Q. Assume that the Fed's inflation target is 2 percent, potential output growth is 3.5 percent, as well as velocity is a function of how much the interest rate differs from 5 percent:
% ? V - 0.5 Ã (i - 5)
Assume that a model of the economy suggests that the real interest rate is determined by the equation r = 8.5 - % ? Y where Y is the level of output, so %? Y is the growth rate of output. Assume that people expect the Fed to hit its inflation target.
a. Calculate the optimal money growth rate needed for the Fed to hit its inflation target in the long run.
b. In the short run, if output growth is just 2 percent for two years as well as the equation determining the real interest rate changes to r = 4.5 - % ? Y, what money growth rate should the Fed aims for to hit its inflation target in that period?
c. What is likely to happen to inflation if the Fed instead maintained the money growth rate from part a?
d. Explain which policy do you think is better in the short run? Which is better in the long run?