Question

This question has been answered, but parts e-g were not included in the answer.

1. The Dragonville’s economy is currently experiencing an inflationary gap. The country’s central bank is determined to help alleviate the problem.

1. Draw a correctly labeled aggregate demand-aggregate supply graph that illustrates Dragonville’s current economy.

2. Name one action that the Dragonville central bank could take to alleviate the economy’s problem.

3. Assume that the central bank enacts one of your policies above. Draw a correctly labeled money market graph showing the impact of the policy. Determine what happens to the following.

(i)Money Supply

(ii) Interest Rates

4. Indicate whether the interest rate you identified in c(ii) is a real or nominal rate.

5. Under what condition will the nominal interest rate differ from the real interest rate?

6. On your graph in part (a) show the short-run effect of the central bank’s policy on Dragonville’s economy.

7. On a correctly labeled graph of the Phillips curve, show how the open-market operation will affect the following in the short run.
   1. Unemployment rate
   2. Inflation rate

Answer 1

e)When the rate of inflation is zero, the real interest rate is equal to nominal interest rate.When there is positive inflation in the economy the real interest rate is higher than the nominal interest rate. The real interest rate is actually the nominal interest rate with the inflation.

f) When real GDP is greater than potential GDP , there is inflationary gap in the economy.In the diagram1 the inflationary gap is Y1-Yp where Y1 is real GDP and Yp is potential GDP.In diagram 2, If AD increase as a result of increase in government purchase,the AD will shift from AD1 to AD2.As a result price will go up to P2 and real GDP to Y2.Thus an inflationary gap is created which is Y2 -Y1 .Here real GDP is higher than potential GDP and so there will be tendency for prices to rise further.Nominal wage will rise as workers try to restore their original purchasing power.Nominal wage will rise as long as there is inflationary gap and the short run AS will shift to the left. As a result real GDP will become less.and inflationary gap will begin to close . When SRAS1 reaches SRAS2 the inflationary gap will close and the economy will haveits real GDP move to potential output and there will be natural level of employment.

g)Through open market operation the central bank changes bank reserves in a way which affects the supply curve of loanable funds.As a result interest rates change. The original equilibrium is at E and and expansionary monetary policy will shift supply curve to the right reducing the interest rate and contractionary policy will shift supply curve to the left increasing interest rate.If an economy is producing at a quantity above its potential GDP ,a contractionary monetary policy will reduce inflationary pressure. By raising interest rate ,borrowing will be discouraged and investment and spending will falland AD will shift to the left. When recession causes unemployment to increase the central bank should follow expansionary monetary policy.An expansionary monetary policy will reduce interest rate and stimulate investment and employment will increase. AD will shift to the right.