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Chapter 22: Q.2 (page 581)

What is the key assumption underlying the Fed鈥檚 ability to control the real interest rate?

Short Answer

Expert verified

The key assumption is that the nominal charge per unit and real charge per unit works in an exceedingly similar direction. Increase in nominal rate of interest will result in increase in real rate and contrariwise.

Step by step solution

01

Concept introduction 

Real rate is adjusted with the rate of inflation, therefore it's simpler measure than the nominal rate. Real rate will be calculated from MP equation:

r=r炉+位蟺Where,-ris Real interest rate.-r鈫�isAutonomous component.-位is Responsiveness of the real interest rate to the inflation rate.-蟺is Inflation rate.

02

Explanation of solution

The key assumption is that the nominal charge per unit and real charge per unit works in an exceedingly similar direction. Increase in nominal rate of interest will result in increase in real rate and contrariwise.

The Fed can control the (nominal) fed funds rate, but real interest rates matters to the economy. To manage the rate of interest Fed will use nominal rate and adjust it with the inflation.

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Most popular questions from this chapter

Why does the MP curve necessarily have an upward slope?

Suppose the MP curve is given by r=2+蟺and the IS curve is given by Y = 20 - 2r.

a. Derive an expression for the AD curve, and draw a graph labeling points at 蟺=0,蟺=4,蟺=8

b. Suppose that 位increases to 位=2. Derive an expression for the new AD curve, and draw the new AD curve using the graph from part (a).

c. What does your answer to part (b) imply about the relationship between a central bank鈥檚 distaste for inflation and the slope of the AD curve?

For each of the following situations, describe how (if at all) the IS, MP, and AD curves are affected.

a. A decrease in financial frictions

b. An increase in taxes and an autonomous easing of monetary policy

c. An increase in the current inflation rate

d. A decrease in autonomous consumption

e. Firms become more optimistic about the future of the economy.

f. The new Federal Reserve chair begins to care more about fighting inflation.

Assume that the monetary policy curve is given by

r = 1.5 + 0.75p.

a. Calculate the real interest rate when the inflation rate

is 2%, 3%, and 4%.

b. Draw a graph of the MP curve, labeling the points

from part (a).

c. Assume now that the monetary policy curve is given

by r = 2.5 + 0.75p. Does the new monetary policy

curve represent an autonomous tightening or loosening

of monetary policy?

d. Calculate the real interest rate when the inflation rate

is 2%, 3%, and 4%, and draw the new MP curve,

showing the shift from part (b).

What factors affect the slope of the aggregate demand curve?
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