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:

R - rbar = nbar*Y

(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)

David · Accepted Answer

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)
Ans) 
Key Assumptions 
1. Fixed Prices (P=1) 
2. Unemployed resources  
3. Closed Economy  
 IS Curve (Expenditure) 
It describes equilibrium in goods market . 
It solves for  Y where planned expenditure =planned output
Basic set of equations: 
1. Y=C+I+G 
2. C=a+b(Y-T) 
3. T=To + tY              [We assume lump sum and income tax] 
4. I=Io –dr                [i=r because of fixed P] 
5. G=Go 
Thus, 
IS curve is given by Y=[a-bTo+Go+Io-dr]/[1-b(1-t)] 
Thus Y=m[Ao-dr] 
Where Ao = a-bTo+Go+Io    Autonomous spending 
m=multiplier=1/[(1-b(1-t)]
Graphing the IS Curve:
MP Curve (monetary policy)
The MP curve represents equilibrium in financial markets.  
1. Monetary Policy: Taylor Rule 
Begin with a monetary policy equation in the form of a “Taylor rule:
r=r*+nY
r* is the target real interest rate. 
Implicit weight on inflation target is 0.
Thus we get financial market equilibrium:
MP: r=r*+nY
 

 
Combining  IS –MPT for equilibrium:
 

(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)
Now a negative demand shock shifts the IS curve to the left.

Assume that the central bank follows the following simplified version of the Taylor rule: R - rbar = nbar*Y (a) What implicit weight is placed on the inflation target under this rule? Discuss. Draw an...

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