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, including appropriate diagrams:

1. 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

(1) Inflation rate can be reduced if Central Bank lowers money supply. As money supply falls, aggregate demand falls, shifting AD curve leftward, lowering both price level and real GDP and creating a recessionary gap in the short run, assuming the economy was operating at full-employment level initially. However, in the long run, lower price level lowers the cost of inputs, so firms increase production and output. Short-run aggregate supply shifts rightward, further decreasing price level but restoring real GDP to its full-employment level.

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 price level P0 and real GDP (= potential GDP) Y0. As aggregate demand falls, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, creating recessionary gap equal to (Y0 - Y1) in short run. However, as SRAS0 shifts right to SRAS1 in long run, it intersects AD1 at point C with further lower price level P2 but real GDP being restored at potential GDP of Y0, eliminating recessionary gap.