Question

b) Inflation in the country of Hypothetica is currently 5%, below the target range of its central bank.

(i).What does this tell you regarding Hypothetica’s likely output gap? Illustrate it using an AS-AD diagram, and briefly explain your diagram (draw)?

(ii) In this situation, what is the central bank likely to do with regard to monetary policy? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (draw and explain your diagram)?

(iii) What happens if the central bank does not intervene? Will the economy eventually return to long-run equilibrium (potential GDP)? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (draw a diagram, it helps you explain your answer)

Answer 1

Answer (i) The economy is operating at recessionary gap, a situation which occurs when the actual GDP is less than potential GDP.

In the above diagram, we can see that the actual GDP is less than the potential GDP and this leads to the situation of recessionary gap. Here, the vertical line represents the long run aggregate supply curve.

The equilibrium occurs where the short run aggregate supply curve and aggregate demand intersect.

(ii)

In this situation, central bank is going to increase the money supply, which would lead to the increase in the aggregate demand and the aggregate demand woul shift towards the right leading to the increase in the price level and output as can be seen in the below diagram.

(iii)

Even if there is no government intervention, the economy would self correct and mve back to the potential GDP point.

In a recesionary gap, the nominal wages would fall due to unemployment and this would shift the short run aggregate supply curve towards the right leading to the decrease in price level.