3. (Note: You should wait to tackle this question until after lecture on Thursday, November 19.) Suppose that the economy is initially in long-run equilibrium: output is at potential and, as a result, inflation is steady. Now, suppose there is a permanent upward shift of the Federal Reserve's reaction function. a. What does this upward shift in the reaction function imply about the Fed's long-run target for the rate of inflation? b. What does the change in the reaction function imply that the Fed will do to the nominal interest rate and to the real interest rate in the short run? Describe two things the Fed could do to bring about this change in interest rates. c. What will be the short-run effect of the shift in the reaction function on GDP?
3. (Note: You should wait to tackle this question until after lecture on Thursday, November 19.) Suppose that the economy is initially in long-run equilibrium: output is at potential and, as a result, inflation is steady. Now, suppose there is a permanent upward shift of the Federal Reserve's reaction function. a. What does this upward shift in the reaction function imply about the Fed's long-run target for the rate of inflation? b. What does the change in the reaction function imply that the Fed will do to the nominal interest rate and to the real interest rate in the short run? Describe two things the Fed could do to bring about this change in interest rates. c. What will be the short-run effect of the shift in the reaction function on GDP?
Chapter15: Monetary Theory And Policy
Section: Chapter Questions
Problem 2.5P
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Transcribed Image Text:3. (Note: You should wait to tackle this question until after lecture on Thursday, November 19.)
Suppose that the economy is initiallyin long-run equilibrium: output is at potential and, as a result,
inflation is steady. Now, suppose there is a permanent upward shift of the Federal Reserve's reaction
function.
a. What does this upward shift in the reaction function imply about the Fed's long-run
target for the rate of inflation?
b. What does the change in the reaction function imply that the Fed will do to the
nominal interest rate and to the real interest rate in the short run? Describe two things
the Fed could do to bring about this change in interest rates.
c. What will be the short-run effect of the shift in the reaction function on GDP?
d. Describe briefly how GDP returns to its potential level. (Hint: What will happen to
inflation after a while? How will the Federal Reserve respond to that?)
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