Assume the short term real policy rate, current and expected, had been \(2 \%\) until now. Suppose the Fed decides to tighten monetary policy and increase the short-term policy rate \(\left(r_{1 t}ight.\) ) from \(2 \%\) to \(3 \%\).

a. What happens to stock prices if the change in \(r_{1 t}\) is expected to be temporary, that is, last for only one period? Assume that expected real dividends do not change. Use equation (14.17).

b. What happens to stock prices if the change in \(r_{1 t}\) is expected to be permanent, that is, is expected to persist? Assume that expected real dividends do not change. Use equation (14.17).

c. What happens to stock prices today if the increase in the real interest rate, current and expected, reflects an increase in expected future output and expected future dividends?

Data from equation 14.17

Transcribed Image Text:

Q Di+1 === + (1 + r1 + x) D+2 (1x)(1 + +1 + x) rt+1