply target is in place, the interest rate acts as an automatic stabilizer against IS shocks. A steeper IS curve means a larger change in the interest rate is needed to offset a given IS shock, but the resulting change in output for a given shock is smaller. This enhances the stabilizing property of a money supply target, making it more effective at dampening IS shocks compared to a flatter IS curve.

Source: Poole (1970) analysis.

2. If a policymaker is risk-neutral instead of risk-averse, what does Brainard's model imply for policy under parameter uncertainty?

The policymaker should act as if certainty equivalence holds and not attenuate policy. The policymaker should attenuate policy even more to avoid any risk. The policymaker should use fiscal policy instead. The optimal policy is to do nothing.

Correct Answer: A.

A risk-neutral policymaker only cares about the expected value (the mean) of the outcome, not its variance. The cautious behaviour in the Brainard model is driven entirely by risk aversion (a desire to avoid variance). A risk-neutral policymaker would ignore the variance-increasing effects of their actions and set policy to close the expected gap completely, which is the certainty equivalence solution.

Source: Brainard (1967); EC3115 Subject Guide, Chapter 12.

3. Aruoba (2008) finds that data revisions are predictable. What is a practical policy implication of this finding?

Policymakers should wait for final data, even if it takes years. Policymakers should ignore initial data releases entirely. The economy is too random to be controlled. Policymakers could potentially use the predictable nature of revisions to construct a more accurate real-time estimate of the economy's state.

Correct Answer: D.

If revisions are predictable, it means they are not pure 'news'. For example, if an initial GDP estimate is known to be, on average, revised up by 0.2% in the next release, a policymaker can incorporate this knowledge into their real-time assessment. They could adjust the initial release by the expected revision to get a better current estimate, a process known as 'filtering' the data.

Source: Aruoba (2008) and the concept of real-time data analysis.

4. In the Poole model, the "combination policy" refers to a strategy where the central bank:

Uses both fiscal and monetary policy. Sets the money supply as a function of the interest rate, creating a positively sloped LM curve that it enforces. Alternates between targeting the money supply and the interest rate. Targets inflation and unemployment simultaneously.

Correct Answer: B.

Poole (1970) shows that neither a pure money supply target (vertical effective LM) nor a pure interest rate target (horizontal effective LM) is fully optimal when both IS and LM shocks exist. He demonstrates that a "combination" or "compromise" policy, where the central bank allows the money supply to respond to interest rate deviations from a target, can produce a lower output variance than either of the pure strategies. This is equivalent to the central bank creating and maintaining an LM curve with a specific positive slope.

Source: Poole (1970).

5. What is meant by the "separation principle" that holds under certainty equivalence?

The problem of estimating the state of the economy is separate from the problem of calculating the optimal policy response. Monetary policy and fiscal policy should be conducted by separate government bodies. The central bank's goals are separate from the government's goals. Short-term policy is separate from long-term policy.

Correct Answer: A.

The separation principle, valid in Linear-Quadratic models with additive uncertainty, states that the policymaker's task can be broken into two distinct parts. First, form the best possible estimate of the current state of the system (e.g., the expected value of GDP). Second, solve for the optimal instrument setting as if that estimate were the true state of the world. Parameter uncertainty breaks this principle because the quality of the estimate and the optimal policy response become intertwined; the policy choice itself affects the uncertainty of the outcome.

Source: General concept in control theory and macroeconomics, related to certainty equivalence.

6. In Brainard's model, if you have two policy instruments to hit one target, and the multiplier of the first instrument is uncertain while the multiplier of the second is known for sure, the optimal policy is to:

Use only the first (uncertain) instrument. Use only the second (certain) instrument. Use a combination of both, relying more heavily on the certain instrument. Use neither and wait for more information.

Correct Answer: C.

Brainard's diversification result is key here. Even if one instrument is certain, it is still optimal to use a combination of both. The uncertain instrument is still useful because it has a non-zero expected effect. However, to minimize overall outcome variance, the policymaker will rely more heavily on the certain instrument than the uncertain one. Using only the certain instrument would be suboptimal as it ignores the expected impact of the uncertain instrument.

