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14) Suppose the AE curve is mis-measured such that the Central Bank under- estimates the effects of interest rates on expendi

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14. Central bank underestimates effect of interest rate on expenditure.

Supply shock implies fall in supply. To recover from this, CB adopts monetary expansion to reduce interest rates and to induce investment expenditure. But due to underestimation of responsiveness of expenditure to interest rate, it will end up doing over expansion of money supply.

Actual effect of over-expansion: Expansion of output and more inflation.

Ans (c) Expansion; inflation above target.

15. According to CB, natural rate = actual rate = 6%. No action taken.

Actual effect: Via phillips curve, higher current unemployment (6%) than natural (5%) means fall in inflation.

Ans (c) A decrease in inflation followed by an increase in the real interest rate.

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