Explain what role money illusion plays in determining the Fed's ...

[Wadzanai]

Explain what role money illusion plays in determining the Fed's ability to affect output in the short run.
 
  What will be an ideal response?

Question 2

Suppose an economy experiences an increase in inflation. Explain the possible macroeconomic benefits of this increase in inflation.
 
  What will be an ideal response?

[swimkari]

Answer to Question 1

Money illusion refers to a situation where individuals make mistakes about the distinction between nominal and real magnitudes. For example, individuals might be reluctant to accept a reduction in the nominal wage (that would cause a reduction in the real wage) while at the same time would accept a reduction in the real wage when inflation exists and the nominal wage does not change. Money illusion, therefore, might allow a central bank to inflate an economy and, therefore, cause output to rise temporarily.

Answer to Question 2

Answers should include discussions of: seignorage, the option of a negative real interest rate, and money illusion.