Question

1. Inflation in the country of Hypothetica is currently 5%, below the target range of its central bank.What does this tell you regarding Hypothetica’s likely output gap? Illustrate it using an AS-AD diagram, and briefly explain your diagram                  

In this situation, what is the central bank likely to do with regard to monetary policy? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer)      

What happens if the central bank does not intervene? Will the economy eventually return to long-run equilibrium (potential GDP)? Briefly explain your answer and state also what is likely to occur to the price level and output at the end of this process (there is no need to draw a diagram, but you can if you feel it helps you explain your answer).                                                                

Answer 1

(i)

Inflation is less than its target if the economy is in a recession, such that aggregate demand falls below long run equilibrium output. This creates a negative (recessionary) output gap.

In following graph, long-run equilibrium is at point A where initial aggregate demand (AD0) intersects initial short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0), with long-run equilibrium price level P0 and real GDP (= potential GDP) Y0. During recession, economy is at point B where aggregate demand lies to the left of LRAS0 at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).

(ii)

To increase aggregate demand and GDP, central bank increases aggregate demand by expansionary monetary policy (open market purchase of securities, decreasing discount rate or decreasing required reserve ratio). This will shift AD1 rightward to AD0, restoring long run equilibrium at point A.

(iii)

Without intervention in long run, lower price level reduces input costs which increases aggregate supply. SRAS0 will shift right to SRAS1, intersecting LRAS0 and AD1 at point C with further lower price level P2 and restoring real GDP to Y0.