Question

In: Economics

Suppose that households and businesses increase autonomous expenditures, driving output well above potential. Describe, in detail,...

Suppose that households and businesses increase autonomous expenditures, driving output well above potential. Describe, in detail, how monetary policy might react to minimize the increase in inflation. Please not no graphs required just a full description. {10 Marks}

Solutions

Expert Solution

Households and business increases their consumption expenditures when they both have higher confidence about future economic outlook.

Aggregate Demand consists of Consumption (C), Investment (I), Government Expenditure (G) and Net Exports (X-M)

Household consumption expenditure increases C and Business expenditure increases I.

As a result, the Aggregate Demand in the economy rises so much so that it raises the output well beyond the potential level of output. This leads to a situation of INFLATIONARY or EXPANSIONARY GAP where the Actual Output > Potential Output.

At the current situation, economy is characterized by high output and high inflation

In order to control the high inflation, Central Bank conducts CONTRACTIONAY MONETARY POLICY. The goal of the bank is to reduce the aggregate demand till the point where the gap is closed.

Such policy will reduce the flow of money supply into the economy. This will reduce the income of the people and there purchasing power to buy goods and services. Gradually, they will start demanding less goods. This puts a downward pressure on the price and aggregate demand.

Aggregate Demand, therefore, reduces till the point where it meets the Long Run Aggregate Supply. At this point, the economy is at its full potential output and the prices are back to normal.

In this way, Central Bank uses Contractionary Monetary Policy to minimize the risk of inflation through reducing aggregate demand.

**if you liked the answer, then please upvote. Would be motivating for me. Thanks.


Related Solutions

Suppose government expenditures are decreased, taxes rise and the supply of money increase leaving output unchanged....
Suppose government expenditures are decreased, taxes rise and the supply of money increase leaving output unchanged. Using the IS-LM model explain the impacts of these policies on the level of interest rates and the level of investment spending
Stabilization Policy: Suppose the economy is initially above potential output. If policymakers prefer price stability and...
Stabilization Policy: Suppose the economy is initially above potential output. If policymakers prefer price stability and do not desire higher interest rates, what type of stabilization policy should it use and then briefly explain how that policy will impact the economy? Use an IS/LM graph and an aggregate demand graph to support your answer.
If real GDP is 1 percent above potential output and inflation is simultaneously 1 percent above...
If real GDP is 1 percent above potential output and inflation is simultaneously 1 percent above the target rate according to the Taylor rule a) What should the Central Bank do in the Open market? b) Should the Central Bank bank of Turkey announce an increase or fall in the interest rate? c) How would the Central Bank of Turkey's Balance Sheet change? d) What would be the impact of this policy change on output in SR(Shortrun) MR (Mediumrun) and...
15. Suppose there is an increase in autonomous consumption. • How would this shock impact a...
15. Suppose there is an increase in autonomous consumption. • How would this shock impact a standard classical model? Written discussion and graphs are both needed for full credit. Be sure to mention what happens to W P , Y, N, P, r, C, S, P rS, P uS Note: Assume that change in investment does not impact the capital stock. Expectations are as follows: • Capture the timing in your written discussion • If a curve shifts, explain why/economic...
Will an increase in an economy’s potential output, caused by supply-side policies, result in an increase...
Will an increase in an economy’s potential output, caused by supply-side policies, result in an increase in real output? (multiple choice) a) According to the monetarist/neo-classical school an increase in potential output always results in an increase in real output, but according to the Keynesian school an increase in potential output only increases real output if the economy is already producing close to full capacity. b) Yes, an increase in potential output always results in an increase in real output...
Accommodative vs. Non-accommodative Monetary Policy: Suppose the economy is initially at potential output. A rapid increase...
Accommodative vs. Non-accommodative Monetary Policy: Suppose the economy is initially at potential output. A rapid increase in energy prices then pushes up the price level. What are the advantages and disadvantages of using accommodative and nonaccommodative monetary policy? In your answer, state the short- and long-run impacts of each policy on the price level and output. Use an aggregate demand graph for each policy option to support your answer.
3. Suppose a country's output is above the policy makers' desired level of output and is...
3. Suppose a country's output is above the policy makers' desired level of output and is experiencing a trade deficit. Assume that the policy makers' goals are to achieve the desired level of output (i.e., natural level of output) and balanced trade. Suppose we do not consider the impact of expectations, answer the following questions. (Hint: using the ZZ and NX curves) . a) Is it possible to use fiscal policy to achieve these two goals simultaneously? What kind of...
1. Suppose financial markets initially view the debt loads of households and businesses of a domestic...
1. Suppose financial markets initially view the debt loads of households and businesses of a domestic country as reasonable. But then many of these households and businesses borrow a lot more and financial markets then view their debt loads as too high, meaning markets expect there will be lots of defaults by these over-indebted borrowers in the future. (a) What happens regarding the perceived financial risk in the domestic country? (b) Given the change in perceived risk, what happens to...
Using a diagram and written explanation explain the combined consequences of a increase in potential output...
Using a diagram and written explanation explain the combined consequences of a increase in potential output shcok and a positive inflation shock.
Suppose that a company's sales increase when the economy is doing well. Also, suppose that the...
Suppose that a company's sales increase when the economy is doing well. Also, suppose that the company's advertising budget is based upon the number of sales, and that larger sales lead to a larger advertising budget. A There is an association between how well the economy is doing and the company's advertising budget. B There is a causal relationship between the company's sales and the company's advertising budget. C Both of the above. D Neither of the above.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT