Suppose that the feds inflation target is 2 percent

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Suppose that the Fed's inflation target is 2 percent, potential outlook growth is 3.5 percent, and velocity is a function of how much interest rate differs from 5 percent:

% triangle V = 0.5 x ( i-5)

Suppose the model of the economy suggests that the real interest rate is determined by the equation where Y is the level of output, so %triangleY is the growth rate of output. Suppose that the people expect the Fed to it its inflation target.

r= 8.5- % triangle Y

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% for two years and the equation determining the real interest rate changes to r = 4.5- %triangleY, what money growth rate should the Fed aim for to hit its inflation target in that period?

C: If the Fed instead maintained the money growth rate from part A, what is likely to happen to inflation?

D: Which policy do you think is better in the short run?which is better in the long run?

Suppose that the economy is though to be 2 percent above potential (that is, the output gap is 2 percent) when potential output grows 4 percent per year. Suppose also that the Fed is following the Taylor rule , with an inflation rate of 2 percent. The federal funds rate is 3 percent. and the weights on the output gap are 0.5 each. The inflation target is 1 percent.

A: Is the Federal funds rate currently too high or too low? by how much? Show your work.

B: Suppose that a year has gone by, output is now just 1 percent above potential, and the inflation rate was 1.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)?

Reference no: EM13373834

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