Question

Inflation in the country of Hypothetica is currently 5%, ABOVE the target range of its central bank

(1) In this situation, what is the central bank likely to do with regard to monetary policy? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer)

(2) What happens if the central bank does not intervene? Will the economy eventually return to long-run equilibrium (potential GDP)? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer).

Answer 1

( 1 )

Most of the central banks in the world have a target range for inflation in order to maintain stable price level in the economy. For example, Federal Reserve of the US has a target of 2% inflation rate, whereas Reserve Bank of India has a target of maintaining inflation at 4%.

Inflation is the sustained general increase in price level of the goods and services in the economy. It eats into incomes of the poor by bringing down the purchasing power of the people, especially poor and lower middle class who have less resources.

Whenever the inflation rate shoots up, the central bank decreases the amount of money supplied in the economy by increasing the interest rate which leads to fall in the demand for money which in turn brings down the price level of goods and services in the economy thereby bringing down inflation rate. Increasing interest rate by Central bank reduces spending, ‘cools’ the economy and reduces inflation, while reducing interest rates increases spending, ‘heats up’ the economy and increases inflation.”

( 2 )

If the central bank does not intervene then the workers and people in general would realize that their wages in real terms have fallen due to sustained rise price level and they would demand higher wages. Similarly many small businesses may fail due to higher cost of borrowing and increased wage cost. All this may lead to higher unemployment and fall in aggregate demand. In the long run the result of sustained high inflation would be more unemployed workers, and failing economy in terms of economic growth.