[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

The relationship between aggregate expenditures
and the real interest rate is given by the following
table (expenditures are in trillions of 2000 dollars):
Real interest rate 3 4 5 6 7 8
Aggregate expenditures 8.3 8 7.7 7.4 7.1 6.8
Plot the ADI curve. If inflation is 4 percent, what is the
level of aggregate expenditures? Suppose investment
now becomes more sensitive to interest rate changes.
How would this affect the ADI curve?
3. Draw an ADI curve. As we move up and to the left on a
given ADI curve, the real rate of interest increases.
Explain why.
4. Suppose output is initially equal to potential GDP. Now
assume the government cuts taxes (and assume government
expenditures remain unchanged). How does this
affect the ADI curve? What happens in the short run to
equilibrium output? To unemployment? Over time, will
inflation tend to rise or to fall? Explain how the adjustment
of inflation works to return the output gap to zero.
What happens to the real interest rate?
5. Suppose output is initially equal to potential GDP. Now
assume the Fed shifts its policy rule by raising interest
rates at each rate of inflation. How does this affect the
ADI curve? What happens in the short run to equilibrium
output? To unemployment? Over time, will inflation
tend to rise or to fall? Explain how the adjustment
of inflation works to return the output gap to zero. What
happens to the real interest rate?
6. Suppose output is initially equal to potential GDP and
inflation is equal to 2 percent. Suppose a new chair of
the Federal Reserve is appointed. This new chair
believes that average inflation should be reduced to
1 percent. To achieve this new lower rate of inflation,
should the Fed shift its policy rule by raising interest
rates at each rate of inflation or by lowering interest
rates at each rate of inflation? What are the consequences
for the output gap in the short run of the policy
shift that results? What are the consequences for the
output gap in the long run?
7. Go to the Federal Reserve’s Web site (www.federal
reserve.gov), follow the links to Monetary Policy and
the FOMC, and find the press releases (“statements”)
from the last two FOMC meetings. Has the FOMC
raised or lowered interest rates at these meetings?
What reasons do the press releases give for these
actions? Would you describe these actions as movements
along a given policy rule (i.e., interest rate
changes arising from a concern about inflation) or
as shifts in the policy rule (i.e., policy actions in
response to factors other than inflation)? If you
feel the policy rule has shifted, what factors was
the FOMC reacting to?
712 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION