Question

6)

Let’s try to understand the long-run and short-run implications of monetary policy issues. Let’s assume inflation is currently 2% and that monetary policy has an inflation targeting rule that makes desired (targeted) inflation also 2%. Finally, suppose the equilibrium real interest rate in the economy is 1% and that “beta” in the Phillips curve is 1.2.

a) In the long-run, the output gap should be 0% and there should be no shocks to inflation. In that situation what will be inflation expectations, the inflation gap, and what will be the targeted federal funds rate? [Hint: use the Phillips curve and Taylor rule.]

b) Now suppose it is the short-run and the output gap is 2%, based on the Phillips curve, what would be the inflation rate now?

c) With the output gap at 2% and your answer for the inflation rate from part b), what is the federal funds rate target according to the Taylor rule?

d) Suppose that in the marketplace the actual federal funds rate is 3%, what would Professor Taylor say about this rate compared to what you calculated in part c).

7) For each statement, state whether you believe the statement is true or false. Provide a brief explanation of your reasoning. a)

If the money supply decreases, household spending on non-durable goods will increase.

If the money supply decreases, adverse selection problems in bank lending will decrease.

If the money supply decreases, mergers and acquisitions will increase

Answer 1

7.

A. False

With decrease in money supply, interest rate increases and borrowing becomes costlier. It discourages the consumers to buy non-durable goods and such purchases actually decrease.

B. True

With the decrease in money supply, interest rate at banks will increase. Due to this reason, fewer people and firms who are genuine and needy, will come for the borrowing. So, ugly disbursements will be stopped. Further, banks will also examine each case with due diligence and scope of asymmetry in information or adverse selection will be reduced.

C. False

When money supply decreases, then financing will be costly and it will be expensive for the firms take loans and acquire firms. Hence, M&A activity will be slowed when money supply decreases.