Question

Suppose a central bank targets an inflation rate of 3%. She projects a long-term economic growth rate of 4%.

a. Using Classical Theories, suggest an appropriate long-term monetary policy. State the essential assumptions. (4 marks)

b. Suppose a new Chairman of the central bank will assume his duty next year. He is widely expected to be a “monetary hawk” – he favors a “tighter” growth in the money supply. Other things being constant, how would this affect the expected inflation rate, nominal interest rate, and the current general price level? Using relevant Classical Theories, briefly explain your answers. (6 marks)

Answer 1

Solution : Giren , Central bank targets an inflation rate = 34. projects an long term economic growth rate = 44. @ using classical theories appropriate long term monetary policy is: - monetary policy is that policy of the government which Corrects the situations of excess and deficient demand by regulating interest rates and availinility of credit in the economy. contractionary components: centeral bank should follow monetary policy of its main aim in this case is to keep inflation in control: Central bank con howeves buy seasities as a part of open tiquidity in the market operations to increase

market if it feels that there is not enough liquidity and is affecting aggregate demand in an eanomy. O Effect on expected inflation rate, nominal interest gate, and ciment generalkrice : - loose monetary policy will mean expansionary monetary policy in which interest rates are kept low and money supply is increased. . This will gefult in to increase in aggregate demand and hence average phie levels may go op Chence in create in inflation), if there is spare capacity in firms then this inflationary pressure will not be very high. expected to go down as part Nominal interest rate is of loose monetary policy and as result real interest inflation rate) Willgo rates (nominal interest rate down as inflation increases.