Suppose the Fed is concerned that deflation would harm the economy over the long run. Use the
Question:
Suppose the Fed is concerned that deflation would harm the economy over the long run. Use the IS-MP model(including the output gap Phillips curve) to analyze how the Federal Reserve would fight deflation.
Use an IS-MP model using the output gap version of the Phillips curve to show long-run macroeconomic equilibrium with a deflation rate of 2%.
1.) Using the line drawing tool, draw a Phillips curve that illustrates a long-run equilibriurm at a deflation rate of
2%.
Properly label your curve.
2.) Using the point drawing tool, plot the long-run equilibrium point.
Carefully follow the instructions above, and only draw the required objects.
If the Fed wants the economy to return to a long-run equilibrium with an inflation rate of 2%, how should it change its target for the federal funds rate?
The Fed should
▼
increase
reduce
its target for the federal funds rate, shifting the
▼
MP curve up
IS curve inward
MP curve down
IS curve outward
and
▼
lowering
raising
the real interest rate. This will
▼
decrease
increase
the output gap and
▼
decrease
increase
the actual inflation rate along the output gap Phillips curve to 2%.
How does
the
economy return to long-run equilibrium at the higher inflation rate?
As the inflation rate persists at 2%, the
▼
actual
expected
inflation rate will
▼
decrease from 2% to 0%
increase from -2% to 0%
increase from -2% to 2%
decrease from 2% to -2%
, shifting the output gap Phillips curve
▼
down
up
. The Fed would then
▼
raise
lower
the
▼
expected
real
interest rate, shifting the
▼
MP curve up
IS curve outward
MP curve down
IS curve inward
and returning the economy to potential GDP.
Money, Banking, and the Financial System
ISBN: 978-0134524061
3rd edition
Authors: R. Glenn Hubbard, Anthony Patrick O'Brien