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 will reduce Inflation by reduction of aggregate demand via a reduction in money supply. When money supply is reduced, aggregate demand falls, shifting AD curve left, leading to a fall in both price level (thus reducing inflation) and real GDP. This policy measure is a contractionary monetary policy, aiming at lowering inflation rate.

(ii) A left shift in AD curve leads to a negative output gap in the short run, provided the economy was initially at long-run equilibrium. But in long run, reduced inflation rate lowers input costs and so, lowers production costs, therefore firms increase production. Aggregate supply rises and short-run aggregate supply shifts right, further lowering the price level and restoring real GDP to full-employment 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 full-employment GDP) level Y0. When aggregate demand falls, AD0 shifts to left to AD1, intersecting SRAS0 at point B with reduced price level P1 and reduced real GDP Y1, as a result leading to a negative output gap equal to (Y0 - Y1) in short run. In long run, when SRAS0 shifts right to SRAS1, it intersects AD1 at point C with further lower price level P2 and real GDP increases back to the full-employment GDP level Y0, and the negative output gap is eliminated.