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

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? <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" /?>

Explanation / Answer

goal is to obtain a 2% inflation target. "so %^Y is the growth rate of output" We need to find out %^Y to get our answer. r= 8.35-%^Y Since the interest rate is 5% we plug it into r. 0.05= 8.35-%^Y Subtract from both sides. -8.30 = -%^Y %^Y = 8.30

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