Question

6.

7.

Inflation targeting and the Taylor rule in the IS-LM model Consider a closed economy in which the central bank follows an interest rate rule. The IS relation is given by Y C(Y- T) I(Y,r) G Where r is the real interest rate. The central bank sets the nominal interest rate according to the rule i = i* + a(n° =- T*) + b(Y- Y1) Where T is expected inflation, T* is the target rate of inflation, and Yn is the natural level of output. Assume that a 1 and b 0. The symbol i* is the target interest rate the central bank chooses when expected inflation equals the target rate and output equals the natural level. The central bank will increase the nominal interest rate when expected inflation rises above the target, or when output rises above the natural level. (Note that the Taylor rule described in this chapter uses actual inflation instead of expected inflation, and it uses unemployment instead of output. The interest rate rule we use in this problem simplifies the analysis and does not change the basic results.) Real and nominal interest rates are related by r = i - Consider the economy described in Problem 6 T a. Suppose the economy starts with Y = Y and e Now suppose there is an Assume that Yn does not change. Using the diagram you drew in Problem 6(b) increase in show how the increase in e affects the MP relation. (Again, remember that a 7 1.) What happens to output and the real interest rate in the short run? b. Without attempting to model the dynamics of inflation explicitly, assume that inflation and expected inflation will increase over time if Y> Yn and that they will decrease over time if Y

Answer 1

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