Question

Problem A: (please complete those 3 questions, they are in one question!)

1. In some countries, the central bank’s only objective is keeping inflation low. What does this imply about the Taylor rule in these countries?

2.. Suppose a country is at potential or the natural rate of GDP and consumption and investment fall. Illustrate the effects on GDP and interest rates using an IS-LM model. Ignoring inflation, or assuming it is zero, what would the Taylor rule imply the Fed should do? Explain and illustrate on your IS-LM graph.

3. Suppose a country is at potential or the natural rate of GDP and people lose faith in the banking system and pull their money out to hold it as cash (increasing the currency deposit ratio). Illustrate the effects on GDP and interest rates with an IS-LM model. Ignoring inflation, or assuming it is zero, what would the Taylor rule imply the Fed should do? Explain and illustrate on your IS-LM graph.

Answer 1

To keep the inftration rate how , according to Tayla's rule, fed should increase the nominal interest rate this will make people to keep there money in bank accounts or other financial instruments rather than holding it as cash because now their opportunity cast of holding nisney is quite high. This reduces the demand for you and as supply is unchanged puce in the economy falls. Hence, low inflation. interest late YY outputly) With fall in consumption and investment Is curve would shift left words ts Is', reducing interest rate and output to it and y' respectively. From Taylorsrule, Fed must cut interest rates to increase dan sumption and investment in the economy, this cut in interest rate would lead to sught ward shift in LM cuve ts LM ", this will reduce interest rate further to i" but bring back the GOP to full potential of Y.

intuen Nati M r IS ou Y' Y outputy When people lose faith in banking system cand cash to deposit ratio in the econoney rises, this leads to fall in money supply and hence, deftward shift of L auure to LM , this leads to fall rise in interest rate toil and fall in output level to y'. Now from Taple's rule Fed should increase money stock in the economy or increase money supply in the economy by lowering the interit crates, this will again shift LM' t LM and bring back GDP to natural eate. V this answer & Hope you find Shelpful, Thank you