Question

Suppose a central bank that has an inflation targeting mandate.

a. Explain why such a mandate might lead to monetary policy becoming a stabilizing policy regarding real GDP. [Hint: Use an AD-AS diagram.]

b. Given the long and variable lags involved in the full effects of monetary policy being felt throughout the economy, is there any danger that the inflation mandate might turn out to be destabilizing (leading to wider swings in GDP)? Explain.

Answer 1

(a)

Let us consider a recession. During recession, real GDP is less than potential GDP and economy experiences deflation. To boost GDP and maintain inflation stability, central bank increases money supply, which decreases interest rate, thus increasing investment and increasing aggregate demand. The AD curve shifts rightward until real GDP reaches potential GDP and inflation rate reaches target inflation rate. Thus, monetary policy stabilizes the economy.

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 lower at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).

When central bank increases money supply, AD1 shifts rightward until it reaches AD0, restoring long run equilibrium at point A.

(b)

Monetary policy can be destabilizing too, considering the time lags involved. If, for example, effect of monetary policy starts much after the right time, aggregate demand increases above full employment level, causing an inflationary gap. In following graph, AD1 shifts rightward to AD2, intersecting SRAS0 at point C with higher price level P2 and higher real GDP Y2, thus eliminating recessionary gap but causing an inflationary gap of (Y2 - Y0).