Question

If the economy is experiencing 10% inflation rate and a 1% unemployment rate:

a. Illustrate the initial condition. That means show the gap on an aggregate demand aggregate/supply graph.

b. What specific monetary policy is appropriate according to Keynesian economists? Explain the link from interest rates to aggregate demand carefully. (See figure 16.4, pages 340-341)

c. What would be the result of this action?

d. what problems could complicate this process?

Answer 1

1. Inflation means a rise in the general price level which is noticeable for a long period of time and which is caused by the market forces of demand and supply—on the demand side it can be situation of excess demand over the existing available stock of goods and services, on the supply side the rise in the inputs needed for production process may lead to a rise in the prices of the product and result in a cost-push spiral.

Inflation measured in percentage shows different levels of price rise , while an inflation of 1-3% can be considered as a positive sign for economic growth, a hyper inflation of the double digit nature –10% or more is considered an unhealthy trend and is a warning signal that the inflation requires immediate ‘controlling’ action to be initiated by the government.

An unemployment rate of 1 % means that there is full employment in the economy ( according to Keynesian approach). Hence any further rise in demand cannot be met by the existing resources since they are all employed, this results in aggregate demand pulling up the price levels with no corresponding increase in the supply or aggregate output. This however cannot be corrected quickly in the short run, a time period which is limited by available resources, however in the long run output is expected to expand to meet the existing demand and the price will stabilise.

In the diagram given below, consumption expenditure has been taken on the y-axis and (national ) income on the x-axis. The AS curve starts from the origin as the Suppliers believe that as income rises the proportion of consumption expenditure will also rise in the same proportion, however, the AD curve –or the aggregate demand curve is not shown as rising in proportion to rose in income, people save and invest, rather spend their entire income on consumption hence the shape of the curve.

Initially AD intersects AS at point ‘E’, which represents the macroeconomic full employment equilibrium. At this point OYf is the output which represents the full employment level of output.

Suppose aggregate demand curve shifts upward to AD1 , the output will not rise corresponding to rise in demand since the economy is already operating at full employment level of output. This causes excess demand—a gap is created which is the difference between the actual aggregate demand and the aggregate supply ( at this full employment level), this gap is called ‘inflationary gap’. In the diagram it is depicted by ‘IE’, portion of the graph. As the consumption expenditure rises from A to B on the Y axis, the rise in demand not matched by rise in output leads to inflation and a gap is created in the market .

It may be caused h a rise in the consumption expenditure of house hold, rise firms investment expenditure   and so on.

2. According to Keynes, the suitable monetary policy ( meaning the policy of the central bank of the country) , would be :

1. Bank rate : The central bank can control the rate at which it lends to commercial banks and rediscounts the first class bills of exchange that they present to the central bank in order to gain credit from it. The central bank increases the bank rate, this leads to a spiralling effect of rise in the interest rates of loans that commercial banks lend to their customers. Since now, the cost of credit is more , the amount of borrowings would be reduced , this will lead to a fall in the consumption expenditure or aggregate demand .
2. Open market operations: The central bank sells securities and bonds in the open market in order to control the situation of excess demand.

Automatically, it will reduce the cash available with the banks as many customers would withdraw money in order to but the shares and bonds. It has to borne in mind that people are prone to speculation at the ‘peak’ of economic or business cycles.

Hence , a reduction in cash holdings with the commercial banks will force them to reduce their lending activities—leading to fall in aggregate demand, as the rate bon interest on loans will rise due to scarcity of funds.

3. Cash reserve ratio : Commercial banks are required to keep a ratio (decided by the central bank) of their deposits with the central bank. The central bank raises this ratio in situations of excess demand such that the commercial banks have to maintain more reserves with the central bank. This reduces the lending power of the commercial banks thereby reducing the consumption expenditure . since the rate of borrowing will be increase, at higher interest rates, the borrowers might not feel positive about borrowing and hence may reduce their demand for credit as well as their consumption expenditure.

3. The consequence of monetary policy would be that the excess of consumption and investment expenditure ( also consider a rise in exports and money supply circulating in the economy ) would be gradually controlled . The objective of the monetary policy is achieved.

It should be noted that the objective of the monetary policy is to control the money supply , since a high rate of inflation could effectively reduce the value of money though accelerating the circulation of ,money in the economy. This is ultimately resorted to in order to achieve ‘economic stability ‘, which is one of the economic policy.

4. The central bank’s power to efficiently foresee the consequences of its ‘tight monetary policy’ action could not be accurate. Its hold on the money supply circulating in the economy maybe much lesser than it anticipates and hence people might speculate even at high interest rates.

The commercial banks may resort to reckless lending (in spite of central banks’ action) since they may be more allured at the prospects of higher interest rates leading to higher profits. The increase in aggregate demand acts as an incentive for them.

Further more , a rise in government spending which could have led to a rise in aggregate demand, may not have been followed by a rise in taxes, which is a part of the fiscal measure to be taken by the government. This could lead to a situation of people having more disposable income in their hands and hence the aggregate  expenditure rises, in spite of monetary restrictions placed.

A rise in exports, leads to an increase in the inflow of money from the foreign sector, this could also aggravate the situation.