Chapter 23

Transmission Mechanisms of Monetary Policy: The Evidence

23.1 Framework for Evaluating Empirical Evidence

1) Evidence that examines whether one variable has an effect on another by simply looking
directly at the relationship between the two variables is
A) reduced-form evidence.
B) organizational-model evidence.
C) direct-model evidence.
D) structural-model evidence.
Answer: A
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2) Evidence that is based on a variable having its effect on another variable through channels
rather than a direct effect is known as
A) indirect-model evidence.
B) organizational-model evidence.
C) reduced-form evidence.
D) structural-model evidence.
Answer: D
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3) On the evening news you hear of a scientific study that directly links premature births to
cigarette smoking. This is an example of
A) direct-model evidence.
B) informed voter-model evidence.
C) structural-model evidence.
D) reduced-form evidence.
Answer: D
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4) The monetarist-Keynesian debate on the importance of monetary policy is unresolved because

monetarists and Keynesians focus on two different types of evidence that generate conflicting
conclusions. Monetarists tend to focus on
A) structural-model evidence, while Keynesians focus on reduced-form evidence.
B) reduced-form evidence, while Keynesians focus on structural-model evidence.
C) reduced-form evidence, while Keynesians focus on direct-model evidence.
D) structural-model evidence, while Keynesians focus on direct-model evidence.
Answer: B
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5) The channels through which monetary policy affects economic activity are called the ________
of monetary policy.
A) transmission mechanisms
B) flow mechanisms
C) distribution mechanisms
D) allocational mechanisms
Answer: A
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6) A model that is composed of many equations that show the channels through which monetary
and fiscal policy affect aggregate output and spending is called a
A) reduced-form model.
B) median-voter model.
C) informed median-voter model.
D) structural model.
Answer: D
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7) Monetarists directly study the link between money and economic activity using
A) structural models.
B) reduced-form models.
C) scientific models.
D) experimental models.
Answer: B
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8) The monetarist reduced-form evidence does not specify the working of the economy and thus is
considered to be a
A) scientific model.
B) open model.
C) black box.
D) black hole.
Answer: C
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9) Which of the following is not an advantage of a correctly specified structural model?

A) Structural models may help us to more accurately predict the effect that monetary policy
has on economic activity.
B) A structural model provides more pieces of evidence about monetary policyʹs effect on
economic activity.
C) Structural models may allow economists to more accurately predict the impact
institutional changes have on the link between monetary policy and income.
D) A structural model imposes no restrictions on the way monetary policy affects the
economy.
Answer: D
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 513

10) Predicting the impact of institutional change on the effectiveness of monetary policy is best done
with a
A) structural model.
B) reduced-form model.
C) black-box model.
D) scientific model.
Answer: A
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11) The monetarists complained that early Keynesian structural models tended to ignore the impact
of monetary policy changes on
A) interest rates.
B) investment spending.
C) consumption spending.
D) capital goods spending.
Answer: C
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12) Monetarists contend that the channels of monetary influence in Keynesian structural models are
too ________ defined, ________ the importance of monetary policy.
A) broadly; exaggerating
B) broadly; understating
C) narrowly; understating
D) narrowly; exaggerating
Answer: C
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13) Monetarists claim that ________ models ignore important transmission mechanisms and
therefore ________ the importance of the effects of monetary policy on the economy.
A) structural; overstate
B) reduced-form; overstate
C) reduced-form; understate
D) structural; understate
Answer: D
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14) Monetarists assert that monetary policy may affect aggregate demand through
A) only an interest rate channel.
B) only an exchange rate channel.
C) only two channels: interest rates and exchange rates.
D) many channels.
Answer: D
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15) If the particular channels through which changes in the money supply affect aggregate income
are diverse and continually changing, the best evidence of monetary policyʹs effect is likely to
come from
A) reduced-form models.
B) structural models.
C) median-voter models.
D) indirect models.
Answer: A
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16) Monetaristsʹ preference for reduced-form models is based on their belief that
A) reverse causation is a problem.
B) structural models may understate moneyʹs effect on economic activity.
C) money supply changes are always endogenous.
D) monetary policy affects only investment spending.
Answer: B
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17) When Keynesians argue that ʺcorrelation does not necessarily imply causation,ʺ they are
probably criticizing
A) structural-model evidence.
B) reduced-form evidence.
C) indirect-model evidence.
D) black-box evidence.
Answer: B
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18) Reverse causation between money and aggregate output is likely to be a problem when a central
bank targets
A) a monetary aggregate.
B) an interest rate.
C) the exchange rate.
D) the inflation rate.
Answer: B
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19) With regard to aggregate demand, early Keynesians tended to believe that
A) monetary policy mattered most.
B) monetary policy was all that mattered.
C) monetary policy mattered.
D) monetary policy did not matter.
Answer: D
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 515

