Question

Suppose a country is facing an inflationary gap, and the Central wants to use monetary policy to stabilize the economy. What kind of policy should it follow? How will it impact bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level. Illustrate your analysis graphically with explanation

Answer 1

If a country is facing inflationary gap, it indicates that, actual GDP is higher than potential GDP. Price level in the economy also will be higher . Inflationary gap is caused by higher aggregate demand.

In order to correct inflationary gap , aggregate demand must be curbed. In order to decrease aggregate demand, central bank will have to reduce money supply.

*The monetary policy which aims at a reduction in money supply is contractionary Monetary policy. Now let's look at how contractionary Monetary policy will effect the following

* Interest rates

Interest rate is r determined by the intersection of demand for money curve Md and money supply curve Ms1. Quantity of money is Q1. As a part of contractionary monetary policy, central bank decreases money supply and money supply curve shifts to left from Ms1 to Ms2. Intersection Ms1 with Md leads to a increase in interest rate from r1 to r2 . Quantity of money available in the economy falls from Q1to Q2.

Thus,Contractionary monetary policy involves raising the interest rates. Higher interest rates will make borrowing expensive. Consumption based on borrowing will experience a reduction due to raise in interest rates.

* Bond prices

As a part of contractionary monetary policy, central bank will sell bonds. As a result supply of bonds Increase, supply curve shifts to right from S1S1 to S2S2. Intersection of S2S2 with existing demand curve DD leads to a fall in bond prices from P 1to P2.

* Investment

Investment is also inversely related to rate of interest. As interest rate is raised from r1 to r2, investment in the economy falls from Q1 to Q2

* Exchange rate

Contractionary monetary policy will shift the demand for foreign exchange to right from D1D1 to D2D2 and supply of foreign exchange to left from S1S1 to S2S2. As a result, Exchange rate raises from E 1to E2

* Net Exports

Contractionary Monetary policy leads to a fall in consumer spending and investment, so production as well exports will experience a fall. Since net exports equal exports minus imports, net exports will decline

* Real GDP and price level

Economy is facing an inflationary gap when real GDP is Y1 and price level is P 1determined by the interaction of aggregate demand curve AD1 and short run aggregate supply curve SRAS1

We already saw that contractionary monetary policy leads to a reduction in consumption, investment and net exports. These are components of Aggregate demand. Therefore, contractionary monetary policy leads to a decline in aggregate demand. Aggregate demand curve shifts to left from AD1 to AD2. Intersection of AD2 with short run aggregate supply curve SRAS 1 and long run aggregate supply curve LRAS leads to a reduction in price level from P1 to P* and real GDP from Y 1 to Y* and the economy is back to equlibrium.