Chapter 21, Problem 1Q

To determine

To explain: Adjustment in federal fund rates due to increase in inflation rate.

Explanation of Solution

A rise in inflation would lead to a fall in real interest rates, which would lead to an increase in output, a further increase in inflation, and a further fall in real interest rates which would lead to even higher inflation.

Real interest rate can be calculated from MP curve equation:

$\text{r}=\overline{\text{r}}+\text{λπ}$

Where,

• r is Real interest rate.
• $\overline{\text{r}}$isAutonomous component.
• λ is Responsiveness of the real interest rate to the inflation rate.
• π is Inflation rate.

Increase in the Federal fund rates in response to the increase in inflation will stop the repetition of increasing inflation. The Fed will use open market operations to tackle this problem, by selling bonds in the market to reduce money supply and increase the Fed fund rate.

Economics Concept Introduction

Introduction: Inflation is the overall increase in general price level of an economy. Inflation causes increase in the price of goods and services which decreases the purchasing power of an economics agent.