Question

Macro

Suppose the real money demand function is:

Mᵈ/P=1500+0.2Y-10,000(r+π⁶)

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Assume M = 4000, P = 2.0, πᵉ = 0.01, and Y = 5000.

Note: we are holding P and Y constant in this problem until we get to case #2 below.

A) What is the market clearing real interest rate?

B) Please illustrate your results on a real money supply, real money demand diagram and label this initial equilibrium point as point A. Be sure to label your graph completely! Be sure to put relevant shift variables in parentheses next to the appropriate function.

C) Suppose Janet Yellen and the Fed were successful in their campaign to decrease inflationary expectations to 0.5% (.005). Why would they want to do this? Use the Fisher equation to support your argument.

D) Solve for the real interest rate that clears the money market given the change in inflationary expectations. Please show work and Label this new point as point B on your diagram above.

E) Explain how this strategy of decreasing inflationary expectations is supposed to pull back on the economy. Recall that output is equal to C + I + G! Be very specific. Hint: The price of current consumption in terms of future consumption and the user cost of capital most definitely need to be in your response.

Answer 1

To find the market clearing real interest rate, substitute the given values into the real money demand function and solve for the real interest rate. Graph the real money supply and real money demand curves and label the initial equilibrium point as point A. Janet Yellen and the Fed would want to decrease inflationary expectations to promote economic stability, as a decrease in expected inflation can stimulate borrowing and investment. Solve for the new real interest rate that clears the money market given the change in inflationary expectations by substituting the new expected inflation rate into the real money demand function and label this new point as point B on the diagram. By decreasing inflationary expectations, it is expected to decrease the nominal interest rate, stimulating borrowing and investment and potentially increasing consumption and investment in the economy.

Step-by-step explanation:

To find the market clearing real interest rate, we can use the real money demand function and set it equal to the real money supply. Given the equation Mᵈ/P=1500+0.2Y-10,000(r+π⁶), we can substitute the given values for M, P, π, and Y. With M = 4000, P = 2.0, πᵉ = 0.01, and Y = 5000, we can solve for r.

B) To illustrate the results on a real money supply, real money demand diagram, we need to graph the real money demand and real money supply curves. Label the initial equilibrium point as point A.

C) Janet Yellen and the Fed would want to decrease inflationary expectations to promote economic stability. By using the Fisher equation, we can see that the nominal interest rate is equal to the real interest rate plus the expected inflation rate. If the expected inflation rate decreases, it will lead to a decrease in the nominal interest rate, which can stimulate borrowing and investment.

D) To solve for the new real interest rate that clears the money market given the change in inflationary expectations, we can use the same real money demand function, but substitute the new expected inflation rate. Label this new point as point B on the diagram.

E) By decreasing inflationary expectations, it is expected to decrease the nominal interest rate, which can stimulate borrowing and investment. This can lead to an increase in consumption (C) and investment (I), which are components of output (Y). The decrease in inflationary expectations can lower the user cost of capital, making it more affordable for firms to invest, and it can also increase the price of current consumption in terms of future consumption, encouraging consumers to save more and spend less.