The economy begins at potential GDP with an inflation rate of 2 percent. Suppose a price...

The economy begins at potential GDP with an inflation rate of 2 percent. Suppose a price shock pushes inflation up to 6 percent in the short run, but the Fed views the effect on inflation as temporary. It expects the inflation adjustment line to shift back down to 2 percent the next year, and in fact, the inflation adjustment line does shift back down.

If the Fed follows its usual policy rule, where will real GDP be in the short run? How does the economy adjust back to potential?

Now suppose that because the Fed is sure that this inflationary shock is only temporary, it decides not to follow its typical policy rule, but instead maintains the interest rate at its previous level. What happens to real GDP? Why? What will the long-run adjustment be in this case? Do you agree with the Fed’s handling of the situation?

Expert Solution

If the Fed follows its usual policy rule, the real GDP will increase in the short –run as the money supply will increase in the short run. The economy adjust back to potential by market forces; demand for and supply of commodity and services. As fed will follow its usual policy so the economy will be back to 2% inflation by market forces as with the increase in prices due to inflation aggregate demand will decrease which will lead to reduce in supply or output in the economy it will ultimately lead to economy back to its potential level.

If Fed is sure that this inflationary shock is only temporary, it decides not to follow its typical policy rule, but instead maintains the interest rate at its previous level then it will reduce the real GDP in long run. As due no change in Fed’s policies the price rate will be high and due to maintaining interest rate at its previous level it will reduce the investments. The long – run adjustment be in this case will be through controlling the money supply in the economy or reducing money with people.

No we don’t agree with the Fed’s handling of the situation because the inflation can affect the economy badly so Fed should take some steps rather than not following its typical policies

Rahul Sunny answered 2 years ago

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