Question

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}

Answer 1

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.

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