Question

Inflation in the country of Hypothetica is currently 5%, below the target range of its central bank.

(i) What does this tell you regarding Hypothetica’s likely output gap? Illustrate it using an AS-AD diagram, and briefly explain your diagram​​​

(ii) In this situation, what is the central bank likely to do with regard to monetary policy? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer) ​

(iii) What happens if the central bank does not intervene? Will the economy eventually return to long-run equilibrium (potential GDP)? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer).​​​​​​​

Answer 1

Ans :-

(i) :- The vast majority of the national banks on the world have a target run for inflation so as to keep up stable price level in the economy.

For instance, Federal Reserve of the US has a target of 2% inflation rate, while Reserve Bank of India has a target of keeping up inflation at 4%.

Inflation is the supported general increment in price level of the merchandise and services in the economy. It eats into wages of the poor by cutting down the buying intensity of the individuals, particularly poor and lower middle class who have less assets.

At whatever point the inflation rate shoots up, the national bank diminishes the measure of cash provided in the economy by expanding the loan cost which prompts fall in the demand for cash which thus cuts down the price level of products and services in the economy.

In this manner cutting down inflation rate. Expanding loan cost by Central bank reduces spending, 'cools' the economy and reduces inflation, while lessening financing costs builds spending, 'warms up' the economy and expands inflation."

Inflation in the country of Hypothetica is currently 5%, below the target range of its central bank.

A lower-than-target inflation means aggregate demand is low. The economy is in recession with a negative output gap.

In following graph, long-run equilibrium is at point A where initial aggregate demand (AD0) intersects initial short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0), with long-run equilibrium price level P0 and real GDP (= potential GDP) Y0.

During recession, economy is at point B where aggregate demand is to the left of LRAS at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1. Short-run Recessionary gap is (Y0 - Y1).

(ii) :- On the off chance that the national bank doesn't intervene, at that point the laborers and individuals by and large would understand that their wages in genuine terms have fallen because of supported rise price level and they would demand higher wages. Also numerous independent ventures may bomb because of greater expense of acquiring and expanded compensation cost. This may prompt higher joblessness and fall in aggregate demand. Over the long haul the aftereffect of supported high inflation would be progressively jobless specialists, and bombing economy regarding economic growth.

Central bank should increase money supply by following expansionary monetary policy tools :-

• Conduct open market purchase of government securities,
• Reduce required reserve ratio or
• Reduce discount rate.

Any of these tools will increase aggregate demand, shifting AD1 rightward to AD0, ensuring long run equilibrium at point A.

(iii) :- Without intervention in long run, lower price level will decrease prices of inputs, raising production costs. Firms will increase production, which increases aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level and real GDP being restored to the potential GDP.

In above graph, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.