Question

a. How do central banks engage in stabilization policy? Describe the tools, targets, and goals of such policies.

b. Suppose that the central bank wishes to raise its inflation target. Show the effects that doing so would have on the monetary policy reaction curve, and on aggregate demand and supply, assuming you start in long-run equilibrium.

Answer 1

Central bank

1. Central bank’s engagement in stabilizing policy

When the Central bank issues more paper notes or increases the volume of credit in the economy, the supply of money increases. When it draws paper notes out of circulation or reduces the volume of credit, the supply of money decreases. It is by changing the supply of money that Central bank tries to stabilize the value of money. When there is inflation the Central bank tries to control it by reducing money supply. When there is deflation, the Central bank controls it by increasing money supply. Stabilizing the value of money means stabilizing the price level.

Tools, targets and goals of stabilizing policy:

1. Short term political pressures
2. Distort monetary policy decision
3. Emphasis on economic activity at the cost of long term objectives
4. Economic distortions causing inefficiencies to create systematic bias towards policies
5. Encouraging savings
6. Mobilization of saving for investment
7. Acting as channels of governmental monetary policies
8. Raising the rate of economic growth

2. At times of great inflation, the Central bank may identify the commodities whose prices are rising faster than the prices of other commodities. Specially credit cuts may be affected in the case of such inflation prone commodities. Similarly, in a society which gives importance to the upliftment of the poor and the down trodden the central bank may wish to ensure the flow of credit to those industries which would benefit the poor.