Source: Brainard (1967).

7. How would the presence of significant parameter uncertainty in the IS curve (e.g., uncertainty about the marginal propensity to consume) modify the conclusions of the Poole model?

It would make no difference. It would definitively make interest rate targeting optimal. It would definitively make money supply targeting optimal. It would introduce a reason for policy caution (attenuation) regardless of which instrument is chosen.

Correct Answer: D.

Poole's model assumes no parameter uncertainty. If we introduce it (a la Brainard), the central bank becomes uncertain about the effects of its policy. For example, under money supply targeting, the slope of the LM curve is known, but the effect of the resulting interest rate change on output is now uncertain. This introduces a Brainard-style trade-off between closing the output gap and controlling output variance. The simple instrument choice rule from Poole is no longer sufficient; policy will become more cautious overall.

Source: Synthesis of Poole (1970) and Brainard (1967).

8. In the Poole model, a flatter LM curve (high interest elasticity of money demand) makes which policy more attractive when LM shocks dominate?

Money supply targeting. Interest rate targeting. The choice is unaffected by the slope of the LM curve. A combination policy.

Correct Answer: B.

A flatter LM curve means that a given shock to money demand (a horizontal shift in the LM) will cause a smaller change in the interest rate but a larger change in output if the money supply is held constant. This makes the economy more vulnerable to LM shocks under a money supply target. Conversely, interest rate targeting perfectly insulates the economy from LM shocks regardless of the LM curve's slope. Therefore, as the LM curve gets flatter, the case for interest rate targeting when LM shocks are dominant becomes even stronger.

Source: Poole (1970) analysis.

9. The finding that data revisions are large (i.e., the variance of the revision is large relative to the variance of the final data) is problematic for the 'news' view because:

It implies that the initial announcement contains very little information about the final value. It suggests the economy is inherently stable. It proves that revisions are predictable. It means the final data is unreliable.

Correct Answer: A.

If the initial announcement were a good forecast (as the 'news' view suggests), most of the variation in the final data would be captured by the initial announcement, and the revision (the forecast error) would be relatively small. If the revision is large, it means the initial announcement was a poor forecast, containing little informational content about the final, true state of the variable. This is one of the key findings in Aruoba (2008) that contradicts the 'well-behaved' nature of data revisions.

Source: Aruoba (2008).

10. In the Brainard model, the optimal degree of policy attenuation (how cautiously to act) increases with:

The size of the expected output gap. The expected value of the policy multiplier. The policymaker's risk tolerance. The variance of the policy multiplier.

Correct Answer: D.

The formula for the optimal policy is \( X = \frac{\hat{g}y^*}{\hat{g}^2 + \sigma_g^2} \). The degree of attenuation is driven by the \(\sigma_g^2\) term in the denominator. A larger variance (more uncertainty) increases the denominator, which reduces the magnitude of the policy response `X`. This means the policy is more attenuated, or more cautious.

Source: EC3115 Subject Guide, Chapter 12.

11. Which statement best describes the concept of "model uncertainty"?

Uncertainty about the current value of GDP. Uncertainty about the value of a specific parameter within a known model. Uncertainty about which model of the economy is the correct one. Uncertainty about the central bank's future policy intentions.

Correct Answer: C.

Model uncertainty is a deeper form of uncertainty than parameter uncertainty. It acknowledges that economists may disagree on the fundamental structure of the economy (e.g., Keynesian vs. Real Business Cycle, or different specifications of the Phillips curve). A policymaker faces model uncertainty when they do not know which of several competing models is the true representation of the economy.

Source: General macroeconomic concept.

12. In Poole's model, if the IS curve is horizontal (infinitely elastic), which instrument should be used?

Money supply targeting. Interest rate targeting. The choice is irrelevant. A combination policy is required.

Correct Answer: B.

