Question

6) Suppose that currently nominal interest rates, inflation, and expected inflation are all 2% right now a)Suppose the Federal Reserve increases interest rates in the economy. Draw a well labeled supply 2 and demand diagram that shows how they typically would do that and how it affects the supply & demand in the money market and bond market. Suppose that when the Federal Reserve takes this action and expected inflation decreases from 2% to 1%. Show the effect of this change in supply & demand diagrams for the money market and bond market (draw new diagrams, do not use the same diagrams you drew in part a) Taking part a) and part b) together, would the Fed's actions on interest rates likely be larger or smaller than the standard liquidity effect? Briefly explain your answer Suppose that due to the Fed's actions, nominal interest rates are now 2.5%, expected inflation is 1%, and current inflation has remained 2% (due to completely stick prices). Compared to the initial numbers given at the start of this question, is the Fed's actions beneficial for borrowers/lenders/both/neither? Briefly explain your answer b) 6 c) d)

Answer 1

Solution A

When Fed Increasing interest rate it decreases bond yields because of inverse relationship. Also aggregate demand decreases due to lesser money supply and hence inflation and Real GDP both shrinks.

Solution B

When the inflation decrease from target levls, the aggregate demand decreases due to lesser money supply and hence the bond yields become unattractive and hence fall. Also the Liquidity Monetary curve shifts left and Investment and Savings increase because less supply of market. ​​​​​​

Solution C

The interest rate will be smaller because if Fed tends to increase interest rate by higher amount then inflation drastically reduces which can cause economic recession due to negative inflation and thus double whammy.

Solution D

Fed Action is highly beneficial for lenders like banks because of high interest they shall receive on loans. However the borrower or home buyer will not benefit because of high interest to be paid on home loan due to Fed Fund increase of rate. Also inflation doesn't decrease which means negative consumption.