ECON 1010 Study Guide - Final Guide: Laffer Curve, Real Wages, Overnight Rate

6. Fed Sees both unemployment and prices on the rise.

The federal reserve sees worse economic problems ahead. But even so, the Fed may be reluctant to cut interest rates any further than it already has. The Fed lowered its economic growth forecast for the year. At the same time, it raised its projections for inflation and unemployment. The Fed raised its unemployment forecast to between 5.5 percent and 5.7 percent and now expects personal consumption expenditures to rise between 3.1 percent and 3.4 percent in 2008 and expects steeper "core" inflation. In an effort to keep the country from falling into recession and to deal with the credit crisis, the Fed has cut its key federal funds rate seven times since September. This short-term interest rate is now 2 percent, down from 5.25percent at the start of the Fed's easing campaign. Some believe the Fed cuts since last September helped fuel inflation, especially the sharp run-up in oil prices because the rate cuts have led to a weakening of the dollar. Along those lines, the two Fed members who voted against the last rate cut argued during the meeting that the Fed cuts were hurting the economy more than helping it. CNN, May 21, 2008.

a. Explain the intended effect of the Fed cutting the target federal funds rate from 5.25 percent to 2 percent and illustrate your explanation with appropriate graphical analysis.

b. Explain how this monetary policy may have "helped fuel inflation, especially the sharp run-up in oil prices".

c. What is core inflation and why does the Fed tend to focus on that measurement of inflation more heavily than overall inflation?

d. Explain the dilemma that the Fed is facing when making decisions in the face of rising unemployment and rising inflation.

8) What can be concluded from Milton Friedman and Edmund Phelps' expectations-augmented Phillips curve?

A) that there is no long run tradeoff between unemployment and inflation

B) that there is a short run tradeoff between unemployment and inflation

C) that there are two types of Phillips curves

D) all of the above

E) none of the above

9) Given the accelerationist Phillips curve ?? = - 0.3 (U - 6) + ?, suppose that inflation in the preceding period was 3 percent, unemployment is 6 percent, and there is a price shock of 2 percent. The current inflation rate is ________.

A) 3 percent

B) 0.2 percent

C) 5 percent

D) 1 percent

E) none of the above

10) Which of the following shows a negative relationship between the output and unemployment gaps?

A) the AS curve

B) the Phillips curve

C) Okun's law

D) the classical dichotomy

E) none of the above

Suppose the economy is thought to be 1 percent above potential (i.e., the output gap is 1 percent) when potential output grows 3 percent per year. Suppose the Fed is following the Taylor rule, with an inflation rate of 3 percent over the past year. The federal funds rate is currently 4 percent. The equilibrium long-run real interest rate is 2 percent and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 2 percent.

a) Is the Feds funds rate currently too high or too low? By how much? Show your work.

b) Suppose a year has gone by, the output is now just 2 percent above potential, and the inflation rate was 3.5 percent over the year. What federal funds rate should the Fed now set (assuming the inflation target does not change)?