Question

Suppose you have the following information on the Fed’s and the European Central Bank’s (ECB) policy rules:

fed real interest rate=.5(inflation rate-2)

ECB real interest rate=.2 x(inflation Rate-2)+1

Graph these policy rules. If the inflation rate is 2 percent in each, what will be the real interest rate in the U.S. and the ECB area?

Some argue that Europe has a much lower tolerance for inflation than the United States. Can you tell—either from the diagram or from the equations—whether this is true?

Answer 1

If the inflation rate is 2 percent, the real interest rate in US and ECB will be 0 and 1 percent respectively.

Tolerance means that with the increase in the inflation rates, the interest rates go not up by the same amount or by less amount. As we can see from the graph, ECB interest rates rose lesser than the FED or US rates with the increase in the inflation rates. Europe is less tolerant than US, as reflected in higher interest rates in Europe than US.