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15) Suppose the Central Bank believes the natural unemployment rate to be 6% when actually it...

15) Suppose the Central Bank believes the natural unemployment rate to be 6% when actually it is 5%. It measures the output gap using Okun’s Law. The unemployment statistics are released suggesting the current unemployment rate is 6%. The Central Bank follows the Taylor Rule. Which of the following do we expect to occur? (For simplicity you can assume there are no lags)

  1. a) An increase in inflation followed by an increase in the real interest rate

  2. b) An increase in inflation followed by a decrease in the real interest rate

  3. c) A decrease in inflation followed by an increase in the real interest rate

  4. d) A decrease in inflation followed by a decrease in the real interest rate

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Answer #1

Ans. D. A decrease in inflation followed by a decrease in the real interest rate. - There would be decrease in inflation ( Okun's law ) and a decrease in real interest rate ( Taylor's Rule ) . This is the correct answer.

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