Question

Complete both parts of this question. Both the Federal Reserve in the United States and the European Central Bank monitor growth in the money supply over time, but use nominal interest rates to implement monetary policy. Provide an example of a situation in which these two approaches to targeting require different central bank responses. Provide an example in which these two approaches are compatible. 
[Hint: prices are sticky in the short run, so expected inflation and actual inflation may differ.]

Consider a country that has experienced a hyperinflation. In general, countries with higher inflation rates tend to have less stability in the inflation rate, making it difficult to forecast. If this country wants to reduce its inflation rate, state which of the following monetary regimes is least likely to succeed: exchange rate target, money supply target, nominal interest rate policy. 
Which approach is most likely to succeed? Explain.

Answer 1

Change in money supply :-

Inflation occurs when an economy grows due to increased spending . Thus government can control inflation by calling of debts owned by government .This will decrease the money supply in the economy.

Now in the first figure the supply decreases from SS to S1S1 , automatically shifting the demand from DD to D1D1 in long lun .

However in short run the Price falls to P1 thus reducing the inflation.

Change in interest rates :-

Another method to control inflation is to increase the interest rates .When the government increase the interest rates , fewer people want to borrow money as the cost of borrowing becomes expensive . So the consumer spending drops , thus price drops which reduces the inflation.

In the second figure ,the increase in r1 to r2 , tends to shift IS curve from IS1 to IS2

Change in exchange rate :-

When there is an increase in interest rates tend to attract foreign investment which tends to increase the demand for that countries currency. This makes dollar more expensive .This means more currency is required to buy dollars . Thus increase in interest rate leads to increase in exchange rates .

Effect of the policy on inflation :-

These policies are contradictory policies which are very effective to reduce the inflation rates .

They helps to regulate spending , consumption, saving, investment and exchange rate .