Question: Both advanced economics and developing countries have experienced a decrease in inflation since the 1980s (see Table in the text). This question considers how the choice of policy regime has influenced such global disinflation. Use the monetary model to answer this question.
a. The Swiss Central Bank currently targets its money growth rate to achieve policy objectives. Suppose Switzerland has output growth of 3% and money growth of 8% each year. What is Switzerland's inflation rate in this case? Describe how the Swiss Central Bank could achieve an inflation rate of 2% in the long run through the use of a nominal anchor.
b. Like the Federal Reserve, the Reserve Bank of New Zealand uses an interest rate target. Suppose the Reserve Bank of New Zealand maintains a 6% interest rate target and the world real interest rate is 1.5%. What is the New Zealand inflation rate in the long run? In 1997 New Zealand adopted a policy agreement that required the bank to maintain an inflation rate no higher than 2.5%. What interest rate targets would achieve this objective?
c. The central bank of Lithuania maintains an exchange rate band relative to the euro. This is a prerequisite for joining the Eurozone. Lithuania must keep its exchange rate within ±15% of the central parity of 3.4528 litas per euro. Compute the exchange rate values corresponding to the upper and lower edges of this band. Suppose PPP holds. Assuming Eurozone inflation is currently 2% per year and inflation in Lithuania is 5%, compute the rate of depreciation of the lita. Will Lithuania be able to maintain the band requirement? For how long? Does your answer depend on where in the band the exchange rate currently sits? A primary objective of the European Central Bank is price stability (low inflation) in the current and future Eurozone. Is an exchange rate band a necessary or sufficient condition for the attainment of this objective?
