Question

b) (2 points) What is the difference between nominal interest rate and real interest rate? Does the central bank control the real or the nominal rate? What do we assume in our model? Financial Frictions in the short run model a) (2 points) What do you expect would happen to the economy when spreads increase? Specifically, what would happen to output and inflation during the period of the increase in spreads? b) (2 points) How do you think would the central bank react to an increase in spreads?

Answer 1

As per HOMEWORKLIB RULES first question is answered

Kindly ask rest of the questions in a separate post

B)

Nominal interest rates are interest rate which are not adjusted for inflation, whereas real interest rates are inflation adjusted interest rates.

Numerically,

Real interest rate = Nominal interest rate - Inflation

The central bank controls nominal interest rates in the economy. However, nominal interest rates are not important to the economy. It is the real exchange rate adjusted for inflation which affects consumers and investors in the economy.

It is assumed that inflation is zero or unchanged in the model.