Question

3. One of Argentina's priorities should be to fight inflation said the International Monetary Fund (IMF) in a report. The inflation rate fluctuates around 24%. Propose what the central bank of Argentina could do to fight inflation. Use the economic models and graphs to support your answer.

Answer 1

Central bank should decrease money supply to decrease aggregate demand. Money supply can be reduced by selling government securities in open market, or by increasing required reserve ration or by increasing discount/bank rate.

Fall in money supply will shift money supply curve leftward, increasing interest rate and decreasing quantity of money.

In following graph, MD0 and MS0 are initial money demand and supply curves intersecting at point A with initial interest rate r0 and quantity of money Q0. As money supply falls, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money Q1.

Higher interest rate lowers consumption and investment, decreasing aggregate demand, shifting AD curve leftward, which decreases real GDP and decreases price level, lowering inflation.

In following graph, AD0 and SRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As aggregate demand falls, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.