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What do you know about the reduced-form evidence in describing the transmission
mechanism of monetary policy? Provide a brief description.
Answer: The quantity theory approach to aggregate demand does not describe specific ways in
which the money supply affects aggregate spending, Instead, it suggests that the effect of money
on economic activity should be examined by looking at whether movements in Y are tightly
linked to movements in M. Reduced-form evidence analyzes the effect of changes in M on Y as
if the economy were a black box whose workings cannot be seen.
Diff: 1 Type: SA Page Ref: 639
Skill: Recall
Objective List: 25.1 Express the different types of empirical evidence
What are the advantages of structural model evidence if the structure is correct?
Answer:
a. Because we can evaluate each transmission mechanism separately to see whether it is
plausible, we can gather more evidence on whether monetary policy has an important effect on
economic activity.
b. Knowing how changes in monetary policy affect economic activity may help us predict the
effect of changes in M on Y more accurately.
c. By knowing how the economy operates, we may be able to predict how institutional changes
in the economy might affect the link between changes in M and Y.
Diff: 3 Type: SA Page Ref: 639
Skill: Recall
Objective List: 25.1 Express the different types of empirical evidence
What are the advantages of reduced-form evidence?
Answer: The main advantage of reduced-form evidence over structural model evidence is that
no restrictions are imposed on the way monetary policy affects the economy. If we are not sure
that we know what all the monetary transmission mechanisms are, we may be more likely to spot
the full effect of changes in M on Y by looking at whether movements in Y correlate highly with
movements in M.
Diff: 1 Type: SA Page Ref: 639
Skill: Recall
Objective List: 25.1 Express the different types of empirical evidence
What is reverse causation and how does it relate to reduced-form evidence on monetary
policy transmission?
Answer: A basic principle applicable to all scientific disciplines, including economics, states
that correlation does not necessarily imply causation. The situation where after finding
correlation between two variables say M and Y, we conclude erroneously that one causes the
other is called reverse causation. The fact that the movement of one variable is linked to another
doesn't necessarily mean that one variable causes the other. The reverse causation problem may
be present when examining the link between changes in money and aggregate output or
spending. If most of the correlation between M and Y occurs because of the Bank's interest-rate
target, controlling the money supply will not help control aggregate output because it is actually
changes in Y that are causing changes in M rather than the other way around.
Diff: 3 Type: SA Page Ref: 641
Skill: Recall