Assignment 3 Economia monetaria

1. Why does the MP curve necessarily have an upward slope?

The MP curve indicates the relationship between the real interest rate and the inflation rate.

! = !̅ + %& %

The equation’s curve is where is the responsiveness of the real interest rate to the inflation rate. Central banks’ main long-term goal is to stabilize inflation and, when inflation rises, the central bank responds by increasing the nominal interest rate more than the increase in inflation rate.

In other words, they follow the Taylor principle. By doing this, the central bank makes sure that the real interest rate also increases – as a direct consequence of the Fisher equation.

Therefore, there is an increase in the cost of borrowing which reduces investment and consumption. As a result, the MP curve shows a positive relationship between inflation and real interest rate.

Another reason why it has an upward slope is that central banks do not increase liquidity when inflation increases. More specifically, as the price level rises, more money is needed to pay for goods and services.

Since the central bank does not increase liquidity, households and firms try to move funds from interest-bearing assets into money. The resulting increase in the nominal interest rate makes the real interest rate increase.

2. Draw diagrams to derive the AD curve from the IS and MP curves

Be sure to label the axes, the curves, and the points.

3. Effects on the IS, MP, and AD curves

For each of the following situations, draw diagrams to show how the IS, MP, and AD curves are affected (e.g. movement along the curve? shift the curve?)

• A decrease in financial frictions
• An increase in the current inflation rate
• A decrease in autonomous consumption
• The new Bank of Canada governor begins to tighten monetary policy

4. Aggregate demand and supply graph

Using an aggregate demand and supply graph, show and describe the effects in both the short run and the long run of the following:

• A negative aggregate demand shock
• A temporary negative aggregate supply shock
• A permanent negative aggregate supply shock