Question

Given a closed, private economy where aggregate demand (AD) can be represented as AD = c0 + c1Y + I0 where c0 is autonomous private consumption, c1 is the marginal propensity to consume, I0 is autonomous business investment, and Y is national income.Central banks conduct monetary policy. Explain how through their conduct of monetary policy central banks can influence the level of economic activity in an economy.

Answer 1

AD = c0 + c1Y + IO. ( where c0 is autonomous private consumption, c1 is the marginal propensity to consume, I0 is autonomous business investment, and Y is national income ).

Now, let us supoose that due to recession economic activity has declined considerably leading to millions of people being jobless. The goal of the central bank is to increase the growth rate or economic activity in the country.

Central bank would need to increase aggregate demand which will in turn help prop up economic growth rate in the economy. As we can see in the equation of aggregate demand given above, an increase in overall consumption or propensity to consume would increase the aggregate demand thereby leading to higher economic growth.

Central bank during times of recession can decrease interest rates in the economy which would provide more liquidity to the people in the economy. Ease of liquidity would encourages greater lending by the banks to the people and the businesses, thereby leading to more overall consumer spending and propensity to consume. This would help increase aggregate demand and economic growth in the country.

Likewise, if the central bank can increase the interest rate to bring down economic activity in the economy.