Question

1. Explain why the Federal Reserve targets a two percent inflation rate rather than a zero percent inflation rate.
2. Explain why an increase in autonomous spending has a multiplier effect on GDP.
3. What is countercyclical monetary policy? What is the main problem in the implementation of a countercyclical monetary policy?
4. Explain why investment depends upon the real interest rate and not the nominal interest rate.

Answer 1

Federal Reserve follows the inflation targeting which is close to 2 %. Fed can not target the zero percent inflation rate. The zero-percent inflation rate would cause a contraction in the economy, thus, output and employment would be negatively affected by such action of the Federal Reserve. Further, zero inflation is likely to reduce the profit margin of the firms. Firms are not incentivized to make investments.

The autonomous spending by the government has multiple effects on the GDP of the country. Expenditure of one person is the income of another. Thus, When initially the government makes an expenditure, initially there is a rise in the income of workers, these workers further make the expenditure, so further income is generated. In this way, initial spending causes multiple rises in the income of the country.

The monetary policy is formed anti-economic cycles which means during the boom, the contractionary monetary policy is followed while the expansionary monetary policy is made by the Fed to combat the recession. Monetary policy becomes ineffective or less effective due to the presence of outside lag effects, there are larger outside lag effects in the economy.

Real interest rate = Nominal interest rate - inflation rate. Thus, investment depends on the real interest rate, not the nominal interest rate. Since the real interest rate accounts for the inflation prevailing as well. The inflation does not show the real cost of procuring the funds from the market. Thus, firms have to take into account the prevailing inflaiton while making the investment related decisions.