Question

Assume households and firms become optimistic about the economy and increase autonomous consumption and investment. Please explain how a central bank should respond to this event? Will the response differ if the central banks’ mandate imposes a strict inflation target? Explain your answer in words and with a graph based on the AS-AD model.
a)

Answer 1

Since here consumers or households are highly optimistic about the future. So they raise the level of their autonomous consumption and expenditure. thus, it will drag up aggregate demand in the economy. A rise in Aggregate demand will establish equilibrium at a higher level corresponding to a higher level of output. But output might not rise if the economy is already operating at full employment level.

Following is a diagram:

• In the above diagram, autonomous rise in the expenditure shifts the AD to AD1 thereby causing rise in GDP.
• Now a question arises, how does the Central bank or Fed will respond to such incidents.
• Fed will not respond by following the contractionary monetary policy if the economy operates below the full employment. Fed will go with a contractionary monetary policy if the economy is already at full employment.

Furthermore, if the Fed is following inflation targeting, then it will see the current inflation and targeted inflation, so accordingly actions would be taken.