Question

Suppose initially that inflation is at the central bank's target and the output gap is zero. Then, government spending goes down. Assume that the central bank has a quadratic loss function. In the basic Taylor rule, if the output gap becomes negative due to the decrease in government spending, what action is the central bank likely to take?

A) Increase the policy rate to reduce inflation
B) Decrease the policy rate to stimulate the economy
C) Keep the policy rate unchanged as the target inflation is maintained
D) Implement a contractionary monetary policy to stabilize inflation

Answer 1

In response to a negative output gap caused by a decrease in government spending, the central bank is likely to implement a contractionary monetary policy by increasing the policy rate to reduce inflationary pressures.

Step-by-step explanation:

In the scenario described, government spending has decreased, causing the output gap to become negative. In response, the central bank is likely to implement a contractionary monetary policy to stabilize inflation.

This means the central bank would increase the policy rate to reduce inflationary pressures. By increasing interest rates, the central bank aims to discourage borrowing for investment and consumption spending, which helps to reduce demand and stabilize inflation.