Assume a central bank has been charged with maintaining the price level at a rate of 2 per cent. For the past twelve months the inflation rate has been at target and interest rates have been stable but the government has been concerned over signs of a slowdown in economic activity. As a result the government has decided to increase its spending on infrastructure projects. If the central bank wishes to maintain interest rates (and inflation) at a stable rate what should it do in the light if this decision?
A) Nothing as changes in government spending on infrastructure does not affect consumer price inflation.
B) Expand the money supply to maintain interest rates at a level consistent with its forecast of consumer price inflation.
C) Reduce the money supply by an equal amount to counteract the increase in government spending.
D) Persuade the government that any additional spending must be financed purely by taxation so that monetary policy does not have to change.

Question

Quizplus · Accepted Answer

An increase in government spending on infrastructure projects will increase aggregate demand, potentially leading to inflation if left unchecked. To maintain interest rates and inflation at a stable rate, the central bank should expand the money supply to offset the increase in government spending and keep aggregate demand stable. This can be achieved through open market operations or changes to reserve requirements. Choices A, C, and D are incorrect as they do not address the potential inflationary impact of increased government spending on aggregate demand.

Assume a Central Bank Has Been Charged with Maintaining the Price