This question is related to the article " Inflation, recession and the perils of overtightening ", The Globe and Mail, November 14, 2022.

 

Source: Parkinson, D. (2022). Inflation, recession and the perils of overtightening: The office of the parliamentary budget officer decided to crunch the numbers to estimate what would happen if the bank of canada overstepped with its rate increases. surprisingly, it might not make much difference in wiping out inflation any faster.

 

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1. In attempt to tame inflation, the Bank of Canada (BOC) has raised interest rate seven times in 2022 (as of December 7, 2022, the overnight is 4.25%). In theory, an increase in interest rate can help to lower inflation rate or to slowdown the increase in inflation rate.  Explain the effect of an increase in interest rate in the foreign exchange market and how the subsequent change in exchange rate can help to tame inflation.  (5 points)
2. The article mentioned that the Office of the Parliamentary Budget Officer (PBO) tried to estimate what would happen to the Canadian economy if the BOC ran an overtightening monetary policy.

• What does overtightening monetary policy mean? (3 points)
• According to the PBO, what are the potential effects of an overtightening monetary policy on the Canadian economy? (7 points)

1. In the latter part of the article, it mentioned that the unexpected and unpleasant finding by the PBO was the interest rate hikes by the BOC would not have major impact on the country’s inflation rate since recent economic developments might offset the attempts by the BOC’s disinflationary attempt. Identify those factors and explain how they might reduce the effectiveness of the BOC’s effort to lower inflation rate.  (10 points)

A rapid increase in the money supply may lead to a(n):

A. increase in the rate of inflation.
B. recession.
C. decrease in interest rates.
D. decrease in spending by consumers and businesses

Using the graph and definitions below of the supply of loanable funds, SLF, and the demand for loanable funds, DLF, discuss the following:

a. What is meant by the equilibrium nominal rate of interest?

b. Illustrate and discuss how an autonomous increase in the expected rate of inflation will change the equilibrium nominal interest rate. Express your discussion in terms of the effect on the supply and demand for loanable funds. Consider an initial real rate of interest of 3 percent and an expected inflation rate of 3 percent. If the expected rate of inflation rises to 4 percent with the real interest rate constant, what would the resulting nominal interest rate become in equilibrium using the Fisher relationship? Assume that investors believe the rise in the expected rate of inflation will remain at the higher level indefinitely.

c. Starting from an equilibrium position as in a, discuss the effects of a tightening monetary policy if the markets believe that a Fed tightening will lower future (next period) inflation. How might a recession occur under this scenario? HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.

How does an autonomous tightening or easing of monetary policy by the Fed affect the MP curve?

A. When the Fed decides to lower the real interest rate at any given inflation rate, the MP curve shifts upward. Monetary policy easing, a decision to raise the real interest rate at any given inflation rate, shifts the MP curve downward.

B. When the Fed decides to raise the real interest rate at any given inflation rate, the MP curve shifts upward. Monetary policy easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve downward.

C. When the Fed decides to raise the real interest rate at any given inflation? rate, the MP curve shifts downward. Monetary policy easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve upward.

D. None of the above is correct.