A horizontal IS curve implies that the level of output is extremely sensitive to the interest rate. Any small change in the interest rate would lead to massive, explosive changes in output. A money supply target would allow LM shocks to shift the interest rate, causing huge output volatility. Therefore, to stabilize output, the central bank must fix the interest rate by choosing an interest rate target. This pins down the equilibrium and provides stability.

Source: Poole (1970) analysis.

13. The 'noise' hypothesis of data revisions, as described by Mankiw, Runkle, and Shapiro, suggests that the revision should be:

Negatively correlated with the initial announcement. Positively correlated with the final, true data. Uncorrelated with all available information. Have a non-zero mean.

Correct Answer: A.

The 'noise' view posits that the initial announcement \(y^i\) is the true value \(y^f\) plus measurement error \(e\): \(y^i = y^f + e\). The revision is \(REV = y^f - y^i = -e\). If the error \(e\) is positively correlated with the announcement \(y^i\) (which is likely if \(y^f\) and \(e\) are independent), then the revision \(REV\) will be negatively correlated with the initial announcement. Aruoba (2008) tests for this and finds evidence supporting it.

Source: Aruoba (2008).

14. Brainard's principle of policy attenuation is a normative conclusion about how policy *should* be conducted. What is the corresponding positive observation of central bank behaviour?

Inflation targeting. The 'cold turkey' approach to disinflation. A fixed money growth rule. Interest rate smoothing.

Correct Answer: D.

Interest rate smoothing is the empirical observation that central banks tend to adjust their policy rates in small, gradual steps rather than large, discrete jumps. This real-world behaviour is widely interpreted as a practical manifestation of Brainard conservatism. Policymakers act cautiously and incrementally because they are uncertain about the true model of the economy and the effects of their actions.

Source: EC3115 Subject Guide, Chapter 12.

15. In the Poole model, if the variance of IS shocks is very large compared to the variance of LM shocks, the output variance under a money supply target will be:

Larger than the output variance under an interest rate target. Smaller than the output variance under an interest rate target. Equal to the output variance under an interest rate target. Infinite.

Correct Answer: B.

This is the core result of Poole (1970). A money supply target allows the interest rate to act as an automatic stabilizer against IS shocks, dampening their effect on output. An interest rate target, by contrast, forces the central bank to accommodate IS shocks, leading to greater output volatility. Therefore, when IS shocks dominate, the variance of output is lower under a money supply target.

Source: Poole (1970).

16. The failure of certainty equivalence under parameter uncertainty means that the policymaker's loss function depends on:

Only the expected deviation from the target. Only the variance of the target variable. Both the expected deviation from the target and the variance of the target variable. Neither the mean nor the variance of the target variable.

Correct Answer: C.

With a quadratic loss function, the expected loss can be decomposed into two parts: the squared expected deviation from the target (bias) and the variance of the target variable. Under parameter uncertainty, the policy instrument affects both terms. The policymaker must therefore trade off a smaller expected deviation (achieved by more aggressive policy) against a smaller variance (achieved by more cautious policy).

Source: EC3115 Subject Guide, Chapter 12.

17. Which of the following is an example of additive uncertainty?

An unexpected, temporary surge in consumer confidence that boosts spending. The central bank being unsure of the interest elasticity of investment. A change in banking regulations that alters the money multiplier. The initial estimate of inflation being revised downwards a month later.

Correct Answer: A.

An unexpected surge in consumer confidence is a shock to aggregate demand that can be modelled as a positive random shock to the IS curve (e.g., the \(\epsilon\) term in \(Y = C(Y-T) + I(r) + G + \epsilon\)). This is a form of additive uncertainty. Options B and C are examples of parameter uncertainty, while option D is data uncertainty.

Source: EC3115 Subject Guide, Chapter 12.

18. In the Poole model, if the LM curve is horizontal (a "liquidity trap"), what is the effect of a money supply target?

It gives the central bank perfect control over output. It causes interest rates to rise sharply. It is equivalent to an interest rate target. The central bank loses control of the interest rate and the money supply becomes endogenous.

