Question

If an​ asset-price bubble begins to​ form, assuming the central bank​ responds, how is it likely to​ respond, and what will be the effect on the MP ​curve?

A.

The central bank would likely follow the Taylor​ principle, reacting to the​ asset-price bubble by raising real interest rates. This would be reflected in a movement along the MP curve in the​ north-east direction.

B.

The central bank would likely follow the Taylor​ principle, reacting to the​ asset-price bubble by lowering real interest rates. This would be reflected in a movement along the MP curve in the​ south-west direction.

C.The central bank would likely autonomously ease policy by decreasing

r overbarr​,

the autonomous​ (exogenous) component of the real interest rate. This would shift the MP curve down.

D.The central bank would likely autonomously tighten policy by increasingr overbarr​,

the autonomous​ (exogenous) component of the real interest rate. This would shift the MP curve up.

Answer 1

Option A - The Central bank would likely follow the Taylor principle, reacting to the asset-price bubble by raising real interest rates. This would be reflected in a movement along the MP curve in the north-east direction.

The Taylor principle says that when the inflation or the Gross Domestic Product (GDP) is too high, the Federal Reserve should raise the interest rates to stabilise the economy.

Now, if an asset price bubble begins to form, it would be due to very low interest rates in the economy that everybody can afford to take a loan and buy assets. So, in this case the Central Bank would likely follow the Taylor principle and raise its interest rates in the economy. The MP curve displays a positive relationship between real interest rate and output. Because the Central Bank has increased the interest rate and there was no other effect on the economy, the MP curve will not shift in this case, instead will would move upwards or downwards along the curve. Here, since the Central Bank is increasing its interest rate, there would be an upward movement along the curve in the north-east direction and a higher equilibrium level of output and interest rate would be reached.