Question

Suppose that, in country of Wonderland, the inflation is at a relatively high level and its

unemployment rate is at a historic low. At the same time, a low interest rate environment

is spurring businesses to hire more workers and invest in new facilities.

1) Why might the central bank of Wonderland be worried about these

developments?

2) Given the circumstances, what would countercyclical monetary policy seek

to accomplish? Explain at least two mechanisms that the central bank can use to

implement this policy.

3) Based on your answers to part 1) and 2), do you think this countercyclical

policy would be enacted if central bankers were appointed by popular vote? What

would happen if they were political appointees that could be hired and fired by the

President of Wonderland? Explain.

Answer 1

The inflation rate is high and unemployment rate is low, meaning more number of people are employed in the country which has increased the demand for goods and services, thus increasing inflation rate. Interest rates are low.

1) The central bank might be worried about these developments because the inflation rate being high, could devastate the economy as the nominal output would grow but not the real output in the economy. The value of the local currency could decline, which would make people buy less of goods as they are unable to afford because of higher inflation, this could ultimately lead to a scenario where there is stagflation as because of the high prices, people will start asking for higher wages which could increase unemployment rate as companies wouldn't be able to afford the high wages.

2) Thus countercyclical monetary policy would seek to increase the interest rates as the money supply in the economy will start to decline because people will start to put their money into banks as they are earning a higher interest rates, instead of spending it on goods and services, this will lead to decline in inflation as demand for goods and services starts to reduce. On the other hand the central bank can also sell bonds, wherein the common public buys the bonds issued by the central bank and the money is pulled bank into the banking system, which reduces the money supply and inflationary pressure in the economy.

3) Yes, the policy could be enacted if central bankers were appointed by popular vote as they have a mandate to keep the inflation rate within permissible levels. If they were hired and fired at the will of the President, than it could be disastrous as there are political parties which try to intervene in the day to day activities, by not necessarily behaving according to the rule book, which dents the chances of the central bankers behaving effectively to address macroeconomic concerns. Thus there would be an impact on the macroeconomic environment, wherein inflation is not contained.