Question

If real GDP is 1 percent above potential output and inflation is simultaneously 1 percent above the target rate according to the Taylor rule

a) What should the Central Bank do in the Open market?

b) Should the Central Bank bank of Turkey announce an increase or fall in the interest rate?

c) How would the Central Bank of Turkey's Balance Sheet change?

d) What would be the impact of this policy change on output in SR(Shortrun) MR (Mediumrun) and LR (Longrun)?

e) What would happen in terms of the bond prices as a result of the change in the polşicy interest rate

Answer 1

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Question:

Answer:

Taylor rule is refers to a rule used by central banks to determine the right interest rate for the economy based on changes in price inflation and other economic conditions. It is the popular rule that is follow by the central bank globally to maintain the economic stability and growth. As per Taylor rule central bank should increase interest rate when inflation or GDP is higher than potential GDP and target rate of inflation and vice-versa.

a). Answer:

Open market operation is monetary tool that is use by the central bank to control the money supply. When central bank want to increase the monetary supply then its purchase the government securities and vice-versa. When the central bank purchases the government securities then its increase the loanable fund of the bank and interest rate also reduce that will increase the demand and inflation rate and when central bank want to reduce  the monetary supply then its sell the government securities then its decrease the loanable fund of the bank and interest rate also increase that will decrease the demand level and inflation rate

Here, the target of the central bank is to increase the interest rate so, central bank will sell the government securities through OMO that will decrease the lendable fund of bank and interest rate will be increased simultaneously.

b). Answer:

As per the question GDP is 1 percent above potential output and inflation is simultaneously 1 percent above the target rate. Here inflation is simultaneously 1 percent above the target rate and  GDP is 1 percent above potential output so, central bank should  increase the interest rate to control the inflation and economic stability

c). Answer:

Balance sheets is made of assets, liabilities and stockholder's equity.The central bank's balance sheet differs from those of other banks because its monetary liabilities, currency in circulation and reserves, are everyone else's assets.  Here, the target of the central bank is to increase the interest rate so, central bank will sell the government securities through OMO so, balance sheet automatically contracts.

d). Answer:

When central bank will increase the interest rate then in short run it will not affect widely the inflation and GDP/output level growth rate. In medium-run it will affect (reduce the demand level at higher interest rate) the consumer demand or aggregate demand and inflation will decreased and it will stabilize the economy. In long run ,when inflation is on target and GDP is growing at its potential, rates are said to be neutral and will stabilize inflation also.

e). Answer:

Here, the target of the central bank is to increase the interest rate so, central bank will sell the government securities through OMO so, the demand of band will be lower than supply. Higher the supply and lower the demand of band will reduced the price of bond.

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