20) The ________ held the view that monetary policy does not matter at all for movements in
aggregate output.
A) new Keynesian economists
B) early Keynesians
C) early monetarists
D) early classical economists
Answer: B
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21) Early Keynesians felt that ________ policy was ________, so they stressed the importance of
________ policy.
A) fiscal; ineffective; monetary
B) monetary; ineffective; fiscal
C) monetary; potent; monetary
D) fiscal; too potent; monetary
Answer: B
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22) Early Keynesians believed that ________ interest rates during the Great Depression indicated
that monetary policy had been ________.
A) high; contractionary
B) high; expansionary
C) low; contractionary
D) low; expansionary
Answer: D
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23) Early Keynesians viewed monetary policy as influencing aggregate demand solely through its
impact on ________ interest rates, which, in turn, affect ________ spending.
A) nominal; consumer
B) nominal; investment
C) real; consumer
D) real; investment
Answer: B
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24) Early Keynesians believed that ________ interest rates during the Great Depression indicated
that monetary policy was ________.
A) high; easy
B) high; tight
C) low; easy
D) low; tight
Answer: C
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25) Early Keynesians believed that low ________ during the Great Depression indicated that
________ policy was easy.
A) money growth; fiscal
B) money growth; monetary
C) interest rates; fiscal
D) interest rates; monetary
Answer: D
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26) Early Keynesians concluded that changes in monetary policy had no impact on aggregate
output because early empirical studies found no linkage between movements in ________ and
________.
A) nominal interest rates; investment spending
B) real interest rates; investment spending
C) money supply; aggregate output
D) investment spending; aggregate output
Answer: A
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27) In response to the early Keynesians, monetarists contended that

A) monetary policy during the Great Depression was not easy.
B) bank failures during the Great Depression were not the cause of the decline in the money
supply.
C) evidence from the Great Depression demonstrated the ineffectiveness of monetary policy.
D) there is a weak link between interest rates and investment spending.
Answer: A
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28) Milton Friedman and Anna Schwartz showed that monetary policy during the Great Depression
had
A) been quite inflationary.
B) never been more contractionary.
C) been more expansionary than in the 1920s.
D) been essentially neutral.
Answer: B
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29) By the standard of low-grade bonds, interest rates were ________ and monetary policy was
________ during the Great Depression.
A) low; tight
B) low; easy
C) high; tight
D) high; easy
Answer: C
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 517

30) During the Great Depression, real interest rates

A) rose to unprecedentedly high levels.
B) rose only slightly above the long-run trend.
C) fell to unprecedentedly low levels.
D) fell only slightly below the long-run trend.
Answer: A
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31) Movements of ________ interest rates indicate that, contrary to the early Keynesiansʹ beliefs,
monetary policy was ________ during the Great Depression.
A) nominal; tight
B) nominal; easy
C) real; tight
D) real; easy
Answer: C
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32) Movements of real interest rates indicate that, contrary to the early Keynesiansʹ beliefs, ________
policy was ________ during the Great Depression.
A) fiscal; tight
B) fiscal; easy
C) monetary; tight
D) monetary; easy
Answer: C
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33) Periods of price deflation, such as the Great Depression, are characterized by
A) low nominal rates but high real rates of interest.
B) low nominal and real interest rates.
C) real rates of interest lower than the nominal rate of interest.
D) high nominal and real rates of interest.
Answer: A
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34) Monetarists contend that

