Question 4 [6 points] The central bank wants to maintain inflation at a fixed target and to see the economy operating at potential output. It sets its overnight rate (onr) based on the following rule: onr = 2.5 + 1.8 (IT - TT") + 0.7 [(Y - Yp)/Yp] x 100 a) If the economy is operating at potential output and the inflation rate is at the Bank's target, Ti*, what is the Bank's onr setting? Note: Keep as much precision as possible during your calculations. Your final answer should be accurate to at least two decimal places. onr = 2.5% b) Suppose a boom in a major trading partner increases demand for domestic exports, increases AD and increases real income Y = Yp = 1,110 to Y = 1,198.8. How would the central bank respond (+ for increase, - for decrease)? Basis point change in onr = 560 c) Alternatively, suppose a drop in labour productivity growth pushed the inflation rate up by 0.5 percent. How would the central bank respond (+ for increase, - for decrease)? Basis point change in onr = -90 Marking: a) Bank's onr Your answer was: 2.50% Congratulations! You have entered the correct answer. b) Basis point change in onr Your answer was: 560 Congratulations! You have entered the correct answer. C) Basis point change in onr Your answer was: -90 The correct answer was: 90 A rise in the inflation rate by 0.5% would mean the inflation rate is 0.5% higher than the Bank's target. The Bank would react to this rise in inflation rate by raising its onr by 1.8 x (0.5%) = 0.9%, which is an increase of 90 basis points. You will lose 2 marks for this part. Total marks for this question: 4