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FRQ 2009 #1. Trevor Fritz. Assume that the United States economy is in long-run equilibrium with an expected inflation rate of 6 percent and an unemployment rate of 5 percent. The nominal interest rate is 8 percent.

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frq 2009 1

FRQ 2009 #1

Trevor Fritz

slide2

Assume that the United States economy is in long-run equilibrium with an expected inflation rate of 6 percent and an unemployment rate of 5 percent. The nominal interest rate is 8 percent.

slide3

Using a correctly labeled graph with both the short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A.

Inflation

A

Unemployment

slide4

Nominal Interest Rate - Rate of Inflation = Real Interest Rate

  • Calculate the real interest rate in the long-run equilibrium.

8% - 6% = 2%

slide5

Assume now that the Federal Reserve decides to target an inflation rate of 3 percent. What open-market operation should the Federal Reserve undertake?

Since inflation and unemployment are inverses of each other according to the Phillips Curve, the Federal Reserve should try to increase unemployment in order to decrease the inflation rate. This can be done by selling government bonds which would shrink the economy and raise unemployment.

slide6

Using a correctly labeled graph of the money market, show how the Federal Reserve’s action you identified in part (c) will affect the nominal interest rate.

Interest Rate

GDP

slide7

How will the interest rate change you identified in part (d) affect aggregate demand in the short run? Explain.

According to the law of demand in the loanable funds market, the increase in the interest rate will cause a decrease in aggregate demand.

slide8

Assume that the Federal Reserve action is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium?

slide9

The short-run Phillips curve: The short-run Phillips curve will not change. There will only be a movement down the curve of the equilibrium point A.

  • The natural rate of unemployment: The natural rate of unemployment (long-run Phillips curve) will shift to the right to stay at the equilibrium point A.