Question

Using simple equations, explain how an expansionary monetary policy by the central bank that did not translate into an improvement in aggregate output can trigger higher inflation in the economy.

Answer 1

Through expansionary monetary policy, the government takes measures to increases the money supply in the country in order to increase the aggregate demand.

Measures taken to increase the money supply are -

--> Reducing interest rate.

--> Buying government securities in open market

--> Reducing margin requirement.

--> Directing banks to give more loan.

--> Reducing statutory liquidity requirements, etc.

In other words more and more emphasis is given in order to increase the money supply in the country, and when the people have more money in their hands the demand increases. Therefore, with the increase in money supply aggregate demand will increase.

With the increase in aggregate demand if the aggregate supply/output increase there will be no change in price level of the economy and output, employment and income in the country will increase. But when the aggregate output can not be changed, with the increase in demand the price level in the country will increase. As the people will have more money to buy the goods(Their purchasing power will be more )their demand will be more and with same supply, it will push the the price upwards. Inflation in the country will rise.

AD Increase, No change in AS --> Price will increase.