Question

a. Discuss the adage that inflation is always and everywhere a monetary phenomenon. Ensure to show how AD and AS can be used to target higher and lower levels of inflation by Central Banks.

Answer 1

Inflation can be seen everywhere in economy as a monetary phenomenon. This inflation is produced by rapid increase in the quantity of money than total level of output. Change in money supply leads to the occurrence of inflation. If the money supply increased in the economy, the price level will increase and leads to inflation in the economy. The central bank has proper inflation targeting mechanisms to make a control over this. In AD-AS framework, the reduction in aggregate supply and rise in aggregate demand will fix the lower and higher rate of inflation. Higher interest rate in the economy will increase the cost of borrowing and this will reduce the level of investment also. This will reduce the aggregate demand and lower the level of inflation. The minimum aggregate demand will make the lowest rate of inflation. On the other hand, the monetary policy of the central bank will fix the highest inflation rate. Here the aggregate supply will remain a higher rate and fix the price level. This price fixation will maintain the level of inflation. AS' AS Price level P* P** AD AD Output Here P* is the higher inflation rate and p** is the lowest inflation rate. Both aggregate demand and aggregate supply will control the inflation and overall price level of the economy.