Question

1. In the textbook and in our lectures, the monetary policy rule was given by: R t = m ( π t − π ̄ ) + r ̄ ,

   where Rt is the real interest rate, πt is the inflation rate, π ̄ is the inflation target and r ̄ is the long-run equilibrium real interest rate. The constant m is a parameter that corresponds to how aggressively the central bank responds to inflation.

   However, the monetary policy rule used by central banks and economists to analyze monetary policy contains an additional term:

   Suppose that the interest rate rule is given by
   R t = m ( π t − π ̄ ) + n Y ̃ t + r ̄

   The additional term corresponds to how the CB responds to GDP (below or above potential).

   (a) Combine this monetary policy rule with the IS curce to get a new aggregate demand (AD) curve.

   Under the new rule, is the CB more or less aggressive to inflation?

   1

2. (b) In the same graph, plot two AD curves: one generated from the old MP rule and one generated from the new. Label carefully.

3. (c) Suppose that the economy experiences a negative shock to its exports for one period only. What happens to a ̄?

   Using the AD-AS framework, predict the response of output Y ̃t and infla- tion for 2 periods: the period that the shock hits and the following period.

4. (d) Bonus part. Compare the response of the economy under the two different MP rules.

Answer 1