Question

Consider the fact that since 2015 till the end of 2017 the central bank of Russia managed to reduce the inflation rate drastically from 16%, keeping it within their target of 4%. Also, it has been noted that after two years of recession the economy started to grow in 2017. Some commentators viewed the decline in inflation as resulting from a deliberate policy of the central bank to be more aggressive in fighting inflation. Answer the following questions:

(i) How can the policy reaction function be used to analyse the action of the Russian central bank?

(ii) Using the AD-AS model outline the impact of the actions of the Russian central bank on the economy’s output in the short and long run.

Answer 1

(i) A central bank can decrease Inflation by lowering aggregate demand through a decrease in money supply. When money supply decreases, aggregate demand also decreases and AD curve shifts to left, which decreases price level and decreases real GDP.

(ii) A leftward shift in AD curve gives rise to a recessionary gap (negative output gap) in the short run, assuming the economy was initially at potential GDP level with long-run equilibrium. In long run, lower price level decreases input costs and production costs, so firms raise output. Short-run aggregate supply shifts to right, further lowering the price level and restoring real GDP to potential GDP.

In following graph, AD0, SRAS0 & LRAS0 are initial aggregate demand, short run aggregate supply & long-run aggregate supply curves intersecting at point A with initial equilibrium price level P0 and real GDP (equal to potential GDP) level Y0. When aggregate demand decreases, AD0 shifts to left from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, thus giving rise to a recessionary gap equal to (Y0 - Y1) in short run. In long run, when SRAS0 shifts right to SRAS1, it intersects AD1 at point C with still lower price level P2 (< P1 < P0) but real GDP increases back to the potential GDP level Y0, removing the recessionary gap.