Chapter 12, Problem 1RQ

To determine

Steps in the short-run model.

Explanation of Solution

The short-run model consists of mainly three building blocks that are the monetary policy (MP), IS, and the Philips curve. When the economy needed a recovery, these three building blocks will be the key mechanisms to the change. The Fed is the central monetary authority in the economy and the main function of the Fed is to set the nominal interest rate in the economy. The choice of Fed is the nominal interest rate in the economy and everything else in the short-run model is decided automatically based on the nominal interest rate.

The inflation rate in the economy will be given and the determination of the nominal interest rate by the Fed leads to the determination of the real interest rate by deducting the inflation rate from the nominal interest rate. The real interest rate is the monetary policy line that is the horizontal line (MP curve) in the short-run model. When the inflation increases in the economy, the output of the economy would fall and it would rise when the inflation is negative. This is determined by the real interest rate in the economy, which is determined through the inflation and nominal interest rates in the economy.

When the short-run output is above the potential level of output in the economy, it will lead to the situation where the inflation rate in the economy will rise and vice versa. This is illustrated by the Philips curve in the short-run model. The realist representation of the monetary policy curve will be upward sloping rather than being horizontal.

Economics Concept Introduction

FED: The FED is the central bank of the US economy. It has the primary function of maintaining the economy from the economic fluctuations, which leads to the business cycle in the economy and control and monitor the money supply and interest rate.