Question

In 2009, the U.S. economy was in a severe recession. The Federal Reserve had lowered the federal funds rate to about 0 percent, but still wanted to stimulate the economy more. The inflation rate in 2009 was about –1%, but households’ and businesses’ inflation expectations for the upcoming year were higher and positive, about 1.5%.

a) First, do households’ and businesses’ investment demand depend on the ex ante or ex post real interest rate? Briefly explain why.

b) Draw an IS-MP diagram that’s consistent with the state of the U.S. economy in 2009. Make sure that your IS and MP curves intersect in a place that is consistent with the setup of the problem, above. In particular, do your IS and MP curves intersect on the flat part of the MP curve, or the upward-sloping part? And do your IS and MP curves intersect at a positive real interest rate or a negative real interest rate?

c) Suppose that the U.S. Congress and President pass a fiscal stimulus package that increases government spending. Assume that the fiscal stimulus is not large enough to raise nominal interest rates above zero. What effect would this fiscal stimulus have on output and the real interest rate in the short run? Draw a graph to help illustrate your answer.

d) Instead of the fiscal stimulus in part c, above, assume that the Fed announces a major increase in the quantity of bank reserves. As a result, households and businesses become worried that inflation might be higher in the future. What effect would this increase in inflation expectations have on output and the real interest rate in the short run? (Assume that the equilibrium nominal interest rate remains unchanged at 0%.) Draw a graph to help illustrate your answer.