A) monetary policy affects aggregate demand solely through investment.
B) monetary policy may affect aggregate demand through many channels.
C) a weak link between nominal interest rates and investment spending implies monetary
policy ineffectiveness.
D) monetary policy affects aggregate demand solely through consumption.
Answer: B
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35) In the early 1960s, monetarists used reduced-form timing, statistical, and historical evidence to
show that
A) fiscal policy had a strong impact on economic activity.
B) monetary policy had a strong impact on economic activity.
C) monetary policy had a weak impact on economic activity.
D) neither monetary nor fiscal policy had a strong impact on economic activity.
Answer: B
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36) In a study published in 1963, Milton Friedman and Anna Schwartz found that in every business
cycle they studied over nearly a hundred-year period, the growth rate of the ________
decreased before ________ decreased.
A) money supply; interest rates
B) money supply; output
C) budget deficit; interest rates
D) budget deficit; output
Answer: B
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37) Friedman and Schwartz found that the rate of money growth fell prior to business cycle
downturns in
A) about three out of every four instances.
B) four out of every five instances.
C) about two out of every three instances.
D) every instance studied.
Answer: D
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38) In a study published in 1963, Milton Friedman and Anna Schwartz found that in every business
cycle they studied over nearly a hundred-year period,
A) the growth rate of the money supply decreased before output decreased.
B) interest rates decreased before output decreased.
C) the growth rate of federal government spending decreased before output decreased.
D) the growth rate of state and local government spending decreased before output
decreased.
Answer: A
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39) Timing evidence is valid only if it is known that the first event is
A) endogenous.
B) exogenous.
C) a leading indicator of the second event.
D) a lagging indicator of the second event.
Answer: B
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 519

40) Because ________ evidence is of a ________ nature, there is always the possibility of reverse
causation, in which output growth causes money growth.
A) historical; structural
B) statistical; structural
C) timing; structural
D) timing; reduced-form
Answer: D
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41) If the movements of the level of the money supply and real output are perfectly coordinated the
growth rate of money
A) will lead the level of real output.
B) will move in synchronization with the level of real output.
C) will lag the level of real output.
D) can either lead or lag the level of real output.
Answer: A
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42) The monetarist statistical evidence examines the correlations between both ________ and
________ with ________.
A) money; aggregate spending; the unemployment rate
B) money; autonomous expenditures; the unemployment rate
C) money; consumption spending; aggregate spending
D) money; autonomous expenditures; aggregate spending
Answer: D
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43) A criticism of the monetarist autonomous spending variable is that

A) some types of autonomous spending do not affect aggregate demand.
B) some types of autonomous spending affect aggregate demand before the spending occurs.
Some types of autonomous spending affect aggregate demand when they occur.
C) some types of autonomous spending affect aggregate demand only long after they occur.
D) Keynesians do not think that autonomous spending affects aggregate demand.
Answer: B
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44) One of the best examples of an episode in which a change in monetary policy appears to have
been an exogenous event is the ________ in reserve requirements in ________.
A) increase; 1936-1937
B) decrease; 1936-1937
C) decrease; 1818-1819
D) increase; 1818-1819
Answer: A
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520 Mishkin · The Economics of Money, Banking, and Financial Markets, 9th Edition

45) The monetarist position on the importance of monetary policy is probably best supported by
________ evidence.
A) timing
B) statistical
C) historical
D) structural
Answer: C
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46) The monetarist ________ evidence in which declines in money growth are followed by
recessions provides the strongest support for their position that monetary policy matters.
A) statistical
B) historical
C) timing
D) structural
Answer: B
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47) As a result of recent empirical research, there has been a convergence of Keynesian and
monetarist opinion to the view that
A) money is all that matters.
B) money does matter.
C) money does not matter.
D) fiscal policy is all that matters.
Answer: B
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48) Real business cycle theorists are critical of monetarist reduced-form evidence because they
believe
A) money is the most important cause of changes in aggregate demand.
B) there is reverse causation from the business cycle to money.
C) there is reverse causation from money to the business cycle.
D) business cycles do not exist.
Answer: B
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49) Real business cycle theory states that the most important cause of business cycles is
A) shocks to the money supply.
B) interest rate shocks.
C) Federal Reserve policy decisions.
D) shocks to tastes and technology.
Answer: D
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 521