Correct Answer: D.

A horizontal LM curve (liquidity trap) means that the public is willing to hold any amount of money at the prevailing interest rate. If the central bank tries to set a money supply target, it loses control. Any attempt to inject more money is simply absorbed by the public with no change in the interest rate. The money supply becomes demand-determined (endogenous), and the central bank cannot enforce its target. In this situation, monetary policy is ineffective, and the distinction between the two instruments is moot, but the attempt to target the money supply fails.

Source: Poole (1970) analysis.

19. The fact that Brainard's analysis from 1967 is still central to discussions of policy under uncertainty suggests that:

Economists have solved the problem of parameter uncertainty. Uncertainty about the true structure and parameters of the economy remains a fundamental challenge for policymakers. Additive uncertainty is no longer considered important. Central banks have stopped being cautious.

Correct Answer: B.

The enduring relevance of Brainard's work highlights that despite decades of research, significant uncertainty about the economy's parameters persists. The trade-off between achieving the mean target and controlling for variance is a timeless problem for any policymaker who does not know the effects of their actions with certainty. This remains a core justification for policy gradualism and caution.

Source: General reflection on the topic.

20. If data revisions are pure 'news', then the initial data announcement is:

A biased estimate of the final value. The final value plus a measurement error. An optimal and rational forecast of the final value given the available information. Less informative than the revision itself.

Correct Answer: C.

The 'news' hypothesis is rooted in the idea of rational expectations and efficient information processing. It posits that the statistical agency produces the best possible forecast of the final value using all information currently available. The subsequent revision is then the forecast error, which reflects new information that could not have been known at the time of the initial announcement.

Source: Aruoba (2008); EC3115 Subject Guide, Chapter 12.

21. In the context of the Brainard model, a policymaker with a stronger aversion to risk would have:

More curved indifference curves in mean-variance space, leading to more attenuation. Flatter indifference curves in mean-variance space, leading to less attenuation. A linear policy constraint. A preference for using only one policy instrument.

Correct Answer: A.

A stronger aversion to risk means the policymaker is less willing to accept an increase in variance in exchange for getting the mean closer to the target. This is represented by more tightly curved indifference curves around the target point. For a given linear policy trade-off, the tangency point with a more curved indifference curve will be further down and to the left, implying a lower mean and lower variance, which corresponds to a more cautious (attenuated) policy.

Source: EC3115 Lecture Slides, Unit L.

22. Which of the following is NOT one of the properties of 'well-behaved' data revisions according to Aruoba (2008)?

Revisions should have a zero mean. Revisions should be unpredictable. The variance of revisions should be small. Revisions should be positively correlated with initial announcements.

Correct Answer: D.

A 'well-behaved' revision, in the 'news' sense, should be unpredictable. This means it should be uncorrelated with any information known at the time of the initial announcement, including the announcement itself. A correlation between the revision and the initial announcement is a sign that the revision process is not 'well-behaved' and likely contains 'noise'.

Source: Aruoba (2008).

23. In the Poole model, the automatic stabilization property of a money supply target comes from:

The response of the money supply to IS shocks. The response of the interest rate to IS shocks. The response of the interest rate to LM shocks. The stability of the money demand function.

Correct Answer: B.

When the money supply is fixed (fixing the LM curve), a shock to the IS curve (e.g., an increase in government spending) pushes the IS curve to the right. This leads to a higher equilibrium interest rate. The higher interest rate crowds out private investment, partially counteracting the initial expansionary shock. This endogenous response of the interest rate is the 'automatic stabilizer'.

Source: Poole (1970).

24. If a central bank has a single instrument and is uncertain about its multiplier, Brainard's model suggests it should set the instrument to close a fraction \(k = 1 / (1 + V^2)\) of the target gap, where V is the coefficient of variation. If the multiplier is known with certainty, what is the value of V and k?

V = 1, k = 1/2 V = infinity, k = 0 V = 0, k = 1 V = -1, k is undefined

Correct Answer: C.

