Question

If the fed reduced the growth rate of the money supply to the long run growth rate of output immediately and people believed that it would persist, what would the immediate impact be? Explain whether each variable rises, falls or not change and why.

A. Expected inflation

B. The nominal interest rate

C. The real interest rate

Answer 1

If the fed reduced the growth rate of the money supply to the long run growth rate of output immediately and people believed that it would persist, then

A. Expected inflation: will fall because decrease in money supply will reduce money with people which will lead to decrease in their demand for goods and services. the decrease in demand will affect the supply and producers will reduce prices which will lead to increase in purchasing power of money and inflation will fall.

B. The nominal interest rate: nominal interest rate does not include inflation so when fed will reduce the money supply people will increase their demand for money and the demand for loans will increase and banks will increase the nominal interest rate

C. The real interest rate: the real interest rate will not change immediately though it considers inflation so when money supply will fall and output will reduce the unemployment will increase, investment and consumption will decrease which will lead to decrease in the GDP of the economy and real interest rate will also fall.