Suppose that the Fed%u2019s inflation target is 2 percent, potential output grow

Question

Suppose that the Fed%u2019s 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 X (i-5)

Suppose that a model of the economy suggests that the real interest rate is determined by the equation:

r=8.5-% 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.

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 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 short run? Which is better in the long run?

Explanation / Answer

Some of the equation in question is not clear. Please send question in word file.

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