If the multiplier is known with certainty, its variance is zero (\(\sigma_g^2 = 0\)). The coefficient of variation \(V = \sigma_g / \bar{g}\) is therefore also zero. Plugging V=0 into the formula for k gives \(k = 1 / (1 + 0^2) = 1\). A value of k=1 means the central bank should close 100% of the gap, which is the certainty equivalence result.

Source: EC3115 Lecture Slides, Unit L.

25. The Lucas Critique, which argues that policy changes can alter the underlying structure of the economy, can be viewed as an extreme form of:

Parameter uncertainty. Additive uncertainty. Data uncertainty. Certainty equivalence.

Correct Answer: A.

The Lucas Critique states that the parameters of macroeconomic models (like the coefficients of a Phillips curve) are not structural but depend on the policy regime. When policy changes, the parameters themselves change. This is a profound form of parameter uncertainty, where the parameters are not just random draws from a stable distribution but are actively changing in response to the policymaker's actions.

Source: General macroeconomic concept.

26. In the Poole model, if the goal is to stabilize output, and the economy is dominated by shocks to money demand, the central bank should:

Keep the money supply constant. Keep the interest rate constant. Keep the exchange rate constant. Keep government spending constant.

Correct Answer: B.

Shocks to money demand are LM shocks. An interest rate target perfectly insulates the real economy from such shocks. The central bank achieves this by adjusting the money supply to meet any shifts in money demand, thereby keeping the interest rate stable and preventing the shock from affecting output. A money supply target would transmit this volatility to interest rates and then to output.

Source: Poole (1970).

27. The idea of "robust control" in modern macroeconomics is an approach to policymaking that:

Assumes a single, correct model of the economy. Ignores uncertainty and acts based on expected values. Is only concerned with additive shocks. Seeks policies that perform reasonably well across a range of possible models, guarding against worst-case scenarios.

Correct Answer: D.

Robust control is a response to model uncertainty. Instead of trying to find the optimal policy for one specific model, it aims to find a policy that is robust, meaning it works acceptably well even if the true model of the economy is different from the policymaker's baseline model. It often involves designing policy to guard against the worst possible outcomes that could occur under plausible alternative models.

Source: General concept in modern macroeconomics.

28. In the Brainard model, if the correlation between the uncertain multiplier and the additive shock is negative, it may be optimal to be:

More aggressive than under certainty equivalence. Less aggressive than under certainty equivalence. Exactly as aggressive as under certainty equivalence. Move the instrument in the 'wrong' direction.

Correct Answer: A.

A negative correlation means that when the policy is unexpectedly potent (high multiplier), the economy tends to be hit by a negative shock. These two effects offset each other. The policymaker can exploit this by being more aggressive. A strong policy move has a built-in hedge: if it turns out to be too powerful, it's likely that a negative shock will dampen its effect anyway. This can lead to the seemingly paradoxical result that uncertainty encourages more aggressive, not less aggressive, policy.

Source: Brainard (1967).

29. The term "real-time data" refers to:

The final, revised data series published by statistical agencies. Data that is adjusted for inflation. The sequence of data vintages that were available to policymakers at each point in time. Data that is published with zero delay.

Correct Answer: C.

"Real-time data" is a crucial concept for evaluating historical policy. It refers to the actual, often preliminary and subsequently revised, data that policymakers had in hand when they made their decisions. Analyzing policy using final, revised data can be misleading because it gives the policymaker credit for information they did not have. The work of Aruoba and others emphasizes the importance of using real-time data.

Source: General concept in empirical macroeconomics.

30. In the Poole model, if the IS curve is very flat (highly interest-elastic), this:

Strengthens the case for money supply targeting when IS shocks dominate. Weakens the case for money supply targeting when IS shocks dominate. Makes the choice of instrument irrelevant. Strengthens the case for interest rate targeting when LM shocks dominate.

Correct Answer: B.

