Suppose the central bank, instead of following the rule r = r(Y,π), has a target level of inflation. Specifically, it sets r according to r = rLR + b[π − π*]. Here rLR is the real interest rate when the economy is in long-run equilibrium; that is, it is the real interest rate that causes the loan market to be in equilibrium when Y = �Y. In addition, π* is the central bank’s target level of inflation, and b is some positive parameter. This rule states that the central bank raises the real interest rate above its long-run level when inflation is above its target and lowers it below its long-run level when inflation is below its target. Assume the economy starts in a situation where π = π* and Y = �Y. Describe the immediate effects of each of the following developments on output, inflation, and the real interest rate: i. There is an unfavourable inflation shock. ii. The central bank reduces its inflation target, π*.
Consider the shift to a tighter monetary policy rule analyzed in Section III-2. What are the immediate effects of the shift on consumption and investment? How do consumption and investment behave as the economy is moving to its new long-run equilibrium? (The figure III-2 is attached below)
Homework Answers
Provided the equation for real interest rate,
r = rLR + b(p - p*)
rLR is the long-run real interest rate
p* is the target level of inflation
Assuming that the economy starts in a situation when p = p* and Y = ?Y
(i). There is an unfavourable inflation shock
Due to sudden inflation, p will be greater than p*, that is, inflation will increase and due to it output will decrease, then the real interest rate will, therefore, increase in the economy.
(ii). The central bank reduces its inflation target, p*.
Due to this, p will now be greater than p*, real interest rates will rise, this will increase investment as people will save more and consume less, this will decrease output.
In the figure, a tighter monetary policy rule is shown.
Due to this, MP0 shifts to MP1, the immediate effect would be that consumption will decrease while investment will increase as interest rates will increase in the economy. But as the economy is moving towards its long-run equilibrium, due to an increase in interest rates, the investment will decrease as well in the economy.
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