Assignment:
Financial Institutions and monetary policy
Instructions: Attempt the following exercises. Justify you answers
Exercise 1
Starting with the economy in long run equilibrium, suppose there is a rise in consumer confidence
a) Use the aggregate demand-aggregate supply framework to illustrate what would happen to the equilibrium inflation rate and real GDP in the short run
b) Assuming the central bank takes no action, what would happen to the equilibrium inflation rate and real GDP in the long run?
c) What happens to the nominal and real interest rates?
d) What happens to investment and the capital stock?
e) In the long run, is the inflation rate still determined by the excess of the growth rate of the money supply over the growth rate of real GDP?
f) If the inflation rate in the long run is not equal to the target inflation rate what was the use of the monetary policy reaction function?
Exercise 2
Consider again the rise in consumer confidence described in exercise 1.
a) What would happen to inflation and output in the long run if the central bank remained committed to its original inflation target and responded with policy tightening?
b) Compare the outcome to the one in exercise 1 using the aggregate demand - aggregate supply framework.
c) What happens to the nominal and real interest rates?
d) What happens to investment and the capital stock?
e) In the long run, is the inflation rate still determined by the excess of the growth rate of the money supply over the growth rate of real GDP?
f) Do you agree with the model that the economy will actually land at full employment and the inflation target without overshooting in either direction?
Exercise 3
Suppose that the public believes that a newly announced anti-inflation program will work and so lowers its expected inflation rate from 5% to 2%. What would happen to the equilibrium real GDP and inflation rate?