Question

IS curve: Yt =a―b(Rt―r)

a=0, b=1, r=4%

Suppose that the central bank sets the real interest rate to 5%, will this economie's level of short run output be above, below or at potential output?

Answer 1

The central bank sets the real interest to 5%, higher interest rate tend to moderate economic growth.Higher interest increases the cost of borrowing,reduce disposable income and therefore limit the growth in consumer spending.Higher interest rate tend to decrease inflationary pressures and cause an appreciation in the exchange rate.The real interest is the nominal interest minus inflation. If interest increases from4% to 5% but inflation increases from almost 2--5%.

In the shortrun if increase money supply and price level is stable, interest actually goes down.So in the shortrun increased money supply could drive down interest rates.In the long run, it will eventually does the opposite.Inshort, increase in real interest will reduce the growth.