In the New Keynesian model, suppose that in the short run the central bank cannot observe aggregate output or the shocks that hit the economy. However, the central bank would like to come as
close as possible to economic efficiency. That is, ideally the central bank would like the output gap to be zero. Suppose initially that the economy is in equilibrium with a zero output gap.
a. Suppose there is a shift in money demand. That is, the quantity of money demanded increases for each interest rate and level of real income.
In the short run in response to this shock, the output demand curve
will be
and the central bank will
the money supply. There
output gap in the short run; the central bank
Its goal
the output supply curve
b. Suppose that firms expect total factor productivity to increase in the future.
In the short run in response to this shock, the output demand curve
will be
and the central bank will
the money supply. There
c. Suppose that total factor productivity increases (temporarily) in the current period.
In the short run in response to this shock,
the output supply curve
and the central bank will
the money supply. There will be
output gap in the short run; the central bank
its goal
gap in the short run; the central bank
the output supply curve
â–¼its goal.
d. The results from parts (a)-(c) inply that following an interest rate rule is
A. effective for the central bank when short-run shocks impact real output demand and supply, but not when short-run shocks occur to money demand
B. effective for the central bank in all circumstances.
OC. effective for the central bank when short-run shocks are to money demand, but not when short-run shocks impact real output demand and supply
D. not effective for the central bank in any circumstances.
