Question

The following table shows two monetary policy rules.

Inflation	Policy Rule 1 Targeet Overnight Rate	Policy Rule 2 Target Overnight Rate
0	1	3
2	3	5
4	5	7
6	7	9
8	9	11

a.    Graph the two policy rules.

       Suppose the Bank of Canada shifts from policy rule 1 to policy rule 2.

b.         For any given rate of inflation, what happens to the interest rate because of this change in policy? What happens to the real rate of interest?

c.    How does this policy change affect the Z-line?

d.    How does this policy change affect the AD curve?

e.    Do either of the two policy rules adhere to the Taylor Principle? Explain.

Answer 1

a) At any given rate of inflation the interest rate increases by 2%.

b)The interest rate increases by 2% in policy rule 2 as the inflation rate increases.The real rate of interest remains constant at 3% for policy 2.

c)The z-Line will show increasing trend towards supply and decreasing trend towards demand for every increase in inflation rate.

d)AD curve falls down when the policy changes from 1 to 2 due to increase in interest rate.

e)According to the taylor's principle increase in inflation rate by one percent should give rise to interest rate by more than one percentage as the real interest rate is equal to nominal interest rate minus inflation rate.This stipulates that real interest rate should increase according to increase in inflation rate to balance the economy position.In the current scenario, as the real interest rate of both the policy increases by 1% and 3% for every increase in inflation rate, both the policy satisfies taylor's principle.