Assume that the central bank follows the following simplified version of the Taylor rule:

Question

Assume that the central bank follows the following simplified version of the Taylor rule:  (a) What implicit weight is placed on the inflation target under this rule? Discuss. Draw an IS-MP diagram but instead of the usual MP curve, graph the monetary policy rule. You might label this curve MPT for the simplified Taylor rule. (5 marks)(b) Now consider the effect of a negative aggregate demand shock in the IS-MPT diagram. Compare and contrast the effect of this shock on the economy in the standard IS-MP diagram (without policy response to the shock) versus the IS-MPT diagram. Is there a difference? (5 marks)(c) Find the equilibrium values of the short-run output and the real interest rate from the IS-MPT model. Explain how these equilibrium values depend on the parameter ¯. (4 marks)(d) Economists refer to the result in the IS-MPT diagram as “crowding out”. What gets crowd out and why? (4 marks)(e) Briefly compare and contrast the economic effects of a temporary negative aggregate demand shock lasting for 2 periods in the standard AS/AD model (of the textbook) with that in the AS/AD model under the simplified Taylor rule above. Assume that in both cases the economy starts in the same long-run equilibrium. (6 marks)
	
Document Preview: Assume that the central bank follows the following simplified version of the Taylor rule:  (a) What implicit weight is placed on the inflation target under this rule? Discuss. Draw an IS-MP diagram but instead of the usual MP curve, graph the monetary policy rule. You might label this curve MPT for the simplified Taylor rule. (5 marks) (b) Now consider the effect of a negative aggregate demand shock in the IS-MPT diagram. Compare and contrast the effect of this shock on the economy in the standard IS-MP diagram (without policy response to the shock) versus the IS-MPT diagram. Is there a difference? (5 marks) (c) Find the equilibrium values of the short-run output and the real interest rate from the IS-MPT model. Explain how these equilibrium values depend on the parameter ¯. (4 marks) (d) Economists refer to the result in the IS-MPT diagram as “crowding out”. What gets crowd out and why? (4 marks) (e) Briefly compare and contrast the economic effects of a temporary negative aggregate demand shock lasting for 2 periods in the standard AS/AD model (of the textbook) with that in the AS/AD model under the simplified Taylor rule above. Assume that in both cases the economy starts in the same long-run equilibrium. (6 marks)

Robert · Accepted Answer

Assume that the central bank follows the following simplified version of the Taylor rule:
(a) In general, the Taylor rule states that:
it = r* + π* + β(πt – π*) + γ(yt – yN)   [where β , γ > 0; r* is the average (long-run) real interest 
rate]
The rule states that the repo rate it should be above its long-run level (r* + π*) when:
• actual inflation πt is above the target π*  
• economic activity yt is above its "full employment" level yN (i.e.

Assume that the central bank follows the following simplified version of the Taylor rule: (a) What implicit weight is placed on the inflation target under this rule? Discuss. Draw an IS-MP diagram but...

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