Question

Consider an economy represented by the following expenditure equations (in $ trillion):

Y = C + I + G + NX

C = 2 + ⅔(Y – T)

I = 6 – r

G = 4, T =3, NX = -1

For the short run, consider the inflation rate fixed at π = 2. The Central Bank wants to target the real interest rate r = 2. What should be the target for the nominal interest rate, i? What is the equilibrium Y?

The money demand equation is M = Y – i. What should the Money supply be in order to achieve the interest rate target?

Answer 1

Real interest rate= nominal interest rate- expected inflation.

Because inflation is constant,so expected inflation= 2

Target real interest rate=2

2=nominal interest rate-2

Required nominal interest rate=2+2=4

Equilibrium Y:

Y=C+I+G+NX=2+2/3(Y-3)+6-2+4-1=2+2Y/3-2+6-2+4-1=7+2Y/3

Y*=7*3=21

In Equilibrium money supply equal to money demand.

So,

Ms= Md=21-4=17