Question

1.You hear a news report that both output and inflation are lower than expected. How would you expect the RBA to respond this contractionary situation? Explain step by step how its policy change is likely to affect the economy over time. Use the AD-AS diagram to illustrate your answer

2. Suppose instead the RBA now faces an expansionary output gap, but inflation is low and is not expected to rise. Briefly explain how that would affect its decision on monetary policy?

Answer 1

The situation is presented in the following diagram:

Initially, the economy is in the short run equilibrium at point A where the SRAS and AD1 are equal. Both price and equilibrium output than their long run levels. In order to eliminate this gap, the bank would try and stimulate the aggregate demand in the economy so as to shift the AD curve rightward to AD2 where equilibrium output is equal to the long run level. The demand in the economy can be increase by adopting expansionary monetary policies like increasing money supply which decreases interest rate and increases investment expenditure in the economy.