A very flat IS curve means that a small change in the interest rate causes a large change in output. Under a money supply target, the interest rate acts as an automatic stabilizer. However, if the IS curve is very flat, the interest rate changes caused by IS shocks will themselves induce large swings in output, making the stabilizer less effective. This weakens the argument for using a money supply target to combat IS shocks.

Source: Poole (1970) analysis.

31. The Linear-Quadratic (LQ) framework is popular for policy analysis because:

It perfectly describes the real world. It suggests policy is always ineffective. It incorporates non-linearities and tipping points. It is mathematically tractable and, under additive uncertainty, leads to the simple certainty equivalence result.

Correct Answer: D.

The main appeal of the LQ framework (Linear model, Quadratic loss function) is its simplicity and tractability. It allows for an elegant, closed-form solution for the optimal policy. When uncertainty is purely additive, it yields the powerful and intuitive certainty equivalence principle, which provides a clear baseline for how policy should be conducted.

Source: EC3115 Subject Guide, Chapter 12.

32. A central bank that explicitly announces it will be "data-dependent" is acknowledging the presence of:

Additive uncertainty and the need to respond to incoming shocks. Parameter uncertainty and the need for caution. Model uncertainty and the need for robust policies. The failure of the certainty equivalence principle.

Correct Answer: A.

A "data-dependent" approach means the central bank will adjust its policy in response to new information ('data') about the state of the economy. This new information typically relates to unexpected shocks to demand, supply, or inflation, which are forms of additive uncertainty. While other uncertainties exist, the term "data-dependent" most directly refers to reacting to the continuous flow of new shocks hitting the economy.

Source: General interpretation of central bank communication.

33. In the Poole model, if the variances of IS and LM shocks are such that the output variances under both pure instrument choices are equal, the policymaker:

Should still choose the money supply target. Should still choose the interest rate target. Is indifferent between the two pure strategies, and a combination policy would be superior. Should cease intervention.

Correct Answer: C.

If the variances are equal, the policymaker is indifferent between the two simple choices. However, Poole's analysis shows that in this situation (and in general, unless one shock variance is zero), a combination policy that allows the money supply to respond to the interest rate can achieve a strictly lower output variance than either of the pure strategies.

Source: Poole (1970).

34. The "attenuation coefficient" in the Brainard model is the factor by which policy is scaled back due to uncertainty. This coefficient is always:

Greater than 1. Between 0 and 1. Equal to 0. Negative.

Correct Answer: B.

The optimal policy is to set the instrument equal to the certainty-equivalent level multiplied by an attenuation coefficient, which is \(\hat{g}^2 / (\hat{g}^2 + \sigma_g^2)\). Since \(\sigma_g^2\) is a variance and thus non-negative, this coefficient is always between 0 (for infinite uncertainty) and 1 (for zero uncertainty). This reflects that policy is scaled back, not eliminated or reversed (assuming no correlation with other shocks).

Source: Brainard (1967).

35. Which of these is a potential downside of the policy gradualism inspired by Brainard's work?

It increases the risk of large policy errors. It is inconsistent with a quadratic loss function. It makes policy harder to communicate. It may allow inflation expectations to become unanchored if the policy response to shocks is too slow.

Correct Answer: D.

While caution is prudent, excessive gradualism can be dangerous. If a central bank responds too slowly and timidly to an inflationary shock, firms and households may come to believe the central bank is not serious about its inflation target. This could cause inflation expectations to rise, making it much harder and more costly to bring inflation back down later.

Source: General critique of policy gradualism.

36. The core assumption in Poole's (1970) model is that the central bank's objective is to:

Minimize the variance of real income (output). Minimize the variance of inflation. Keep the interest rate as low as possible. Maximize tax revenue for the government.

Correct Answer: A.

The entire analysis in Poole's paper is framed around a single objective: stabilizing the real economy. The central bank's problem is to choose the monetary policy instrument (interest rate or money supply) that results in the smallest possible variance of real income around its target level.

Source: Poole (1970).

