Question

Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country’s central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

Answer 1

When it comes to the effects of Central Bank on the economy, it can be well said that it depends upon the credibility and credentials of the Bank Itself. This is because the change in interest rates cannot be forced upon the commercial banks but is rather expected in nature.

The Federal Bank uses tools such as increasing the minimum requirement, purchasing bonds or increasing or decreasing interest rates for commercial banks, however it is up to the commercial banks if they pass the benefit to the consumers or not.

If the federal bank lacks credentials, it would be tougher for it to be able to regulate the market, as commercial banks would take additional time to think upon its decisions.

This can be explained in the form of a diagram which is as follows:-

Here, if we assume that both the economies were at AD1 as a recession struck, then the movement from AD1 to AD2 indicating an increase in Real GDP would be indicated for the country which has a weaker Central Bank. On the other hand the shift would be from AD1 to AD3 for a country which has a stronger Central Bank.

This is because the degree at which commercial banks respond to the central bank is higher and the credibility would lead to to prices rising and aggregate demand rising much faster in the economy,

Please feel free to ask your doubts in the comments section if any.