Question

You are the new leader of Egypt’s central bank. Egypt has been experiencing high inflation, and your task is to reduce that inflation rate.

a.     What policy actions can your central bank take to reduce inflation? (3 points)

b.     In a well-labeled graph, show how your policy actions affect the trade-off between inflation and unemployment in the short and long run. (5 points)

c.     Explain how inflation and unemployment change over time as a result of your policy actions (3 points).

Answer 1

a. According to Monetarists, Inflationary level means economy is producing more than potential During an inflationary level, govt. can adopt contractionary fiscal policy(Raising tax rates and decreasing govt. spending) and central bank can have contractionary monetary policy ( raising interest rates and lowering money supply ).

b. As shown below. Inflationary gap shows that economy is producing at Ye which is more than its potential Yf. Average price levels have gone up from Pf to PLe. Increasing interest rates and reducing money supply will shift this AD2 to AD1 and economy may achieve its potential reducing economic pressures.

trade-off between inflation and unemployment in the short and long run.

It is clear that at output Ye more jobs will be produced in the short run and average price levels will be higher. Hence higher inflation is compensated by more jobs in an economy. However, in the long run output comes back to equilibrium as extra economic activity during inflationary gap leads to more wages and other costs of production t go up and firms will shift aggregate supply to left(decrease aggregate supply ). This may create additional inflation but economy will come back to potential. For further clarity student can refer to Philips Curve.

c.

As explained in part a. contractionary monetary policy is implemented during inflationary gap.Higher interest rates and less money supply. This may decrease purchasing power and in the short run may control inflation but people may lose jobs as aggregate demand goes down In the long run as discussed in part b.