Suppose last month’s inflation report estimated monthly inflation to be 0.4% over the month. The monetary authorities want inflation to not exceed 2% per year. Estimates of potential output state that our economy is currently near potential output. Unemployment rates have been stable at around 5%, but these rates have been rising slightly in the past months. Give a brief summary of what policy makers might be concerned about and suggest what you might do about it, if anything at all. Support your recommendation with analysis using the AS/AD model to illustrate your points.

Question

Suppose last month’s inflation report estimated monthly inflation to be 0.4% over the month. The monetary authorities want inflation to not exceed 2% per year. Estimates of potential output state that our economy is currently near potential output. Unemployment rates have been stable at around 5%, but these rates have been rising slightly in the past months. Give a brief summary of what policy makers might be concerned about and suggest what you might do about it, if anything at all. Support your recommendation with analysis using the AS/AD model to illustrate your points.

Answer 1

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Answer 2

Based on the given information, policy makers might be concerned about the following:

1. Inflation exceeding the target: The estimated monthly inflation rate of 0.4% suggests that the annual inflation rate could potentially be higher than the desired 2% target. This could lead to an erosion of purchasing power and potentially disrupt the stability of the economy.

2. Rising unemployment rates: Although unemployment rates have been relatively stable at 5%, the fact that they have been slightly rising in recent months could be a cause for concern. Increasing unemployment can lead to reduced consumer spending, lower aggregate demand, and overall economic slowdown.

To address these concerns, policy makers have a few options:

1. Tighten monetary policy: The central bank could employ tighter monetary policy measures, such as raising interest rates, to curb inflationary pressures. By making borrowing more expensive, this would reduce overall spending in the economy, leading to lower aggregate demand and potentially curbing inflation.

Using the AS/AD model, we can illustrate the impact of tighter monetary policy. As interest rates rise, it would lead to a decrease in investment and consumption. This would shift the Aggregate Demand (AD) curve to the left, causing a decrease in both price levels and output. The adjustment would help bring inflation closer to the desired target.

2. Expansionary fiscal policy: Policy makers could also consider implementing expansionary fiscal policies, such as increasing government spending or reducing taxes. These measures can boost aggregate demand and stimulate economic activity, potentially addressing the rising unemployment rates.

Using the AS/AD model, we can illustrate the impact of expansionary fiscal policy. An increase in government spending or a reduction in taxes would lead to an increase in government expenditure or private consumption, respectively. This would shift the Aggregate Demand (AD) curve to the right, causing an increase in both price levels and output. The adjustment would support reducing unemployment.

It is important to note that the effectiveness of these policies may vary depending on the specific circumstances and the overall economic environment. Therefore, policy makers should carefully assess the situation and consider a combination of monetary and fiscal measures to achieve their objectives. Additionally, thorough analysis of other factors, such as productivity, wage growth, and global economic conditions, would further inform the appropriate policy response.