1.Long-term effects of the FED lowering interest rates: If the Fed wants to perm

Question

1.Long-term effects of the FED lowering interest rates: If the Fed wants to permanently lower interest rates, then it should raise the rate of money growth if

a.there is slow adjustment of expected inflation.

b.the liquidity effect is larger than the other effects.

c.the liquidity effect is smaller than the expected inflation effect.

d.there is fast adjustment of expected inflation

a.there is slow adjustment of expected inflation.

b.the liquidity effect is larger than the other effects.

c.the liquidity effect is smaller than the expected inflation effect.

d.there is fast adjustment of expected inflation

Explanation / Answer

The correct option is b. When liquidity effect is larger this means that the changes in nominal interest rate, investment and price stability will be greater. Thus the Fed would want to permanently lower interest rate only when there are chances of greater stability in terms of inflation and also output growth and this would happen when sensitivity of real variables and nominal variables is large with respect to changes in money supply as captured by the liquidity effect.

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