Question

If the Federal Reserve conducts a policy of keeping GDP above its full-employment level for a long period of time

	nominal interest rates will rise to reflect higher inflation expectations
	nominal interest rates will fall in the short and long run
	real interest rates will fall in the short run and in the long run
	real interest rates will fall and nominal interest rates will fall in the long run

Answer 1

The correct option is: real interest rates will fall and nominal interest rates will fall in the long run

This is because:

• If the Federal Reserve conducts a policy of keeping GDP above its full-employment level for a long period of time then it has to increase the money supply continuously in order to keep increasing the aggregate demand so that the GDP remains above its full employment level. As the money supply rises, nominal interest rates falls and price level will increase.
• We know that, Real interest rate = Nominal Interest rate - Expected inflation. Therefore, as the money supply keeps on rising, central bank decreases the nominal interest rate (because people will prefer to hold more money in hand less in bonds) also, the inflation rises (AD rises and remains more than full employment level, creates inflationary pressure in the economy). This causes the real interest rate to fall in the long run.