Suppose that the Fed’s inflation target is 2 percent,
Potential output growth is 3.5 percent, and velocity-
is a function of how much the interest rate
Differs from 5 percent:
%?V ? 0.5 ? (i ? 5)
Suppose that a model of the economy suggests
That the real interest rate is determined by the
R ? 8.5 ? %?Y
Where Y is the level of output, so %ΔY is the
Growth rate of output. Suppose that people
Expect the Fed to hit its inflation target.
A Calculate the optimal money growth rate
Needed for the Fed to hit its inflation target in
The long run.
B In the short run, if output growth is just
2 percent for two years and the equation
Determining the real interest rate changes to
r ? 4.5 ? %ΔY, what money growth rate
should the Fed aim for to hit its inflation
target in that period?
c If the Fed instead maintained the money
growth rate from part a, what is likely to
happen to inflation?
d Which policy do you think is better in the short run? Which is better in the long run?
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