Question

A central bank has a new head, who decides to raise the target inflation rate from 2 to 3 percent. Using a graph of the dynamic AD-AS model, show the effect of this change. What happens to the nominal interest rate immediately after the policy change and in the long run? Explain

Answer 1

The objective of the new head of the central bank is to increase the target inflation from 2% to 3%, and in the simplest of terms, inflation can be defined as the increase in prices of goods and services over time. To achieve this target inflation the head of the central bank will have to employ an expansionary monetary policy to induce higher levels of investment and consumption.

This increase can be attained by increasing the money supply in the economy. This will cause the money supply (MS) curve to shift to the right (MS1 -> MS2)increasing the quantity of money in the economy from Qe to Q1, causing the interest rates to fall from Ie to I1. A lower interest rate and will lead to increased borrowing and cause the consumption and investment to rise, which will lead to the aggregate demand (AD) shifting to the right (AD1 -> AD2), and this will increase the short-run output from Ye to Y1 and the price level will rise from Pe to P1.

However, in the long-run, the increased nominal wages will reduce the short-run aggregate supply and cause the SRAS curve to shift leftwards (SRAS1 -> SRAS2), therefore causing the output to shift back to initial equilibrium output Ye, and the price levels to increase further Pe2. Furthermore, over time, the increase in money supply will be met by an increased money demand (MD1 -> MD2) which will cause the interest rate to rise but with higher quantity of money in the economy.

a LRAS Pence levet | Nominal SRAS2 RSRAS, MS, Moe Interest rate 24 Pe MD 1 AD - MOI Yt Y Culput, GOP Qe Qe Quantity 아 Money