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Chapter 22: Q.2 (page 581)

What is the key assumption underlying the Fed’s ability to control the real interest rate?

Short Answer

Expert verified

The key assumption is that the nominal charge per unit and real charge per unit works in an exceedingly similar direction. Increase in nominal rate of interest will result in increase in real rate and contrariwise.

Step by step solution

01

Concept introduction 

Real rate is adjusted with the rate of inflation, therefore it's simpler measure than the nominal rate. Real rate will be calculated from MP equation:

r=r¯+λπWhere,-ris Real interest rate.-r→isAutonomous component.-λis Responsiveness of the real interest rate to the inflation rate.-πis Inflation rate.

02

Explanation of solution

The key assumption is that the nominal charge per unit and real charge per unit works in an exceedingly similar direction. Increase in nominal rate of interest will result in increase in real rate and contrariwise.

The Fed can control the (nominal) fed funds rate, but real interest rates matters to the economy. To manage the rate of interest Fed will use nominal rate and adjust it with the inflation.

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Most popular questions from this chapter

Suppose that a new Fed chair is appointed and that his or her approach to monetary policy can be summarized by the following statement: "I care only about increasing employment. Inflation has been at very low levels for quite some time; my priority is to ease monetary policy to promote employment." How would you expect the monetary policy curve to be affected, if at all?

A measure of real interest rates can be approximated by the Treasury Inflation-Indexed Security, or TIIS. Go to the St. Louis Federal Reserve FRED database, and find data on the five-year TIIS (FII5) and the personal consumption expenditure price index (PCECTPI), a measure of the price index. Choose “Quarterly” for the frequency setting of the TIIS, and download both data series. Convert the price index data to annualized inflation rates by taking the quarter-to-quarter percent change in the price index and multiplying it by 4. Be sure to multiply by 100 so that your results are percentages.

a. Calculate the average inflation rate and the average real interest rate over the most recent four quarters of data available and the four quarters prior to that.

b. Calculate the change in the average inflation rate between the most recent annual period and the year prior. Then calculate the change in the average real interest rate over the same period.

c. Using your answers to part (b), compute the ratio of the change in the average real interest rate to the change in the average inflation rate. What does this ratio represent? Comment on how it relates to the Taylor principle.

How is an autonomous tightening or easing of monetary policy different from a change in the real interest rate caused by a change in the current inflation rate?

Ifλ=0,what does this imply about the relationship between the nominal interest rate and the inflation rate?

If financial frictions increase, how will this affect credit spreads, and how might the central bank respond? Why?
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