Question

In: Economics

Suppose that the Central Bank follows a monetary policy rule as discussed in the textbook and...

Suppose that the Central Bank follows a monetary policy rule as discussed in the textbook and lectures. The country is in the long-run macroeconomic equilibrium. Suppose that in period 1 the country experiences a 3% inflation shock that lasts only for one period, so in periods 2, 3, and so on there is no inflation shock.

1. What happens to inflation and output in period 1? Does inflation rise by more or by less than 3%? (Use the AD-AS framework to figure out the answer.)

2. Now, what will happen to inflation in period 2,3, and so on. ( again use AD-AS to find the answer)

Assume the following for parts c and d. The governors of the Central Bank change their monetary policy rule as follows: . Note that it=r+πt is the nominal interest rate.

3. Derive the new AD curve. how does the short-run respond to inflation along the AD curve. ( hint: first find the MP rule in real terms)

4. redo parts a and b with the new AD curve. how will the economy respond to a one-time inflation shock.

Expert Solution

1)

inflation rises by 3% from 0% to 3% which cause upward shift in aggregate supply curve from SRAS₀ TO SRAS₁ which cause decrease in output from Y* to Y' equilibrium shift from point A to point B.

2)

in period 2-3 inflation decreases from ₁ to ₂ and aggregate supply curve shift rightward from AS₁ to AS₂ and output increases from Y₁ to Y₂ and equilibrium shift from C to B.

3) fixed monetary rule, which states that the Fed should be required to target the growth rate of money to equal the growth rate of real GDP, leaving the price level unchanged.

The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP). In addition, the increase in the money supply will lead to an increase in consumer spending. This increase will shift the aggregate demand curve to the right.

central bank increase money supply equals to output which cause right shift in aggregate demand curve with same inflation rate causing shift in new equilibrium from B to C.

4)a) one time inflation shock with new AD curve does not change output and price level only shift equilibrium upward as shown in question 3.

b)

with new AD curve in period 2,3 AS curve shift leftward at output level Y at initial output causing decrease in inflation level as shown in diagram.

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Rahul Sunny answered 2 years ago

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