8 10 points suppose that the central bank strictly

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(8) [10 points] Suppose that the central bank strictly followed a rule of keeping the real interest rate at 3% per year. That rate happens to be the real interest rate consistent with the economy’s initial equilibrium 6
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(a) [5 points] Assume that the economy is hit by a money demand shock only. Under the central bank’s rule, how will the money supply respond to a money demand shock? Will the rule make aggregate demand more stable or less stable than it would be if the money supply were constant? If the Fed targets the real interest rate, then money demand shocks are offset by changes in the money supply, so the LM curve does not move. Since the shock causes the money supply to change, but does not affect output, the money supply is acyclical. By following the interest-rate-targeting rule, the AD curve is unaffected by money-demand shocks (since they are offset by money-supply changes), so it is more stable than if the Fed did not respond at all (b) [5 points] Assume that the economy is hit by IS shocks only. Under the central bank’s rule, how will the money supply behave? Will the interest-rate rule make aggregate demand more stable or less stable than it would be if the money supply were constant? When there are IS shocks, the rule does not work very well. Suppose a shock shifts the IS up and to the right. Targeting the real interest rate requires the Fed to increase the money supply to shift the LM curve down and the right. While this maintains the real interest rate at its initial level, output is above full-employment output. The money supply is procyclical, since the shift in the IS curve caused output to rise, and the increase in the money supply caused output to rise further. This response to IS shocks makes the aggregate demand curve less stable, as it shifts the AD curve farther to the right in response to an IS shock than it would have if the LM curve did not respond 7
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r S, I 1 S I ( r ) r 1 I 1 r 2 I 2 2 S Figure 1: The Reagan deficits: Closed Economy Model ( ) 1 ( *) - 1 1 2 2 ( *) - 2 Figure 2: The Reagan deficits: Open Economy Model 8
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Y P LRAS SRAS 1 1 1 e P P = AD 1 AD 2 2 e P = 2 P 3 3 e P P = 1 Y Y = 2 Y 3 Y = SRAS 2 Figure 3: Effects on Price and Output of an Unexpected Expansionary Monetary Policy Change u π n u 1 β e π ν Figure 4: Effects on Unemployment and Inflation of an Unexpected Expansionary Monetary Policy Change 9
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u π n u 1 e π ν + 2 e π ν + Figure 5: Effects on Unemployment and Inflation of an Expected Expansionary Monetary Policy Change 10
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