Question

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 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.

b) 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).

c) 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.

d) 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.

Answer 1