6.An economy is facing the inflationary gap shown in the accompanying diagram. T
ID: 1237977 • Letter: 6
Question
6.An economy is facing the inflationary gap shown in the accompanying diagram. To eliminate the gap, should the central bank use expansionary or contractionary monetary policy? How will the interest rate, investment spending, consumer spending, real GDP, and the aggregate price level change as monetary policy closes the inflationary gap?
7. In the economy of Eastlandia, the money market is initially in equilibrium when the economy begins to slide into a recession.
a.
Using the accompanying diagram, explain what will happen to the interest rate if the central bank of Eastlandia keeps the money supply constant at
b.
8. If the central bank is instead committed to maintaining an interest rate target of r1, then as the economy slides into recession, how should the central bank react? Using your diagram from part a, demonstrate the central bank
Explanation / Answer
The interest rate is the market clearing price that balances money supply (which we'll say is set by the central bank) and money demand, which is a function of income. As income falls, the demand for money at a given interest rate will also fall (the curve shifts down and to the left). This will cause the interest rate to decline. B. If the CB wants to keep the interest rate constant they would need to contract the money supply (shift that "curve" back as well) in order to cause the interest rate to increase back to its original value According to Phillips curve / nairu theory the CB could achieve this in the short run by lowering rates/increasing the money supply, but in the long run this would only generate inflation and the unemployment rate would return to 5%. Please keep in mind that this theory is way out of date and isn't the way current research things the economy actually works.
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