Question

Draw the full short- run model graph (IS/MP and the corresponding Phillips Curve).  You must fully label all axis with both symbols and verbally. (for example  (symbol) is inflation (verbal)).  Start the economy at full employment with inflation equal to the central bank target (2%) and label that point "A".

Then, assume the central bank decides to lower interest rates to boost employment.  Demonstrate how this influences the short-run model (shift appropriate curves and show a move along appropriate curves). Label the new short run equilibrium point B.  

Discuss how this will influences the output gap, unemployment, the change in inflation (is it positive or negative), AND the inflation rate itself (does it rise or fall, and how do you know). You must fully explain how interest rates cause a change in the output gap (think of what is included in the IS equation - which part responds to R?).

Are there any negative consequences to this action? Explain.

Answer 1

Central Bank will decrease the level of interest by increasing money supply in the economy. This increase in the money supply will shift the LM curve of the economy rightwards to LM' and new equilibrium shifts from point A to point B where rate of interest has decreased and national output has increased. In the Philips curve diagram below, there is movement from point A to point B, because increase in national output increases production and demand for labor which reduces unemployment rate in the economy and increases inflation rate. Thus, the above change causes inflationary gap in the economy.

Since the economy is at full employment level, the above change will only lead to incrase in inflation rate in the economy in the long run and no change in the level of Real GDP in the economy. Thus, increase in money supply only causes inflation in the economy.