Question

2. The Bank of Canada's analyst brings to the Bank's attention that there is a dispute between Russia and Saudi Arabia and they try to undermine each other's revenues by lowering the oil prices. The analyst suggests that the lower oil prices increase aggregate demand in Canada and we should expect an increased inflation rate. To achieve price stability, the Bank should reduce the money supply - and the expansionary gap will be eliminated and the price level will remain unchanged.

Is the analyst correct? Inspect this shock in the IS-LM-FE model. If you think the analyst is correct, explain how the proposed policy changes the curves and achieves the desired equilibrium (stable prices). If you think the analyst is incorrect, explain how the Bank should conduct its policy to achieve the desired equilibrium.

Answer 1

The Analsyt is correct in his assessment that, in order to contain the expansionary gap due to the increase in AD, the central bank needs to increase the money supply. Since the increased aggregate demand in the economy, given the aggregate supply can lead to increase in inflation in the economy, what needs to be done to contain this inflationary push is to reduce the amount of liquidity in the market. This can be achieved by adopting contractionary policy stance by the central bank, which will lead to reduction in the money supply.

If we analyse this from the IS LM Perspective,

In the money market, the reduction in money supply will shift the money supply curve to the left. Given the money demand, the decrease in the money supply will lead to increase in the rate of interest. This in turn will lead to leftward shift in the LM curve. The IS curve being constant, the decrease in the LM curve will lead to decrease in the level of income. Consequently in the AD - AS framework, when the rate of interest increases, due to the reduction in money supply, it will make the borrowings costly. This in turn will lead to decrease in the level of private investments. The Aggregate demand being composed of Consumption, investment, government expenditure and net exports, decrease in the level of investments will lead to decrease in the Aggegate demand. When the Aggregate demand decreases, given the level of aggregate supply, the inflationary gap will get contained.

If we analyse it from the perspective of Foreign exchange rate:

When the domestic rate of interest increases as compared to the foreign rate of interest, the exchange rate also increases, and the domestic currency appreciates. This is because, greater interest rates, will attract more foreign investors to increase the investments in the given country. This increased demand for investments in the country, will lead to increase in the demand of domestic currency, which in turn will lead to increase in the exchange rate as the currency appreaciates. Whereas when the domestic interest rates come down, the foreign investors will not be attracted to invest in the given country anymore, as a result they will sell the doemstic currency and mobilise their investments to foreign countries. This will reduce the demand for domestic currency which in turn will lead to decrease in the exchange rate as a result the currency depriciates.

In the present case, the decrease in money supply will lead to increase in the rate of interest which in turn will lead to increase in the foreign exchange rate. When the foreign exchnage rate increases, the exports will become costlier and the imports will become cheaper. Since the AD constitutes Net exports as well, the decrease in exports and increase in imports will reduce the Aggregate demand in the economy, thereby decreasing the levels of inflation.

The above picture depicts how the change in LM curve, shifts the exchange rate upwards. This in turn will reduce the level of income and given the multiplier effect , this will lead to decrease in the level of aggregate demand as well.