1. The IS/MP model assumes that the Fed sets the real interest rate at a given level Rt. Suppose the Fed adopts a monetary policy rule that instructs it how to change the real interest rate in response to short-run output. Let's call this a monetary policy rule (MPR): The parameter x is positive. Rt=+xY a) Redraw the IS/MP diagram replacing the MP curve with the MPR curve. Show how an aggregate demand shock affects output and interest rates in the short run. Use the IS and MPR equations to solve for the changes in output and the real interest rate. b) How does the change in a affect investment in the IS/MPR model? Explain how a tax cut affects short-run output and investment in this version of the short-run model. The effect on investment is called crowding out. c) Add the Phillips curve to complete the short-run model. Illustrate how the Fed's choice of large it makes reveals its trade off between inflation and output in the short run.
1. The IS/MP model assumes that the Fed sets the real interest rate at a given level Rt. Suppose the Fed adopts a monetary policy rule that instructs it how to change the real interest rate in response to short-run output. Let's call this a monetary policy rule (MPR): The parameter x is positive. Rt=+xY a) Redraw the IS/MP diagram replacing the MP curve with the MPR curve. Show how an aggregate demand shock affects output and interest rates in the short run. Use the IS and MPR equations to solve for the changes in output and the real interest rate. b) How does the change in a affect investment in the IS/MPR model? Explain how a tax cut affects short-run output and investment in this version of the short-run model. The effect on investment is called crowding out. c) Add the Phillips curve to complete the short-run model. Illustrate how the Fed's choice of large it makes reveals its trade off between inflation and output in the short run.
Chapter16: Monetary Policy
Section: Chapter Questions
Problem 12SQP
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Transcribed Image Text:1. The IS/MP model assumes that the Fed sets the real interest rate at a given level Rt. Suppose the Fed
adopts a monetary policy rule that instructs it how to change the real interest rate in response to short-run
output. Let's call this a monetary policy rule (MPR):
The parameter x is positive.
Rt=+xY
a) Redraw the IS/MP diagram replacing the MP curve with the MPR curve. Show how an
aggregate demand shock affects output and interest rates in the short run. Use the IS and MPR equations
to solve for the changes in output and the real interest rate.
b) How does the change in a affect investment in the IS/MPR model? Explain how a tax cut
affects short-run output and investment in this version of the short-run model. The effect on investment is
called crowding out.
c) Add the Phillips curve to complete the short-run model. Illustrate how the Fed's choice of large
it makes reveals its trade off between inflation and output in the short run.
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