1.Consider an economy in which the central bank sets the nominal interest rate according to the...
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1.Consider an economy in which the central bank sets the nominal interest rate according to the rule: (1) i=i+a(ne-n*)+ẞ(Y-Y₂) In which parameters a>1 and p>0, and it is the target interest rate, i is the interest rate chosen by the central bank, ze is the expected future inflation rate, * the inflation target, Y is output and y, is the natural level of output. I (a) Define r-i-ne and r*-*-*. Use these definitions to express the interest rate rule in terms of real interest rates. (5 marks) (b) The IS relationship in a closed economy is given by Y=C(Y-T)+1(Y,r)+G. Graph the IS curve in diagram with income (Y) on the horizontal axis and (r) on the vertical axis. On the same diagram graph the interest rate rule that you have derived in part (a) for given values of ¹,² and Yn. Show the MP schedule for monetary policy. Indicate the slope and the intercept of the MP curve you have derived and discuss the factors that would make this curve shift. (10 marks) (c) Using the diagram from part (b), show the effects of an increase in government spending on output and the real interest rate in the short run. (5 marks) (d) Using static expectations derive the AD and graph the curve in a diagram with income (Y) on the horizontal axis and inflation rate (7) on the vertical axis. (10 marks) (e) Consider a change in the monetary policy rule. Suppose the central bank reduces its inflation target T. Explain and illustrate how the fall in * affects the MP line in the IS/MP diagram and the AD curve in the AD diagram. What happens to output, real interest rates and inflation? (10 marks) 1.Consider an economy in which the central bank sets the nominal interest rate according to the rule: (1) i=i+a(ne-n*)+ẞ(Y-Y₂) In which parameters a>1 and p>0, and it is the target interest rate, i is the interest rate chosen by the central bank, ze is the expected future inflation rate, * the inflation target, Y is output and y, is the natural level of output. I (a) Define r-i-ne and r*-*-*. Use these definitions to express the interest rate rule in terms of real interest rates. (5 marks) (b) The IS relationship in a closed economy is given by Y=C(Y-T)+1(Y,r)+G. Graph the IS curve in diagram with income (Y) on the horizontal axis and (r) on the vertical axis. On the same diagram graph the interest rate rule that you have derived in part (a) for given values of ¹,² and Yn. Show the MP schedule for monetary policy. Indicate the slope and the intercept of the MP curve you have derived and discuss the factors that would make this curve shift. (10 marks) (c) Using the diagram from part (b), show the effects of an increase in government spending on output and the real interest rate in the short run. (5 marks) (d) Using static expectations derive the AD and graph the curve in a diagram with income (Y) on the horizontal axis and inflation rate (7) on the vertical axis. (10 marks) (e) Consider a change in the monetary policy rule. Suppose the central bank reduces its inflation target T. Explain and illustrate how the fall in * affects the MP line in the IS/MP diagram and the AD curve in the AD diagram. What happens to output, real interest rates and inflation? (10 marks)
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a Definitions r i pi Real interest rate r i pi Real interest rate target Expressing the interest rate rule in terms of real interest rates Starting wi... View the full answer
Related Book For
International Economics Theory and Policy
ISBN: 978-0273754206
9th Edition
Authors: Paul R. Krugman, Maurice Obstfeld, Marc J. Melitz
Posted Date:
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