U.S. Monetary Policy: An Introduction. Part 3: How Does Monetary Policy Affect the U.S. Economy?

1. Define the following terms used in the reading:
   1. real interest rate
   2. flexible exchange rates
   3. lags

2. What is the real interest rate on a car loan at 8% when the inflation rate is 10%? When inflation is 2%? Ceteris paribus, in which case will the demand for cars be higher? Why?

3. Why doesn't the Fed control real interest rates directly?

4. The reading states that "markets' expectations about monetary policy tomorrow have a substantial impact on long-term interest rates today." Explain.

5. Through what channels can changes in real interest rates affect output, employment, and inflation? Relate these to specific transmission mechanisms discussed in Mishkin's The Economics of Money, Banking, and Financial Markets, Chapter 26.

6. What estimates are given for the lags between monetary policy actions and their impacts on output and inflation? Why are lags difficult to predict?

Source: "U.S. Monetary Policy: An Introduction. Part 3: How Does Monetary Policy Affect the U.S. Economy?" Federal Reserve Bank of San Francisco FRBSF Economic Letter, No. 2004-03, January 30, 2004, pp. 1-3.