37. If a central bank has multiple policy instruments, Brainard's diversification principle suggests using a portfolio of them. This is analogous to what concept in finance?

The efficient markets hypothesis. The capital asset pricing model (CAPM). Modern portfolio theory (MPT). Behavioral finance.

Correct Answer: C.

Modern Portfolio Theory, developed by Harry Markowitz, shows how an investor can reduce the overall risk of a portfolio by combining different assets whose returns are not perfectly correlated. Brainard's result is a direct application of this logic to policymaking: by combining different policy instruments whose effects (multipliers) are not perfectly correlated, the central bank can reduce the overall uncertainty of its policy impact.

Source: Brainard (1967).

38. The 'news' vs 'noise' debate about data revisions is fundamentally a debate about:

The competence of government statisticians. Whether initial data releases are rational forecasts or measurements with error. Whether the economy is better described by Keynesian or classical models. The optimal frequency of data publication.

Correct Answer: B.

This is the heart of the matter. The 'news' view assumes the initial release is a rational forecast, making the revision an unpredictable forecast error. The 'noise' view assumes the initial release is the true value contaminated by measurement error, making the revision a (potentially predictable) correction of that error. Aruoba's (2008) work empirically tests the predictions of these two competing views.

Source: Aruoba (2008).

39. In the Poole model, if the interest elasticity of money demand is very low (a steep LM curve), this:

Makes interest rate targeting more effective against IS shocks. Makes money supply targeting less effective against IS shocks. Makes interest rate targeting more effective against LM shocks. Makes money supply targeting more effective against IS shocks.

Correct Answer: D.

A steep LM curve means a given change in income requires a large change in the interest rate to clear the money market. When the money supply is fixed and an IS shock occurs, this large required change in the interest rate acts as a powerful automatic stabilizer, causing a large amount of crowding out and thus dampening the output effect of the shock. This strengthens the case for money supply targeting when IS shocks are dominant.

Source: Poole (1970) analysis.

40. The optimal policy under parameter uncertainty depends on the policymaker's preferences regarding the trade-off between:

The mean and variance of the target variable. Inflation and unemployment. Rules and discretion. The short run and the long run.

Correct Answer: A.

This is the central trade-off introduced by Brainard (1967). A more aggressive policy can bring the expected value (mean) of the target variable closer to the desired level, but at the cost of increasing its variance. A risk-averse policymaker must choose a point on this trade-off curve, balancing their desire for accuracy on average against their desire for stability.

Source: Brainard (1967).

41. If a central bank successfully implements a "combination policy" as described by Poole, the effective LM curve it presents to the economy would be:

Horizontal. Vertical. Upward sloping. Downward sloping.

Correct Answer: C.

A pure interest rate target makes the LM curve horizontal. A pure money supply target makes the effective LM curve vertical (in the sense that the money supply is fixed). The optimal combination policy involves allowing the interest rate to rise somewhat in response to an increase in income, which implies an upward-sloping effective LM curve. The slope of this curve is chosen optimally to balance the effects of IS and LM shocks.

Source: Poole (1970).

42. The existence of long and variable lags in the effect of monetary policy is a form of:

Additive uncertainty. Parameter uncertainty. Data uncertainty. The 'news' vs 'noise' problem.

Correct Answer: B.

"Long and variable lags" means that the policymaker is uncertain about both how long it will take for their actions to affect the economy and how large that effect will ultimately be. This is a classic example of parameter uncertainty, as it relates to the magnitude and timing of the policy multipliers in the economic model.

Source: Concept originally from Milton Friedman.

43. In the Poole model, if the central bank's goal was to stabilize the interest rate rather than output, what would be the optimal policy?

Money supply targeting. A combination policy. It would be impossible. Interest rate targeting.

Correct Answer: D.

This is a straightforward question. If the objective is to stabilize the interest rate (i.e., achieve zero variance in the interest rate), the optimal policy is, by definition, to target the interest rate. This fixes the rate at the desired level, resulting in zero volatility.

Source: Logical extension of Poole (1970).

44. The main takeaway from Brainard's (1967) paper is that when policy effectiveness is uncertain, the optimal response is generally:

Cautious and gradual. Aggressive and pre-emptive. To follow a fixed rule. To use fiscal policy instead.

Correct Answer: A.

The core message of Brainard's analysis is that parameter uncertainty breaks certainty equivalence and leads to policy attenuation. Policymakers should act less aggressively than they would if they were certain about the effects of their policies. This translates into a cautious, gradualist approach to policy adjustments.

Source: Brainard (1967).

45. According to the 'noise' view of data revisions, the final, revised data is:

Uncorrelated with the initial announcement. A biased estimate of the true value. The best estimate of the true, underlying value of the variable. Less informative than the initial announcement.

Correct Answer: C.

In the 'noise' framework, the initial announcement is the 'true' value plus error. The revision process is about removing that error. Therefore, the final, fully revised data is assumed to be the best available measure of the true, unobserved economic concept (e.g., the actual level of GDP in a given quarter).

Source: Aruoba (2008).

46. In the Poole model, an interest rate target fully accommodates which type of shocks?

LM shocks. IS shocks. Both IS and LM shocks. Neither IS nor LM shocks.

Correct Answer: B.

When targeting the interest rate, the LM curve becomes horizontal. If an IS shock occurs (e.g., a rightward shift), the central bank must increase the money supply to prevent the interest rate from rising. By doing so, it allows the full effect of the IS shock to pass through to output. The policy 'accommodates' the shock, leading to higher output volatility from this source.

Source: Poole (1970).

47. The breakdown of certainty equivalence implies that for a risk-averse policymaker, the optimal policy depends on:

Only the first moment (mean) of the target variable's distribution. Only the third moment (skewness) of the target variable's distribution. Only the fourth moment (kurtosis) of the target variable's distribution. At least the first and second moments (mean and variance) of the target variable's distribution.

Correct Answer: D.

Certainty equivalence means only the first moment (mean) matters. Its failure means that higher moments of the distribution of the target variable become relevant to the policy decision. In the standard Brainard model with a quadratic loss function, the first moment (mean) and the second moment (variance) are what determine the optimal policy.

Source: Brainard (1967).

48. If a central bank observes that its policy actions seem to have a smaller effect on the economy than its models predict, this is direct evidence of:

Parameter uncertainty. Additive uncertainty. Data uncertainty. A well-specified model.

Correct Answer: A.

This scenario describes a situation where the true policy multiplier is different from the central bank's estimate. The discrepancy between the expected effect and the actual effect of policy is the very definition of parameter uncertainty. The bank is uncertain about the true value of the parameters governing policy effectiveness.

Source: General application of the concept.

49. In the Poole model, the relative benefit of a money supply target over an interest rate target increases as:

The variance of LM shocks increases. The IS curve becomes flatter. The variance of IS shocks increases. The LM curve becomes flatter.

Correct Answer: C.

A money supply target is good at stabilizing against IS shocks, while an interest rate target is good at stabilizing against LM shocks. Therefore, the relative advantage of a money supply target grows as the shocks it is good at handling (IS shocks) become more important (i.e., their variance increases).

Source: Poole (1970).

50. The overall message from the study of monetary policy under uncertainty is that policymaking is:

A simple technical exercise of applying formulas. A complex task of managing trade-offs in an environment of incomplete information. Largely futile due to the randomness of the economy. Best replaced by a fixed, unthinking rule.

Correct Answer: B.

The work of Poole, Brainard, Aruoba, and others demonstrates that real-world policymaking is fraught with challenges. Data is imperfect, the effects of policy are uncertain, and the correct model is unknown. Optimal policy is not about applying a simple rule but about navigating the trade-offs between achieving targets and controlling for risk in a constantly evolving and uncertain environment.

Source: Synthesis of the entire topic.

EC3115 - Chapter 12 Quiz 2: Monetary Policy and Data/Parameter Uncertainties