Question

Consider a third world economy where agriculture plays a key role. Suppose there is poor
harvest in a particular year for most crops. What should the central bank do? [Hint: Use the IS
curve and the Phillips curve to analyze this problem]

Answer 1

Thrid world economy all over the world is majorly dependent on the agricultural sector, not necessarily because it contributes majorly in the GDP of economy, but because it engages most of the population . The reason for this is lack of training , poverty , low technological growth etc.

Agricultural sector is majorly very unpredictable and is dependent on conditions which are mostly out of human control like weather . This results in high vulnerability of labour employed in the sector as well.

Suppose , due to some factors like flood (example), the harvest is spoiled and causes a sudden increase in the rate of unemployment.

This is the state of the economy at point A , in the attached diagram . The govt. Tries to cover up the loss by implementing an expansionary fiscal policy , which essentially is increasing the aggregate demand in economy with the help of spending done by the govt or reduction of taxes. This shifts the economy from point A to point B.

It can be noted that this incresed spending of economy also causes rate of unemployment to reduce back to natural rate of unemployment , if fiscal policy is enough to bring back the economy to that point Un. The other effects were rising inflation and even rate of interest in the economy.