You are the central banker for a country that is considering the adoption of a new nominal anchor. When you take the position as chairperson, the inflation rate is 4% and your position as the central bank chairperson requires that you achieve a 2.5% inflation target within the next year. The economy’s growth in real output is currently 3%. The world real interest rate is currently 1.5%. The currency used in your country is the lira. Assume prices are flexible.
a. Why is having a nominal anchor important for you to achieve the inflation target? What is the drawback of using a nominal anchor?
b. What is the growth rate of the money supply in this economy? If you choose to adopt a money supply target, which money supply growth rate will allow you to meet your inflation target?
c. Suppose the inflation rate in the United States is currently 2% and you adopt an exchange rate target relative to the U.S. dollar. Compute the percent appreciation/ depreciation in the lira needed for you to achieve your inflation target. Will the lira appreciate or depreciate relative to the U.S. dollar?
d. Your final option is to achieve your inflation target using interest rate policy. Using the Fisher equation, compute the current nominal interest rate in your country. What nominal interest rate will allow you to achieve the inflation target?