Demand Shock in Economy - Assignment Example

Dynamic AD/AS Model; Monetary Policy Table of Contents Answer to question 1 2 Answer to question 2 4 From the adaptive expectation rule we have Et (πt+1) = πt, so Et-1 =πt, or πt = 2% i.e. 2 4 Answer to question 3 6 Answer to question 4 7 Answer to question 5 9 Answer to question 1 Demand shock occurs when suddenly demands for goods as well as services rises or falls. A positive shock in demand increases the demands for goods as well as services whereas a negative shock in demand decreases the demands for goods as well as services. As the demands for goods as well as services rises or falls subsequently its price too rises or falls. As a result the demand curve shifts either to the right or to left. Such a shock can take place when the Government decides to go for a tax reduction or loosen its monetary policies or by decreasing or increasing the government spending. Thus a demand shock basically represents an event in which the demands for goods as well as services are influenced for given values of parameters such as natural output level and real rate of interest (Mankiw, 2006). A negative demand shock reduces the output level and reduces the inflation prevailing in the economy as well as reduces the level of real and nominal interest rate. No suppose there occurs a demand shock in the economy that persists for 4 years. The dynamic effect can be analysed with the help of a diagram below. At the initial condition the i.e. at period t-1 the output level is Y. With a sudden demand shock the supply side of the economy does not react immediately at time t. So as a result of the demand shock the output and the inflation will fall from the actual level A to B as depicted in the figure. In the periods following from t+1 to t+3, the demand shock that is negative in nature persists. At this time the inflationary expectation fall as the future inflation is based on the expected inflation which has fallen due to the negative demand shock. Also as a result of this negative demand shock an output gap arises which persists in the periods following. So it is expected that the central bank will react by lowering its nominal rate of interest. As the nominal rate of interest falls so does the real interest falls. These effects are depicted in the diagram below with the help DAS and DAD curves. The movements from A to E represent the reactions of the parameters due to the demand shocks (Mankiw, 2006). At period t+4 since the DAS curve continues to move downwards as a result of the low inflationary pressure in the period t+3. As the negative demand shock that is described in this situation persists the DAD curve returns to its actual position which is DADt-1, t+4, thus the economy moves to point F. Since the DAS curve is lower than it was earlier, so a recovery process will cause the curve to move upwards to point A. This may be due the rise in employment level or an increase in the wage rate by the workers in the economy or a general rise in the output level owning to the inflation prevailing in the economy. Source: Mankiw, 2006 Answer to question 2 As the economy undergoes a demand shock, the central bank responds immediately to combat the ill effects of such a shock. Generally in real case scenario the shock persists for several time periods. A negative demand shock calls for a fall in the output and the inflation level. Therefore the Central bank responds by lowering the level of interest rate. Now as the interest rate falls, so the level of goods as well as services demanded rises. Thus the contractionary effect of demand shock is offset. As the inflation level falls, so does the expected inflation level. As a result of the demand shock the nominal and the real rate of interest falls, however as the shock disappears the interest rate too increases (Mankiw, 2006). From the adaptive expectation rule we have Et (πt+1) = πt, so Et-1 =πt, or πt = 2% i.e. 2 The nominal interest rate is given as i= πt + ρ + φπ (πt –π*) + φy (Yt – Y) i = 1.091+.02+0.5(1.091-0.2) + 0.5 (96.36 – 100) = -0.1745. Real rate of interest Rt = it - πt = - 0.1745 – 1.091 = - 1.2665 Answer to question 3 Inflation targeting is basically an economic policy where by the Central bank of the economy tries to project a targeted level of inflation and tries to drive the economy towards that level by using various monetary tools. If the prevailing rate of inflation is above the target then the Government raises its interest and the opposite happens when the inflation is below the target. A negative demand shock causes the inflation level of the economy to fall. Therefore the Central bank loosens the monetary policies so that the economy comes back to the targeted level of inflation, this further causes the economy to go back to the full employment level. Since the interest rate rises as the inflation is above the targeted level, this prompts the Central banks to go for inflation targeting. Thus inflation targeting can make wonders to an economy if