Question

For A) - C): Consider a closed economy. The central bank does not fix the money supply. Instead, it sets the real interest rate. The central bank's target inflation rate pi^T is 2 percent. It tries to keep realized inflation equal to 2 percent every year. The natural rate of unemployment (NAIRU) uⁿ is 6 percent. Think about what the central bank will do in each of the following situations. Given the central bank's action, what is likely to be the resulting unemployment rate and inflation rate?

A) Expected inflation is 2 percent. Government purchases, taxes and other determinants of spending turn out to be as forecast by the central bank. Unemployment and inflation are likely to turn out to be:

a) u = 6%, inflation = 2% b) u < 6%, inflation > 2% c) u > 6%, inflation < 2%

d) u < 6%, inflation = 2% e) u > 6%, inflation = 2%

B) Expected inflation is 3 percent. Government purchases, taxes and other determinants of spending turn out to be as forecast by the central bank. Unemployment and inflation are likely to turn out to be:

a) u = 6%, inflation = 2% b) u < 6%, inflation > 2% c) u > 6%, inflation < 2%

d) u < 6%, inflation = 2% e) u > 6%, inflation = 2%

C) Expected inflation is 1 percent. Government purchases, taxes and other determinants of spending turn out to be as forecast by the central bank. Unemployment and inflation are likely to turn out to be:

a) u = 6%, inflation = 2% b) u < 6%, inflation > 2% c) u > 6%, inflation < 2%

d) u < 6%, inflation = 2% e) u > 6%, inflation = 2%

Answer 1

Answer

A) Assuming natural rate of unemployment prevails in the economy, expected inflation rate is 2% and everything goes as per the central bank's expectation. Therefore,

a) u = 6%, inflation = 2%

B) The central bank will push inflation rate to 2% by reducing money supply because expected inflation rate is higher than targeted inflation. Assuming natural rate of unemployment prevails in the economy before central bank's interruption, also there exist a negative relationship between unemployment and inflation. Thus unemployment rate will increase. Therefore,

e) u > 6%, inflation = 2%

C) Ideally in this case central bank will push inflation rate to 2% by increasing money supply because expected inflation rate is lower than targeted inflation. Assuming natural rate of unemployment prevails in the economy before central bank's interruption, also there exist a negative relationship between unemployment and inflation but unemployment rate can not be reduced below the natural rate of unemployment. Therefore,

a) u = 6%, inflation = 2%