Deck 16: Inflation and Monetary Policy

Question 1

Suppose that a law required the Fed to do everything possible to keep the inflation rate equal to zero. Using AD and AS curves, illustrate and explain how the Fed would deal with (a) a negative demand shock from a decrease in investment spending and (b) an adverse aggregate supply shock. What would be costs and benefits of such a law?

Answer 1

a) The Fed would increase the money supply to neutralize the effects of a negative demand shock. Increase in money supply would lead to a decline in the interest rate, which would attract investors to invest more money. So, the investment spending would increase. As a result of this increase, the AD curve would shift to the right. The above figure shows the changes in aggregate demand and supply with respect to changes in the fed policies. As it can be seen, the overall output of the economy increases with no change in the price level or inflation.
b) An increase in the money supply causes an inflation to rise. A rising inflation is always harmful for the economy in long term. As a result of a supply shock, the Fed would decrease investment spending in the economy so as to reduce the AD in the economy, shifting the curve to the left. This can be seen as below: The costs and benefits of such a law would be:
Costs:
Constant government intervention
Fluctuating price levels in the economy
Benefits:
Economy would remain at a stable level

Question 2

Suppose that, in a world with no ongoing inflation, the government raises taxes. Using AD and AS curves, describe the effects on the economy if the Fed decides to keep the money supply constant. Alternatively, how could the Fed use active policy to neutralize the demand shock?

Answer 2

An increase in taxes leads to a decline in the spending. Profitability of the entrepreneurs tends to decline due to hike in the taxes. The personal disposable income of the individuals declines due to an increase in the taxes. This would cause a leftward shift in the aggregate demand curve.
The following is a graphical representation of the aggregate demand and supply curve. The above figure indicates leftward shift in the aggregate demand curve. Thus, demand shock occurs in the economy due to an increase in the taxes.
The Fed should increase the money supply if it wants neutralize the demand shock. An increase in the money supply would help to lower the rate of interest.
Reduction in the rate of interest causes a rise in the investment spending. An increase in the investment spending helps to increase the aggregate demand.

Question 3

Suppose that, initially, the price level is P 1 and GDP is Y 1 , with no built-in inflation. The Fed reacts to a negative demand shock by neutralizing it. The next time the Fed receives data on GDP and the price level, it finds that the price level is above P 1 and GDP is above Y 1. Give a possible explanation for this finding.

Answer 3

The fed increases the money supply for neutralizing the negative demand shock. An increase in the money supply leads to a rise in the employment level. An increase in the employment level causes a rise in the real GDP.
Consumption expenditure tends to decline due to a rise in the employment level. Rise in the consumption expenditure leads to an increase in the aggregate demand.
Thus, the GDP and price level tends to rise due to initial increment in employment level and investment spending.

Question 4

Suppose the economy has been experiencing a low inflation rate. A new chair of the Federal Reserve is named, and he or she is known to be sympathetic to dove policies. Explain the possible effects on the Phillips curve.

Question 5

"The idea of the Fed having to choose between hawk and dove policies in Figure 5 is silly. All the Fed has to do is shift the AS curve back to its original position, which would prevent both recession and inflation." Do you agree? Why or why not?

Question 6

Using a graph similar to Figure 9, and some additional curves, show what would happen in the future if the Fed tried to keep the unemployment rate permanently at a level like U2-below the natural rate.
Reference:

Question 7

Suppose the economy is experiencing ongoing inflation. The Fed wants to reduce expected inflation, so it announces that in the future it will tolerate less inflation. How does the Fed's credibility affect the success of the reduction? How can the Fed build its credibility? Are there costs to building credibility? If so, what are they?

Question 8

This chapter mentioned what would happen if the Fed over- or underestimated the natural rate of unemployment. Using the AD-AS model, suppose the economy is at the true natural rate of unemployment, so that GDP is at its potential level. Suppose, too, that the Fed wrongly believes that the natural rate of unemployment is higher (potential GDP is lower) and acts to bring the economy back to its supposed potential. What will the Fed do? What will happen in the short run? If the Fed continues to maintain output below potential, what will happen over the long run?