it initially lowers than the targeted level. Now if the Government goes for a permanent reduction in the inflation targeting in period t, then the DAD curve will shift leftwards from DADt-1 to DAD t, t+1,....,. Thus the economy shifts from point A to point B. Thus the level of inflation and the output level fall. As the inflation in the future is based on the expectations from the previous experiences so the expected rate of inflation too decreases. Hence the DAS curve moves down. The economy therefore shifts to point C in period t+1 from point B. Over the period of time as the expected level of inflation tends to decrease, the DAS curve repeatedly moves downwards and the economy reaches a new level of equilibrium at point Z. Output comes back to the natural level and the inflation ends up at a lower level. As the targeted level of inflation falls the nominal rate of interest increases. However as the expected and the prevailing inflation level falls and moves toward the targeted levels o does the rate of interest falls. So in the short run, the nominal rate of interest rises due to low inflationary target but in the long run it falls (Mankiw, 2006). Source: Mankiw, 2006 Answer to question 4 In the short run as the Central Bank goes for inflation targeting supposedly by reducing its targeted level of inflation then at the first place both the output and the inflation level falls. This is due to the fact that as the targeted level of inflation falls then according to the monetary policy rules the prevailing inflation is above the targeted inflation. Therefore the central bank responds by increasing the level of real as well as nominal rate of interest. As the interest rate raises so the demand for goods as well as services falls. Therefore the output level decreases. According to the Phillips curve the inflation too decreases. However as people base their expectations on the previous experiences so the expected inflation also falls. Therefore over the period of time the inflation tends to fall. Finally in the long run the economy reaches a new equilibrium level where the output goes back to the natural level and inflation sets at a new target. The nominal rate of interest too rises in the short run but falls in the long run (Mankiw, 2006). The monetary policies responds to the inflationary targets according to the influence of two parameters which are firstly, response of targeted rate of interest to inflation and secondly the response of targeted rate of interest to the output level. The central bank can affect the slope of DAD curve as it reacts on the basis of the afore mentioned parameters. The central banks objective is to ensure stability in the economy. On setting the inflation target the central bank suffers various complications depending on the response of the above parameters. The central bank might respond weakly to the inflation on setting the interest rate and strongly to the output. This happens when the economy suffers a supply shock, the rate of inflation rises and this call for a reduction in the rate of interest. The fall in the rate of interest further reduces the demand for goods as well as services. Hence the central bank here reacts as an inflation fighter. On the other hand the central bank reacts weakly to the inflation rate and more strongly to the output level then the policy rules responds by avoiding major recession in the economy and accommodates the inflation shock. The complications can be avoided depending on the Centrals banks choice to play any of the above mentioned cases, so that the trade off between output and the inflation can be avoided. Therefore the central bank needs to decide upon choosing either for output variability or supply shock response to inflation or the combination of the factors (Mankiw, 2006). As per my consideration frequent changes in the inflationary targets misleads the people of the economy as the expected inflation changes frequently due the shocks in the economy. So it may drastically affect the output level and future rate of inflation. Source: Mankiw 2006 Answer to question 5 Apart from going for inflation targeting, the alternative method that the central bank of an economy can adopt is to undergo interest rate adjustment. The objective of a country’s central bank is to ensure stability in the country i.e. maintaining price stability and to have a low unemployment rate as well as a low inflation rate. According to the AD- AS model the policy rule adopted by ECB will eventually lead to more variation in the output and a more stable inflationary rate, given other things remaining constant. However interest rate adjustment is better than inflationary target as frequent changes in the inflationary targets misleads the people of the economy, as the expected inflation changes frequently due the shocks in the economy. So it may drastically affect the output level and future rate of inflation (Mankiw, 2006). References Mankiw, G. 2006. Macro economics. Worth publishers. Read More