Suppose that the Fed\'s inflation target is 2%, potential output growth is 3.5%,

Question

Suppose that the Fed's inflation target is 2%, potential output growth is 3.5%, and velocity is a function of how much the interest rate differs from 5%: %^V= 0.5 X (i-5). Suppose that a model of the economy suggests that the real interest rate is determined by the equation r= 8.35-%^Y where Y is the level of output, so %^Y is the growth rate of output. Suppose that people expect the Fed to hit its inflation target. <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" /?>

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% for two years and the equation determining the real interest rate changes to r=4.5-%^Y, 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?

Explanation / Answer

There will be an increase in inflation

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