Question

1. Some economists argue suddenly reducing money supply growth is a costly way to reduce inflation and that it may not work. For example, if a government cuts money growth but makes no real fiscal reforms, people will expect the government will eventually need to expand the money supply to pay for its expenditures. Thus, the promise to fight inflation will not be credible. Explain why credibility is important to a reduction in the inflation rate.

2. Use the sticky-wage theory of aggregate demand to explain the short-run Phillips curve.

3. Carefully explain how monetary policy can be used to counter a recession. Explain what the central bank does as well as HOW its actions affect the economy.

4. Suppose that a country has an inflation rate of about 3 percent per year and a real GDP growth rate of about 3 percent per year. How large of a deficit can the government run (as a percentage of GDP) without raising the debt- to-income ratio?

5. List and EXPLAIN two costs of inflation.

6. Explain how tax cuts can increase aggregate supply.

Answer 1

Monetary policy is a policy determined by central bank and has two tools; interest rates and money supply. When there is inflation and central bank wants to reduce over consumption in an economy then it increases interest rates and decreases money supply. This is called as contractionary monetary policy.

Government may want central bank to influence money supply to face price change problems. A sudden decrease in money supply may not cause expected benefits. It is not only real money exchange but electronic fund usage can be used by people and also plastic money. Bank run, panic may also cause tention in economy. Inflation may rise due to sudden buying fearing for future reduction.

It is also true that people will expect that government will eventually need to expand the money supply to pay for its expenditures and again worsen the situation.

Hence step by step approach, along with economy confidence and fiscal policy support is needed for inflation control efforts.