Suppose that the overnight rate and the overnight rate target are at 4.5 percent

Question

Suppose that the overnight rate and the overnight rate target are at 4.5 percent. The interest rate spread household and business borrowing should be 2.5 percent. a. To achieve the real interest rate of 2.5 percent, at what level should you set the overnight rate target? b. All conditions remain the same as above, but the interest rate spread rises from 2 percent to 3.5 percent. To achieve the real interest rate of 2.5 percent, at what level should you now set the overnight rate target? c. The interest rate spread remain at 3.5 percent but the inflation rate falls to zero .To achieve the real interest rate of 2.5 percent , at what level should now set the overnight rate target ? Do you have a problem?

Explanation / Answer

a.You should set the overnight rate target at 2.5 percent. (The nominal rate faced by a typical household or business would then be 4.5 percent. Subtracting an inflation rate of 2 percent gives a 2.5 percent real rate for household and business borrowing.)

b. You should set the overnight rate target at 1 %.

c. You should set the overnight rate target at - 1 %. The problem is that the effective lower bound for the overnight rate target is 0.25 percent

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