Question

What is the key assumption underlying the Fed’s ability to control the real interest rate?

Short answer

The key assumption is that the nominal charge per unit and real charge per unit works in an exceedingly similar direction. Increase in nominal rate of interest will result in increase in real rate and contrariwise.

Step-by-step solution

Concept introduction 

Real rate is adjusted with the rate of inflation, therefore it's simpler measure than the nominal rate. Real rate will be calculated from MP equation:

$$\begin{gathered} \mathrm{r}=\overline{\mathrm{r}}+\lambda \pi \\ Where, \\ \text{-}r\text{is Real interest rate.} \\ \text{-}\overrightarrow{r}\text{isAutonomous component.} \\ \text{-}\lambda \text{is Responsiveness of the real interest rate to the inflation rate.} \\ \text{-}\pi \text{is Inflation rate.} \end{gathered}$$

Explanation of solution

The key assumption is that the nominal charge per unit and real charge per unit works in an exceedingly similar direction. Increase in nominal rate of interest will result in increase in real rate and contrariwise.

The Fed can control the (nominal) fed funds rate, but real interest rates matters to the economy. To manage the rate of interest Fed will use nominal rate and adjust it with the inflation.