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Provide several ways that the central bank could establish credibility.
Answer: Some ways in which the central bank could establish credibility include: continued
success of keeping inflation under control, inflation targeting, public announcements of medium-
term numerical targets for inflation, giving the central bank more independence from the political
process, appoint "conservative" central bankers who have a strong aversion to inflation.
Diff: 2 Type: SA Page Ref: 633
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates
Describe the two main benefits of a credible nominal anchor.
Answer: First, a credible nominal anchor acts like a behaviour rule and reduces the issues
associated with the time-inconsistency problem. Second, a credible commitment to a nominal
anchor will help anchor inflation expectations which leads to smaller fluctuations in inflation
which helps with price stability.
Diff: 2 Type: SA Page Ref: 625
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates
Explain how the impacts of a positive aggregate demand shock can be mitigated by monetary
policy credibility.
Answer: Monetary policy credibility has the benefit of stabilizing inflation in the short run when
faced with a positive demand shock as the public's expectation of inflation will remain
unchanged.
Diff: 2 Type: SA Page Ref: 626
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates
Explain the difference in how the Canadian economy responding during the three oil shocks
and the role monetary policy credibility played.
Answer: Three oil shocks occurred in 1973, 1979 and 2007. After the first two episodes,
monetary policy was weak because the Bank of Canada was unable to keep inflation under
control and inflation increased to over 10 percent. During the oil crisis in 2007, the Bank of
Canada had established monetary policy credibility and inflation never rose about 4 percent.
Economists attribute the lower inflation rate to the credibility of the Bank of Canada in keeping
inflation within the target range.
Diff: 2 Type: SA Page Ref: 628
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates