Question

Determine the likely effects of the following hypothetical news items on output, the real interest rate, inflation, stock prices, and bond prices (up/down/unchanged/ambiguous). Explain briefly.

a. Congress and the President agree on a major tax cut. The Fed keeps the real interest rate stable.

b. Housing starts are unexpectedly low, indicating a decrease in housing investment. The Fed is worried about a recession and will do whatever it can to prevent a reduction in output.

c. New data show that the government has overestimated recent productivity gains. The data show that the economy is operating above potential output and that the Fed will have to do something to prevent a rise in inflation.

d. A survey of telecom equipment producers indicates that capital investment is likely to grow by 10%. Prior to the survey, analysts had expected that capital investment would grow by 20%. Assume the Fed’s objective is to keep the real interest rate stable.

Answer 1

a. This is positive for the economy so, the output will increase as people will produce more because of lower costs, real interest rate-stable, inflation will increase or be stable as output will increase, stock prices will move up as it is a good news for the economy, bond prices will stay same/decline.

b. This is bad news for the economy and Fed yet has to implement anything. Thus output will reduce as demand is showing deceleration, real interest rate-ambigous as Fed has not taken any step, but it if taken it will most likely reduce the interest rate, inflation will reduce because of decline in demand, stock prices will fall as investors turn cautious, bond prices will rise as people start to move to bond market with stock market turning volatile.

c. This is also bad for the economy, thus the output is much higher than the demand, real interest rates-ambigous, Fed will reduce it most likely, inflation will be stable/rise, stock prices will fall, and bond prices will increase.

d. This is bad for the economy as capital investment was expected to be much higher, thus the output will be low, interest rates will be stable, inflation will reduce/stable, stock prices will fall and bond prices will rise/stable because of stable interest rates.