Consider a closed economy where the central bank follows an interest rate rule.
ID: 1209975 • Letter: C
Question
Consider a closed economy where the central bank follows an interest rate rule. The IS relation is given by where r is the real interest rate The central bank sets the nominal interest rate according to the rule MP1 where i iste nominal interest rate,ae is expected inflation,r is the target rate of inflation, Y is the level of output or income, and Y, is the natural level of output. Assume that a 0. The symbol i is the target interest rate the central bank chooses when expected inflation equals the target rate and output equals the natural level. The central bank will increase the nominal interest rate when expected inflation rises above the target or when output rises above the IS1 natural level. 12 14 1618 Real Output, Y trillion dollars) Since the real interest rate,the central bank's interest ratc nule can be (0, 0) expressed as where the variable r is defined asi and aExplanation / Answer
The classical IS-LM model does not include inflation and inflation expectation in it; it is exogenous in nature. The LM curve shifts because of the changes in price level and consequently the real money supply changes assuming the money stock stays constant. It is shown below
It is a kind of negative supply shock. A decline in the aggregate supply leads to an increase in price level (inflation) and reduction in output. The equilibrium in the AS-AD relation moves up along the AD curve. An increase in the price level under the same level of nominal money supply raises the real interest rate as well as the nominal interest rate in this case, resulting that the real money supply curve shifts leftwards because the nominal interest rate increases faster than does the inflation rate. At any output level, interest rate must rise; the LM curve shift leftwards. In the goods market, the rise in input prices will induce firms to raise goods prices. Since the demand for most goods are price-elastic, the increasing prices will decrease firms’ revenues, lowering profitability of firms. Firms reduce investment with this expectation. As a result, the output falls.
It is distinguished from higher inflation expectation induced by expansionary monetary policy. When the central banks increase monetary base, initially, nominal interest rate falls due to liquidity effect while the price level stays the same. At the same time increase in monetary base causes higher inflation expectation in the future. These effects lower the real interest rate and stimulate consumption and private investment, increasing output. Consumers will consume faster when they expect higher price level in the future; businesses will invest more if rises in prices are caused by greater demand. Thus, the IS curve as well as the LM curve shifts rightward, eventually increasing both nominal interest rate and output.
According to this, a liquidity trap cannot occur. However, the nominal interest rate is zero, there is no reason to consider that the central bank is not able to increase inflation expectation and lower the real interest rate below whatever level would induce greater investment and consumption. If T-bills are not enough, central bank can buy longer term bonds such as MBS and even private securities like commercial papers and stock issues. If people are really worried about the central bank buying private assets, then it can even buy foreign exchanges. There are a lot of other ways that the central bank increases monetary base and induce greater inflation expectation. The greater inflation expectation, the lower is the real interest rate. An expansionary monetary policy would still be expansionary at zero lower bound.
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