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Suppose that the economy is currently at the natural rate of interest, r*, with no output gap and inflation at its target, i*. Now suppose that the natural rate of interest decreases to r < 0. That is the natural rate of interest is below zero (it is a real interest rate, and thus can be below zero). Answer the following questions about this scenario: A. Show on the two diagrams how the Fed gets stuck at the zero lower bound in this case. At this point, does the economy have an output gap? Where is inflation relative to its target rate? B. Suppose the Fed pursues Forward Guidance, and raises inflation expectations. Draw the effect of this on the Phillips Curve diagrams. C. If the Fed successfully removes the output gap, where is inflation relative to its target? If the Fed is balancing its Dual Mandate, would you expect it to maintain the nominal interest rate target of zero? Why or why not?

Suppose that the economy is currently at the natural rate of interest, r*, with no output gap and inflation at its target, i*. Now suppose that the natural rate of interest decreases to r < 0. That is the natural rate of interest is below zero (it is a real interest rate, and thus can be below zero). Answer the following questions about this scenario: A. Show on the two diagrams how the Fed gets stuck at the zero lower bound in this case. At this point, does the economy have an output gap? Where is inflation relative to its target rate? B. Suppose the Fed pursues Forward Guidance, and raises inflation expectations. Draw the effect of this on the Phillips Curve diagrams. C. If the Fed successfully removes the output gap, where is inflation relative to its target? If the Fed is balancing its Dual Mandate, would you expect it to maintain the nominal interest rate target of zero? Why or why not?

Brief Principles of Macroeconomics (MindTap Course List)
Brief Principles of Macroeconomics (MindTap Course List)
8th Edition
ISBN:9781337091985
Author:N. Gregory Mankiw
Publisher:N. Gregory Mankiw
Chapter16: The Influence Of Monetary And Fiscal Policy On Aggregate Demand
Section: Chapter Questions
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Suppose that the economy is currently at the natural rate of interest, r*, with no output gap and inflation at its target, i*. Now suppose that the natural rate of interest decreases to r < 0. That is the natural rate of interest is below zero (it is a real interest rate, and thus can be below zero). Answer the following questions about this scenario: A. Show on the two diagrams how the Fed gets stuck at the zero lower bound in this case. At this point, does the economy have an output gap? Where is inflation relative to its target rate? B. Suppose the Fed pursues Forward Guidance, and raises inflation expectations. Draw the effect of this on the Phillips Curve diagrams. C. If the Fed successfully removes the output gap, where is inflation relative to its target? If the Fed is balancing its Dual Mandate, would you expect it to maintain the nominal interest rate target of zero? Why or why not?
Transcribed Image Text:Suppose that the economy is currently at the natural rate of interest, r*, with no output gap and inflation at its target, i*. Now suppose that the natural rate of interest decreases to r < 0. That is the natural rate of interest is below zero (it is a real interest rate, and thus can be below zero). Answer the following questions about this scenario: A. Show on the two diagrams how the Fed gets stuck at the zero lower bound in this case. At this point, does the economy have an output gap? Where is inflation relative to its target rate? B. Suppose the Fed pursues Forward Guidance, and raises inflation expectations. Draw the effect of this on the Phillips Curve diagrams. C. If the Fed successfully removes the output gap, where is inflation relative to its target? If the Fed is balancing its Dual Mandate, would you expect it to maintain the nominal interest rate target of zero? Why or why not?
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