23.2 Transmission Mechanism of Monetary Policy

1) Economic theory suggests that ________ interest rates are ________ important than ________
interest rates in explaining investment behavior.
A) nominal; more; real
B) real; less; nominal
C) real; more; nominal
D) market; more; real
Answer: C
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2) According to the traditional interest-rate channel, expansionary monetary policy lowers the real
interest rate, thereby raising expenditure on
A) business fixed investment.
B) government expenditure.
C) consumer nondurables.
D) net exports.
Answer: A
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3) The monetary transmission mechanism that links monetary policy to GDP through real interest
rates and investment spending is called the
A) traditional interest-rate channel.
B) Tobinsʹ q theory.
C) wealth effects.
D) cash flow channel.
Answer: A
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4) If the aggregate price level adjusts slowly over time, then an expansionary monetary policy
lowers
A) only the short-term nominal interest rate.
B) only the short-term real interest rate.
C) both the short-term nominal and real interest rates.
D) the short-term nominal, the short-term real, and the long-term real interest rates.
Answer: D
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5) If monetary policy can influence ________ prices and conditions in ________ markets, then it can
affect spending through channels other than the traditional interest-rate channel.
A) asset; labor
B) asset; credit
C) commodity; labor
D) commodity; credit
Answer: B
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6) An expansionary monetary policy lowers the real interest rate, causing the domestic currency to
________, thereby ________ net exports.
A) appreciate; raising
B) appreciate; lowering
C) depreciate; raising
D) depreciate; lowering
Answer: C
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7) An expansionary monetary policy increases net exports by ________ interest rates and ________
the value of the dollar.
A) lowering nominal; decreasing
B) lowering real; decreasing
C) raising nominal; increasing
D) raising real; increasing
Answer: B
Ques Status: Revised

8) A contractionary monetary policy raises the real interest rate, causing the domestic currency to
________, thereby ________ net exports.
A) appreciate; raising
B) appreciate; lowering
C) depreciate; raising
D) depreciate; lowering
Answer: B
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9) A contractionary monetary policy decreases net exports by ________ interest rates and ________
the value of the dollar.
A) lowering real; decreasing
B) lowering real; increasing
C) raising nominal; increasing
D) raising real; increasing
Answer: D
Ques Status: Revised

10) Tobinʹs q is defined as the market value of firms ________ the replacement cost of capital.
A) times
B) minus
C) plus
D) divided by
Answer: D
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 523

11) Tobinʹs q theory suggests that monetary policy may affect investment spending through its
impact on
A) stock prices.
B) interest rates.
C) bond prices.
D) cash flow.
Answer: A
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12) In the late 1990s, the stock market bubble ________ the value of Tobinʹs q, and caused ________
in business equipment.
A) increased; underinvestment
B) increased; overinvestment
C) decreased; underinvestment
D) decreased; overinvestment
Answer: B
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13) During the Great Depression, Tobinʹs q

