Question

Suppose the central bank is following a constant-money-growth-rate rule and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show the possible effects on the economy. How does this situation reflect on the credibility of the central bank if it maintains the money growth rule? How does it reflect on the central bank’s credibility if it abandons the money growth rule to respond to the downturn?

Answer 1

A severe downturn would result in the aggregate demand curve shifting sharply to the left to AD2 below. With a strict constant money growth rule, this would result in a limited expansionary effect on aggregate demand, shifting aggregate demand back to AD3. However, this would be inadequate to fully stabilize output, and a recessionary condition would still persist. This could reflect poorly on the central bank in the sense that, by failing to stabilize output, it may be viewed by the public as not doing its job. The central bank could abandon the constant money growth rule and expand aggregate demand enough to move the economy back to potential output (at AD1), however this would be moving away from a rules-based policy, which helps keep credibility high and inflation expectations low, to a more discretionary framework in which credibility would be lower and inflation expectations higher.