1. Discuss how long it takes monetary policy to affect the economy and inflation and pose your own explanation of why the effects are not felt immediately.

As pointed out in the article, the lag in monetary policy between implementation and action can be long and variable. Major effects are seen early in the process as policy effects demand. For example, an increase in the interest rate will reduce demand for goods and services and have a contractionary effect on the economy. The effect on production of goods and services is usually felt within three months to two years of implementation. Research has shown, however, that the final effect on inflation tends to involve longer lags of up to three years. Student's own explanations will vary, but should in some way discuss the issues of unemployment, the business cycle, recession, inflation, etc. Given the long lags and uncertain effects of monetary policy actions, the Federal Reserve policy makers must anticipate the effects of its policy actions into the distant future of up to three years. Bernanke was obviously making this point in the article. Needless to say, anticipating policy effects into the future is a difficult task but this knowledge helps us to understand the recent monetary strategy of the Fed which increased interest rates only a little at a time as they tried to grasp the effect of the policy already in "the pipeline".

2. Explain how interest rate increases reduce inflation.

An increase in interest rates causes the public's demand for foods and services to change, mainly by increasing the cost of borrowing and the availability of bank loans. As the cost of borrowing increases, consumers reduce their spending on durable goods such as autos and new homes. Businesses reduce their spending on new capital and equipment. This reduction in spending by households and businesses leads firms to reduce production and employment which reduces spending even further. In economic terms, aggregate demand is reduced and inflationary pressure is removed from the economy.

Multiple Choice/True False Questions