A) rose dramatically, as did real interest rates.
B) fell to unprecedentedly low levels.
C) stayed fairly constant, in contrast to most other economic measures.
D) rose only slightly, in spite of Hooverʹs attempts to prop it up.
Answer: B
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14) According to Tobinʹs q theory, ________ policy can affect ________ spending through its effect
on the prices of common stock.
A) fiscal; consumption
B) fiscal; investment
C) monetary; consumption
D) monetary; investment
Answer: D
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15) According to Tobinʹs q theory, when q is ________, firms will not purchase new investment
goods because the market value of firms is ________ relative to the cost of capital.
A) low; low
B) low; high
C) high; low
D) high; high
Answer: A
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16) According to Tobinʹs q theory, if q is ________, new plant and equipment capital is ________
relative to the market value of business firms, so companies can buy a lot of new investment
goods with only a ________ issue of stock.
A) high; dear; large
B) high; cheap; large
C) high; cheap; small
D) low; cheap; large
E) low; cheap; small
Answer: C
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17) According to Tobinʹs q theory, when equity prices are low the market price of existing capital is
________ relative to new capital, so expenditure on fixed investment is ________.
A) cheap; low
B) dear ; low
C) cheap; high
D) dear; high
Answer: A
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18) According to Tobinʹs q theory, when equity prices are high the market price of existing capital is
________ relative to new capital, so expenditure on fixed investment is ________.
A) cheap; low
B) dear ; low
C) cheap; high
D) dear; high
Answer: D
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19) Franco Modigliani has found that an expansionary monetary policy can cause stock market
prices to ________ and consumption to ________.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase
Answer: A
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20) Since Regulation Q has been abolished, there have been doubts raised about the size of the effect
of the ________ channel.
A) balance sheet
B) bank lending
C) cash flow
D) unanticipated price level
Answer: B
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 525

21) A rise in stock prices ________ the net worth of firms and so leads to ________ investment
spending because of the reduction in moral hazard.
A) raises; higher
B) raises; lower
C) reduces; higher
D) reduces; lower
Answer: A
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22) Because of the presence of asymmetric information problems in credit markets, an expansionary
monetary policy causes a ________ in net worth, which ________ the adverse selection problem,
thereby ________ increased lending to finance investment spending.
A) decline; increases; encouraging
B) rise; increases; discouraging
C) rise; reduces; encouraging
D) decline; reduces; discouraging
Answer: C
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23) Due to asymmetric information in credit markets, monetary policy may affect economic activity
through the balance sheet channel, where an increase in the money supply
A) raises stock prices, lowering the cost of new capital relative to firmsʹ market value, thus
increasing investment spending.
B) raises firmsʹ net worth, decreasing adverse selection and moral hazard problems, thus
increasing banksʹ willingness to lend to finance investment spending.
C) raises the level of bank reserves, deposits, and bank loans, thereby raising spending by
those individuals who do not have access to credit markets.
D) lowers the value of the dollar, increasing net exports and aggregate demand.
Answer: B
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24) An expansionary monetary policy raises firmsʹ cash flows by ________ interest rates.
A) lowering real
B) lowering nominal
C) raising real
D) raising nominal
Answer: B
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25) If a contractionary monetary policy lowers the price level by more than expected, it raises the
real value of consumer debt. This reduces consumer expenditure through
A) the bank lending channel.
B) Tobinʹs q.
C) the traditional interest-rate channel.
D) the household liquidity effect.
Answer: D
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26) An expansionary monetary policy may cause asset prices to rise, thereby reducing the likelihood
of financial distress and causing consumer durable and housing expenditures to rise. This
monetary transmission mechanism is referred to as
A) the household liquidity effect.
B) the wealth effect.
C) Tobinʹs q theory.
D) the cash flow effect.
Answer: A
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27) According to the household liquidity effect, an expansionary monetary policy causes a ________
in the value of householdsʹ financial assets, causing consumer durable expenditure to ________.
A) decline; rise
B) rise; rise
C) rise; fall
D) decline; fall
Answer: B
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28) According to the household liquidity effect, higher stock prices lead to increased consumption
expenditures because consumers
A) feel more secure about their financial position.
B) want to sell stocks and spend the proceeds before stock prices fall.
C) believe that their wages will increase due to increased profitability of firms.
D) can now afford more expensive imports.
Answer: A
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29) Corporate scandals involving Enron and Arthur Andersen reduced investment and aggregate
spending because these scandals
A) forced the Fed to raise interest rates.
B) caused appreciation of the dollar.
C) worsened adverse selection and moral hazard.
D) caused bank failures.
Answer: C
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30) In a period of deflation, when there is a declining price level, ________ nominal interest rates do
not necessarily indicate that the cost of borrowing is ________ or that monetary policy is easy.
A) low; low
B) low; high
C) high; low
D) high; high
Answer: A
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 Chapter 23 Transmission Mechanisms of Monetary Policy: The Evidence 527

31) In a period of deflation, when there is a declining price level, low nominal interest rates do not
necessarily indicate that the cost of borrowing is ________ or that monetary policy is ________.
A) low; tight
B) low; easy
C) high; tight
D) high; easy
Answer: B
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32) The subprime financial crisis caused a recession because of the ________ in adverse selection
and moral hazard problems and the ________ in housing prices.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
Answer: B
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33) Explain the traditional interest-rate channel for expansionary monetary policy. Explain how a
tight monetary policy affects the economy through this channel.
Answer: In the traditional channel, a monetary expansion reduces real interest rates, lowering the
cost of capital and increasing investment spending. The increase in investment increases
aggregate demand. A monetary contraction has the opposite effect, raising real interest
rates, lowering investment and aggregate spending.
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34) Explain how expansionary and contractionary monetary policies affect aggregate demand
through the exchange rate channel.
Answer: An expansionary monetary policy reduces real interest rates, causing depreciation of the
domestic currency. This depreciation increases net exports and aggregate spending. A
monetary contraction increases real interest rates, causing appreciation of the domestic
currency, reducing net exports and aggregate spending.
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35) Discuss three channels by which monetary policy affects stock prices and aggregate spending.
Answer: The answer should include three of the following:
In Tobinʹs q theory, a monetary expansion increases stock prices, increasing the value of
the firm relative to the cost of new capital. This stimulates investment in new capital
goods, which in turn increases aggregate spending.
A monetary expansion increases stock prices, increasing wealth and stimulating
consumption and aggregate spending.
Expansionary monetary policy increases equity prices. This improves firmsʹ balance
sheets, reducing adverse selection and moral hazard and increasing lending for
investment, which increases aggregate spending.
In the household liquidity effect, the increase in equity prices due to a monetary
expansion improves consumer balance sheets, reducing the probability of financial
distress, and increasing consumer spending on durable goods and housing.
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23.3 Lessons for Monetary Policy

1) Analysis of the transmission mechanisms of monetary policy provides four basic lessons for a
central bankʹs conduct of monetary policy. These lessons include:
A) Rising interest rates indicate a tightening of monetary policy, whereas falling interest rates
indicate an easing of monetary policy.
B) Monetary policy can be highly effective in reviving a weak economy even if short -term
interest rates are already near zero.
C) Avoiding fluctuations in the level of unemployment is an important objective of monetary
policy, thus providing a rationale for interest-rate stability as the primary long-run goal
for monetary policy.
D) Other asset prices beside those on short-term debt instruments do not contain important
information about the stance of monetary policy because they are not important elements
in various monetary policy transmission mechanisms.
Answer: B
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2) Analysis of the transmission mechanisms of monetary policy provides four basic lessons for a
central bankʹs conduct of monetary policy. Which of the following is not one of these lessons?
A) Rising interest rates indicate a tightening of monetary policy, whereas falling interest rates
indicate an easing of monetary policy.
B) Monetary policy can be highly effective in reviving a weak economy even if short -term
interest rates are already near zero.
C) Avoiding unanticipated fluctuations in the price level is an important objective of
monetary policy, thus providing a rationale for price stability as the primary long-run
goal for monetary policy.
D) Other asset prices beside those on short-term debt instruments do not contain important
information about the stance of monetary policy because they are important elements in
various monetary policy transmission mechanisms.
Answer: A
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3) In the late 1990s and early 2000s, the Japanese economy has experienced
A) easy monetary policy as indicated by falling nominal interest rates.
B) easy monetary policy as indicated by short -term interest rates near zero.
C) tight monetary policy as indicated by falling asset prices.
D) tight monetary policy as indicated by short-term interest rates near zero.
Answer: C
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4) Recent Japanese experience has been characterized by tight monetary policy, as indicated by
A) falling interest rates.
B) short-term interest rates near zero.
C) falling asset prices.
D) low real interest rates.
Answer: C
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