Question

7. If inflation is significantly above the target and real output growing steadily above trend, the Central Bank should conduct a monetary policy consisting of:

A) lowering official policy interest rates, to increase reserves held by banks, lower overall interest rates, and accelerate Aggregate Demand.

B) increasing official interest rates, to decrease reserves held by banks, increase overall interest rates and decelerate Aggregate Demand.

C) increasing official interest rates, to decrease reserves held by banks, increase overall interest rates and accelerate Aggregate Demand.

D) lowering official policy interest rates, to increase reserves held by banks, lower overall interest rates, and decelerate Aggregate Demand.

Answer 1

The correct answer is (B) increasing official interest rates, to decrease reserves held by banks, increase overall interest rates and decelerate Aggregate Demand.

As inflation is significantly above the target and real output growing steadily above trend, the Central Bank should conduct that policy in which they decrease Aggregate Demand in order to decrease Price level and Aggregate demand decreases means AD will shift to the Left and Result in decrease in Price level. Hence Lets see how can central Bank uses Monetary Policy to shift AD to the left.

In order to shift AD to the left, Central Bank should increase official interest rate and decrease Money Supply. There is direct relation between Money Supply and Monetary Base which includes reserves. Hence, Central Bank Monetary Policy must consist of Decreasing Reserves so that Money supply decreases and LM shifts to the Left which results in increase in overall interest and hence further Results in decrease in Investment and Hence, decelerate Aggregate Demand.

Hence, the correct answer is (B) increasing official interest rates, to decrease reserves held by banks, increase overall interest rates and decelerate Aggregate Demand.