Question

Beginning in 2022 central banks around the world began to respond to increasing inflation rates by increasing their policy interest rates. This problem explores the reasons for these policy decisions and the expected results. (a) Using an AD-AS diagram, explain two potential causes of inflation above target if we assume target inflation is associated with long-run macroeconomic equilibrium.

Explain the effects of the decision on interest rates and how the central banks must respond to support this policy decision. [Hint: Use a diagram for the money market, make sure to discuss the adjustment to the new equilibrium in the money market.] [5]

(c) What effect will the policy change have on investment, on aggregate expenditure? Include diagrams in your answer. [5]

(d) What additional effect will there be on aggregate expenditure if the economy was an open one? [

Answer 1

Two potential causes of inflation above target are continual attempts to stimulate aggregate demand and people's expectations of inflation. Central banks respond to increasing inflation rates by increasing their policy interest rates, adjusting the money supply to decrease inflationary pressures. The policy change can decrease investment and aggregate expenditure, while in an open economy, it can also affect net exports.

Step-by-step explanation:

Two potential causes of inflation above target are continual attempts by the government to stimulate aggregate demand and people's expectations of inflation. In the AD/AS diagram, if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, inflation can occur.

Additionally, if people expect a certain level of inflation, it can lead to price, wage, and interest rate increases.

When central banks respond to increasing inflation rates by increasing their policy interest rates, it affects the money market. An increase in interest rates reduces the demand for loanable funds, leading to a decrease in investment. To support this policy decision, central banks must adjust the money supply to decrease inflationary pressures.

The policy change can also have an effect on aggregate expenditure. In an AD-AS diagram, an increase in interest rates would shift the aggregate demand curve to the left, resulting in a decrease in investment and aggregate expenditure.

In an open economy, the effect on aggregate expenditure would be influenced by international trade. Higher interest rates might attract foreign investors, leading to an increase in capital inflows and an appreciation of the currency. This would decrease net exports and result in a decrease in aggregate expenditure.