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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?

How does an autonomous tightening or easing of monetary policy by the Fed affect the aggregate demand curve?

Go to https://www.federalreserve.gov/monetarypolicy/ files/FOMC_LongerRunGoals.pdf. Review the FOMC鈥檚 document, 鈥淟onger-Run Goals and Monetary Policy Strategy.鈥� Explain why these goals are consistent with the Taylor principle.

Suppose that government spending is increased at the same time that an autonomous monetary policy tightening occurs. What will happen to the position of the aggregate demand curve?

What factors affect the slope of the aggregate demand curve?
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