Say whether you think the statement is true, false, or uncertain; and support your answer in...

Say whether you think the statement is true, false, or uncertain; and support your answer in a few lines.

1. Consider two similar economies hit by the same temporary negative supply shock. In the economy with the more credible monetary policy, there will be smaller increases in both ináation and the real interest rate.

2. If the public believes the commitment to a nominal anchor to be credible, the e§ect of a negative aggregate demand shock is for short-run aggregate supply to be una§ected.

3. A negative shock in aggregate demand will likely result in a permanently lower equilibrium ináation rate, unless the central bank responds by lowering interest rates.

4. According to the Taylor rule, a negative output gap will lead to a higher nominal overnight interest rate.

Solutions

Expert Solution

1) True. This is because expectations of inflation depend a lot on the credibility of the monetary policy as well as the Central Bank. If the Central Bank and monetary policy is known to be more credible then the expected inflation does not rise which ultimately leads to a smaller rise in the inflation as well as real interest rates. So a lot depends on the trust that people have on the central bank and its monetary policy.

2) Uncertain. If the public believes the commitment to a nominal anchor to be credible, it is quite uncertain whether a negative aggregate demand shock is going to leave short run aggregate supply unaffected or not. There are many factors which needs to be looked at while viewing this problem like the intensity of the shock. Although it is very difficult for the short run supply to remain completely unaffected but a credible nominal anchor will definitely reduce any impact that the shock has on short run supply.

3) False. A negative shock in the AD will not result into a permanently lower equilibrium inflation rate because a shock itself is temporary in nature. So, over time the inflation rate will climb back to its long run equilibrium inflation rate.

4) False. A negative output gap will lead to a lower nominal overnight interest rate as can be seen from the formula:

i = r* + pi + 0.5 (pi-pi*) + 0.5 ( y-y*) where

i = nominal fed funds rate, r*= real fed funds rate, pi= rate of inflation , pi* = targeted rate of inflation , y= real output, y* = potential output.

Rahul Sunny answered 1 year ago

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