Suppose the level of real aggregate demand for output

1. Suppose the level of real aggregate demand for output in a macro economy is a negative function of the expected real interest rate- the nominal interest rate minus the expected inflation rate. Suppose also that the monetary authorities are setting the nominal interest rate and accommodating the private sector’s demand for outside money, at that fixed nominal interest rate. Assuming adaptive inflation expenditure, exacerbating the shock? How could an interest-rate-setting monetary authority overcome this problem?2. ‘Conducting monetary policy by way of nominal interest rate setting can destabilize the economic system.’ Outline and critically appraise this proposition (e.g. by use of a simple macroeconomic model). How might his difficulty be escaped, via the manner in which the monetary authorities react to the behavior of the economy, in their setting of the interest rate?


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