- Question Three Nominal Rigidity Assume That The Bank Of Zambia Has The Ability To Control Real Interest Rate And Suppo 1 (102.51 KiB) Viewed 28 times
Question Three: Nominal Rigidity Assume that the Bank of Zambia has the ability to control real interest rate. And suppose the economy is described by two equations. The IS equation given as Y = -rt/ while the money-market equilibrium condition: m - p = L(r + ; Y). Where Lr + Te < 0; Ly > 0; m and p denote log M and log P. a. Suppose prices respond partially to increases in money. Specifically, assume that dp = dm is exogenous, with 0 < dp = dm < 1. Also assume n = 0. i. Find an expression for dr = dm. ii. Does an increase in the money supply lower the real interest rate? b. Suppose increases in money also affect expected inflation. Specifically, assume that dne = dm is exogenous, with drie = dm > 0. Continue to assume 0 < dp = dm < 1. i. Find an expression for dr = dm. ii. Does an increase in the money supply lower the real interest rate? iii. Does achieving a given change in r require a change in m smaller, larger, or the same size as in part (a)? c. Consider Keynes's model of nominal rigidity where nominal wages are completely unresponsive to current developments, there is labour market imperfection, and firms are competitive with flexible prices. If there is an increase demand brought about by an increase in money stock, what would be the impact of this increase in demand on the real wage and output? You may use graphs to illustrate your answer. d. In your own words, explain the Lucas Critique and its implications for policy decisions based on statistical/econometric relationships.