Use the rule-of-thumb to predict how the Central Bank would want to change its funds rateand the real interest rate targets for each of the following scenarios if its estimate of theneutral real interest rate is 2%.a. A recession hits the economy leading output to be 0.75% below potential output andinflation to fall to 1%.b. An increase in consumer and business confidence pushes the economy to producingoutput at 2% above potential output while inflation rises to 3.5%c. Show the effect of b) in an AD-AS diagram
Question
Use the rule-of-thumb to predict how the Central Bank would want to change its funds rateand the real interest rate targets for each of the following scenarios if its estimate of theneutral real interest rate is 2%.a. A recession hits the economy leading output to be 0.75% below potential output andinflation to fall to 1%.b. An increase in consumer and business confidence pushes the economy to producingoutput at 2% above potential output while inflation rises to 3.5%c. Show the effect of b) in an AD-AS diagram
Solution
a. In the event of a recession where output is 0.75% below potential output and inflation falls to 1%, the Central Bank would want to lower its funds rate and real interest rate targets. This is because lower interest rates stimulate economic activity by making borrowing cheaper. This can help to increase output and bring the economy closer to its potential. Additionally, lower interest rates can help to increase inflation, bringing it closer to the Central Bank's target.
b. If an increase in consumer and business confidence pushes the economy to producing output at 2% above potential output while inflation rises to 3.5%, the Central Bank would want to raise its funds rate and real interest rate targets. Higher interest rates can help to slow down the economy, reducing output and bringing it closer to its potential. Additionally, higher interest rates can help to reduce inflation, bringing it closer to the Central Bank's target.
c. In an AD-AS (Aggregate Demand-Aggregate Supply) diagram, an increase in consumer and business confidence (which increases aggregate demand) would shift the AD curve to the right. This leads to an increase in both the price level (inflation) and real GDP (output). If the economy was initially at potential output, this increase in AD would push output above potential, leading to an inflationary gap. The Central Bank would respond by raising interest rates to reduce aggregate demand, shifting the AD curve back to the left and bringing the economy back to potential output and the target inflation rate.
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